The Proposed SEC Rule on Auditor Independence and Its Consequences

By Melancon, Barry C. | Journal of Accountancy, October 2000 | Go to article overview

The Proposed SEC Rule on Auditor Independence and Its Consequences


Melancon, Barry C., Journal of Accountancy


Last month members were alerted to a recent SEC proposal(*) that would place severe limitations on the nonaudit services CPA firms can offer to audit clients (see "The SEC's Proposed Rule Threatens Our Profession and the Public," JofA, Sep.00, page 6). Although the proposed rule, S7-13-00, "Revision of the Commission's Auditor Independence Requirements," is meant to strengthen auditor independence, we at the AICPA believe the actual effect would be to weaken the quality of financial reporting, limit companies' choices of outside professionals and damage the economic vitality of many CPA firms without any positive effect on independence. The proposal has dramatic and far-reaching implications, with serious consequences for the future of the accounting profession and the public. We consider it to be the most significant rule proposal on auditor independence since the federal securities laws were enacted in the 1930s.

This radical scope-of-services rule is a solution in search of a problem. Even the SEC enforcement director has admitted the commission has never brought a case alleging that an audit failure occurred as a result of the accounting firm's lack of independence. The U.S. General Accounting Office, in a 1996 report, concluded that none of the studies relating to auditor independence "reported any conclusive evidence of diminished audit quality, or harm to the public interest, as a consequence of public accounting firms providing advisory or consulting services to their audit clients." The POB's Panel on Audit Effectiveness, which was set up at the request of the SEC, found, after reviewing 37 audit engagements involving the provision of nonaudit services to audit clients, not one instance in which nonaudit services "had a negative effect on audit effectiveness." On the contrary, they concluded that, in 25% of the audits reviewed, nonaudit services had a positive effect. Moreover, in its last 10 annual reports to Congress, the SEC never mentioned any concerns about the scope-of-services issue.

The commission, however, relies on a "common sense" hypothesis that nonaudit services may give the auditor so great a stake in the client relationship as to impair independence or judgment. Similarly, the commission seeks to base its case for the profession to undergo radical surgery on the diagnosis that investor confidence in audited financial information could be compromised by the perception that nonaudit services would have that effect. But the regulators' perception of what constitutes common sense is no basis for such draconian regulatory action. Moreover, no study of the perceptions of users of audited financial information supports the massive shift in public policy that the proposed rule would enforce.

An issue for all members

Make no mistake about it--the proposed rule is highly likely to affect virtually everyone in the profession, including members at the smallest firms and those working in business and industry. Although the commission has jurisdiction only over SEC registrants, the rule, if adopted, will set the stage for a new round of regulation by state boards of accountancy and other regulatory agencies. In fact, some banking regulators have already indicated they will follow suit, and the Department of Labor likely will adopt the rule for ERISA audits. The proposed rules could influence the regulatory approach to auditor independence outside the United States as well.

The ripple effect of this precedent thus would reach deep into the profession. While many practitioners may see this as a large firm issue, it is potentially most damaging to smaller firms that may well have great difficulty divesting themselves of their consulting practices.

In particular, if such an effect occurs, the proposed rule will have impact on firms providing reviews and compilations. As these services have independence requirements (except for those compilations where disclosure is made), other services for review and compilation clients could be affected. …

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