Magazine article Regulation

The Push for Auditor Independence: The SEC Sought to Restructure the Accounting Profession with Its New Auditor Independence Rule. (Securities & Exchange)

Magazine article Regulation

The Push for Auditor Independence: The SEC Sought to Restructure the Accounting Profession with Its New Auditor Independence Rule. (Securities & Exchange)

Article excerpt

IN NOVEMBER OF 2000, THE SECURITIES and Exchange Commission (SEC) adopted a new rule that prohibits accounting firms from providing certain non-audit "consulting" services to their audit clients. The rule also requires public companies to disclose in their proxy statements the fees paid to their independent auditors for audit and non-audit services. In adopting the rule, the SEC argued that a basic conflict exists in providing both auditing and consulting services to a client. That conflict, the commission claimed, undermines the integrity of audits.

Initially, the SEC sought a major restructuring of the accounting profession by separating auditing from most consulting services. It failed to achieve that objective primarily because of a lack of evidence demonstrating that providing non-audit services does, in fact, compromise auditor independence. Now, it appears that the SEC has indirectly achieved its objective through the fee disclosure requirement. The SEC used that requirement to send a message to public companies and their audit committees that the size of non-audit fees alone indicates a lack of independence.

The events surrounding the genesis of the Auditor Independence Rule were not the SEC's finest hour. As we argue in this article, the episode represents a failure of the regulatory process -- one that we witnessed first-hand as members of the Public Oversight Board Panel on Audit Effectiveness (also known as the O'Malley panel). An examination of the episode provides important lessons for the future, not just for the SEC, but also for all regulatory agencies attempting to restructure a regulated industry or profession.


By late 1998, the SEC had moved earnings management and the quality of financial reporting and auditing to the top of its regulatory and enforcement agendas. Against the backdrop of a rising stock market and increasing pressure on companies to meet analysts' forecasts of earnings or revenues, a series of major enforcement actions involving accounting irregularities prompted the commission to act.

The SEC focused attention on the conduct of external (independent) audits and the role of audit committees. First, it encouraged the formation of the Independence Standards Board (ISB) to establish standards for auditor independence. Then, the SEC pushed for the formation of both the O'Malley panel to improve the quality of audits and a separate blue ribbon committee to improve the functioning of audit committees. Finally, the commission's enforcement chief announced that the SEC would bring other important actions against both public companies and their auditors for accounting fraud.

Those initiatives had an immediate, positive, and lasting effect by forcing corporate managements to focus on the quality of financial reporting, alerting audit committees to their responsibilities to shareholders, and compelling accounting firms to pay far greater attention to auditing and the quality of their audits. In most of the initiatives, the SEC relied upon the private sector and the self-regulatory organizations of the accounting profession to improve financial reporting and the quality of audits. The profession, through the American Institute of Certified Public Accountants (AICPA), endorsed all of the committees and panels, and directly sponsored and financed most of them.

Yet, inexplicably, before the private sector initiatives could be implemented fully or given an opportunity to work, the SEC proposed the Auditor Independence Rule (Securities Act Release No. 33-7870). The June 2000 proposal came after the commission failed to persuade all five major accounting firms to divest themselves of their consulting activities. (The proposal came at a time when three of the firms, each of which had announced divestiture plans to monetize their investments in consulting, needed relief from current SEC independence requirements to carry out their plans. …

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