Independence Impairments Threaten the Public Interest

(My friend, Steven Mintz, the Ethics Sage, has a new column that he has graciously allowed me to post. This is his blog – here.)

The accounting profession has lost its way and has reverted to old behaviors, including increased commercialism, and created a worrisome trend of deficient audits. It may be time to change the regulatory regime and completely prohibit the performance of all non-audit services for audit clients. Restrictions in place since the passage of the Sarbanes-Oxley Act (SOX) in 2002 seemed to work at first as audit firms were on their best behavior, but recently the profession has reverted to commercial behaviors that brings into question their commitment to serve the public interest, not the client’s interest or self-interest.

Most people do not realize that the accounting profession is the only profession where the public interest must be placed ahead of other interests. In law, the client’s interest is above all else. In medicine, with some exceptions, the patient’s interests are paramount. Indeed, the accounting profession is a profession because the SEC created its franchise right in that only CPAs can conduct audits of public companies.

The years and activities since the passage of SOX shows that the profession has reverted to its old ways. Firms like PricewaterhouseCoopers sold off its consulting business back in 2002 to IBM for $3.5 billion. It didn’t take long for PwC to back-track and in October 2013, the firm announced it was acquiring the consulting firm of Booz & Company thereby adding $9.2 billion in global consulting revenue to its total global firm revenue of $32.1 billion, or a 28.5% share for consulting services of the overall firm revenue.

Other firms have been sanctioned for providing prohibited non-audit services to audit clients. In January 2014, KPMG agreed to pay $8.2 million to settle charges by the SEC that the firm violated auditor independence rules by providing restructuring, corporate finance, and expert services as well as providing non-audit services such as bookkeeping and payroll services to an affiliate of an audit client. These activities create a self-review threat to independence because the audit firm winds up reviewing its own services.

Some of the independence impairments border on the bizarre, at least with respect to the broadening efforts of Big-4 firms to gain a competitive advantage and bring in lucrative consulting work. In July 2014, Ernst & Young agreed to pay more than $4 million to settle accusations by the SEC that the firm violated independence rules by lobbying on behalf of two of its audit clients, an advocacy threat to independence.

Greed has also infected the actions of some auditors. In May 2013, Scott London, the former partner in charge of KPMG’s Southern California regional practice, provided inside information to a close friend about audit clients. Once KPMG found out, the firm had to recall its audit reports on two clients, Herbalife and Skechers, because of the lack of independence. London sold his soul for $50,000 in cash and a Rolex watch.

A troubling trend is the high level of deficiencies cited in inspection reports by the Public Company Accounting Oversight Board (PCAOB). In 2014, the PCAOB identified deficiencies as high as 54% (KPMG) to a low of 21% (Deloitte). The deficiencies most often cited include a failure of internal controls over financial reporting, inadequate responses to risks of material misstatement, inadequate review and assessment of auditing estimates, and deficiencies in the audit of inventory, loan reserves, and revenue recognition.

The nature of the revenue stream for public accounting firms has changed since the passage of SOX. The audit function that had previously been treated as a loss-leader in many cases has now become a consistent source of firm revenue in part due to compliance requirements with SOX. New requirements, such as the rotation off the audit of the lead and reviewing partners every five years, has, presumably, created a check on auditors getting too cozy with their clients. Moreover, the PCAOB is considering whether to require audit firm rotation every 10-20 years, as has been done in the European Union (EU) for public interest entities.

Protecting the public interest starts with maintaining the foundation of independence and commitment to serve investors and creditors above all else. Given the ongoing challenges for the accounting profession and questionable results of prohibitions of certain non-audit services for audit clients in the post-SOX era, I believe it’s time to prohibit all such services for audit clients. Of course, firms would still be able to provide non-audit services, just not while they perform audit services for the same client.

Are there other options to protect the public interest? Yes. Similar to audits in the EU, the audit function might become a statutory one regulated through “audit directives”. In this case the annual and consolidated financial statements of public interest entities would be based on these prescribed regulations. The big firms would still be able to perform such audits but they would be answerable to the state as well as to investors and creditors. This exists in the U.S. right now through the PCAOB audit requirements, but a statutory regime implies determination by a governmental body that currently does not exist except for areas such as regulated industries (i.e., utilities).

The time has come for the audit profession to rethink the way in which it provides services, both audit and non-audit, to public clients. The recent trends cited above give me great pause about a diminished commitment to professionalism. I believe the reason is non-audit services are performed largely by non-CPAs that have a lesser commitment to the ethics of the profession and serving the public good rather than the commercial and financial reporting interests of their clients. The audit culture and non-audit culture can sometimes be diametrically opposed.

Blog posted by Steven Mintz, aka Ethics Sage, on August 18, 2016. Dr. Mintz is Professor Emeritus from Cal Poly San Luis Obispo. He also blogs at http://www.ethicssage.com.