Independence and the Users of Closely Held Companies' Financial Statements

By Mastracchio, Nicholas J., Jr. | The CPA Journal, June 2002 | Go to article overview

Independence and the Users of Closely Held Companies' Financial Statements


Mastracchio, Nicholas J., Jr., The CPA Journal


IT'S

NOT QUITE

APPLES-TO-APPLES

The accounting profession has been awash in independence discussions for the last few years. The focus is almost always on SEC registrants and their auditors. Little concern has been expressed for the independence issues facing closely held companies and their auditors. As rule-- making for publicly traded companies proceeds, some have expressed concern that these rules will trickle down to smaller companies unchanged.

Defining the Problem

Earnscliffe Research and Communications reported to the Independence Standards Board in November 1999 that the general consensus on financial statement integrity was that "there might be a slight deterioration of integrity over time, but no more significant in the financial and business sector than in society as a whole." They also reported that auditors currently meet high standards of independence, but there are growing reasons for concern. The report identified the following pressures on auditor independence:

* The variety of services offered by CPA firms

* The use of the audit as a loss leader

* A firm culture where the role of the auditor, who is doing less-profitable work, is seen as inferior to the role of the consultant.

Earnscliffe found that auditors thought that consulting services do not intrinsically threaten their independence, whereas regulators thought that a problem was emerging that needed sweeping immediate action. Regulators predicted-fairly accurately, in hindsight-that a major prolonged market correction could result in a severe backlash from disappointed investors. The report's conclusions were based upon interviews with officers of SEC registrants, investment analysts, and audit partners. No consideration was given to closely held companies or their auditors.

The New SEC Independence Rules

The SEC recently amended its auditor independence rules for the first time since 1983. The preamble to the final rule states:

The accounting industry has been transformed by significant changes in the structure of the largest firms. Accounting firms have woven an increasingly complex web of business and financial relationships with their audit clients. The nature of the non-audit services that accounting firms provide to their audit clients has changed, and the revenues from these services have dramatically increased. In addition there is more mobility of employees and an increase in dual-career families.

The new rules identify nine areas of nonaudit services that could impair independence. Not all of these are new; most were in the previous rules and some are in the current AICPA rules. The rules prohibit valuation and appraisal services where it is reasonably likely that the result would be material to the financial statements. Bookkeeping services are prohibited, as is acting as an officer or hiring the chief financial officer. The auditor cannot act as promoter or underwriter. The auditor cannot install the information system that generates the financial information. Outsourcing the internal audit function to the auditor is prohibited if the company has more than $200 dollars in assets. The SEC also requires proxy statement disclosure of the aggregate amount of audit fees, the aggregate amount of fees billed for financial information systems design and implementation, and the aggregate amount of fees for all other services.

SEC Chairman Arthur Levitt pointed out that the SEC rules pertain only to publicly traded companies and had no direct impact on local firms and their clients. Nevertheless, some countered that state regulatory boards would follow the SEC's lead, under the logic that what is good for the big firms is good for all. Thus, there would be a trickledown effect to the smaller firms and their clients.

Partnering for CPA Practice, the current name for the AICPA's private company practice section, was represented at SEC hearings by the chair of its executive committee, Harold L. …

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