Independence and Nonpublic Companies
Examining New Rules in a Different Reporting Environment

By Jeffrey S. Zanzig and Dale L. Flesher

Auditor independence protects the interests of capital providers in public capital markets. Investor losses, in part attributable to recent audit failures such as Enron and WorldCom, have subjected the accounting profession to increased regulatory scrutiny. The Sarbanes-Oxley Act of 2002 has created stricter independence requirements for the auditors of publicly traded companies. Although the act applies primarily to public companies, section 209 of the act delegates to state regulatory agencies the applicability of the standards to small and mid-sized accounting firms that provide services to nonpublic companies.

The audit process has long served the financial markets by ensuring reliable financial reporting to an organization’s stakeholders. An audit client can obtain short-term benefits when its auditor acquiesces to questionable reporting practices. As questionable reporting practices are revealed, however, stock prices can drop dramatically because stakeholders cannot depend on the information in financial reports and on the audit process that approves them.

An auditor must objectively judge whether management has met appropriate financial statement assertions as required by GAAP. The auditor cannot permit a personal relationship with the client to interfere with objectivity. The audit process provides the highest level of assurance; other common types of nonpublic financial statement engagements include reviews and compilations. A review provides only limited assurance as to whether the financial statements comply with GAAP, while compilations provide no such assurance. Whether the new independence rules for public companies should apply to audits, reviews, and compilations of nonpublic companies remains an open question.

Reporting Environment of the Nonpublic Company

Because auditor objectivity is such an important part of the financial reporting process, the argument can be made that independence rules should be the same regardless of whether the audit client is a public company. In considering this argument, it is beneficial to consider two ways in which the reporting environment of the closely held nonpublic company differs from the public company:

It is commonly understood that an external auditor must be independent in both fact and appearance. Recent audit failures have increased the importance of how the public perceives auditor independence. As a result, the Sarbanes-Oxley Act prohibited auditors from performing certain services considered incompatible with the audit function. An important question is whether this deterioration of perceived auditor independence has also occurred in the nonpublic company environment.

In considering the nonpublic company environment, Nicholas Mastracchio, Jr., in “Independence and the Users of Closely Held Companies’ Financial Statements” (CPA Journal, June 2002), surveyed lenders about independence and the audit process. Interestingly, the lenders generally felt that having the auditor provide services in the areas of bookkeeping, systems design and installation, and valuation either enhanced the audit process or made no difference. This evidence indicates that the reporting environment of the nonpublic company may allow auditors to perform some of what are now considered to be incompatible services for the auditors of public companies. If so, independence in fact should be the primary concern in determining whether the services prohibited by the Sarbanes-Oxley Act should be extended to auditors of nonpublic companies. Independence in fact can only be determined within the mind of the auditor.

Research Methodology

This research considers how CPAs feel about applying the independence provisions of the Sarbanes-Oxley Act to financial statement engagements involving nonpublic companies. The survey was sent to 963 Alabama CPAs in public practice. A total of 244 usable surveys were received, a response rate of 25%. Survey participants indicated that 58% of the firms provide audit services, 69% provide review services, and 95% provide compilation services.

For each of the independence provisions, respondents were asked to rate its applicability to the three types of nonpublic company engagements: audits, reviews, and compilations. Responses were based on how the independence provision would best serve the public interest with regard to nonpublic company engagements, and were based on a scale from 1 (strongly disagree) to 5 (strongly agree).

Independence Concepts

The survey presented five concepts dealing with the independence of the accountant in a financial statement engagement. Formal statistical analysis (the Kolmogorov-Smirnov test) identified differences in the distributions of responses for audits, reviews, and compilations. Audits and reviews were analyzed further to determine if the responses of accountants that provide the services differed from responses of accountants that do not.

Because the applicability of an independence concept could depend on the level of assurance the accountant is providing, the analysis compares the distributions for the three levels of service. For each concept, tables show the extent to which CPAs are in agreement as to whether the accounting profession should adhere to the concept. Interestingly, the distributions for audits, reviews, and compilations are significantly different from each other except for Concept 5, periodically rotating the accounting firm.

For audits and reviews, the tables also indicate when the responses of CPAs providing the engagement are significantly different from the responses of those that do not. Such differences between providers and nonproviders were found to exist, particularly between auditors and nonauditors.

Traditionally, accountants have been permitted to perform both accounting and audit services as long as the following three requirements were met:

Concept 1. The results of this survey indicate that CPAs generally believe it is acceptable to combine bookkeeping services with compilation or review engagements. Many respondents believed, however, that combining these services may interfere too strongly with the objectivity necessary for an audit. Nonauditor CPAs were even less likely than auditors to think that combining bookkeeping and audit services is acceptable (Exhibit 1).

Concept 2. CPAs do not appear to find a problem with combining systems design and implementation services with compilation or review engagements; however, the responses indicate a lack of consensus about the compatibility of combining an audit engagement with such services. Although CPAs generally favored allowing the services with an audit engagement, 36% thought that combining the services could cause a problem. Nonauditor CPAs were less likely than auditors to think that combining audits with systems design and implementation services is acceptable (Exhibit 2).

A possible explanation for these results is that good internal controls in an information system can limit the opportunity for errors to enter into the financial statements. The auditor’s help could be beneficial in making sure such controls are implemented from the beginning. There is the potential, however, that auditors may not be able to objectively evaluate financial information generated by a system that they created.

Concept 3. Many CPAs thought that an accountant performing a compilation engagement could also perform appraisal or valuation services for the client. For review engagements, the average response of 3.47 indicates some uncertainty about providing such services in conjunction with a review. In contrast, more than half of the respondents indicated a potential problem with independence when the auditor also performs appraisal or valuation services for the client (Exhibit 3).

Concept 4. For both review engagements and compilation engagements, respondents believed that the rotation of supervisory personnel off the engagement is unnecessary. CPAs that do not perform review services are more likely than reviewers to favor supervisor rotation for review engagements. The responses also show some support, primarily from nonauditor CPAs, for supervisor rotation in audit engagements. CPAs providing audit services were more likely to disagree with requiring supervisor rotation for audit engagements (Exhibit 4).

An accountant who establishes a long-term working relationship with a client risks becoming complacent to the point that, because of past experience, appropriate thought is not given to the audit process. Auditor CPAs may be weighing the benefit of rotation of audit supervisors against the value of having personnel familiar with the client and its system of internal controls. Indeed, prior knowledge of the audit client is an important source of information in both evaluating internal controls and performing substantive testing.

Concept 5. The responses indicate that periodically rotating the accounting firm off the engagement is unnecessary for each of the three types of engagements; however, the level of disagreement for audits was not as strong as for compilations and reviews. Nonauditors expressed significantly less disagreement with periodic rotation of the audit firm than did auditors (Exhibit 5).

Limitations in the Application of Sarbanes-Oxley?

The SEC points out that the auditor of a publicly traded company must be independent in both fact and appearance. Independence in appearance is necessary in order for financial statement users to place value on the audit report. Independence in fact must be present for an auditor to be truly objective in evaluating whether a set of financial statements is presented in accordance with GAAP. Financial statement users of nonpublic companies, however, are often more informed about the audit client and may prefer more flexible rules regarding independence in appearance.

The survey conducted in this research is limited in that CPAs have a vested interest in keeping their current engagement relationships, which might be disrupted by stricter independence requirements. Three offsetting arguments can be raised against this limitation.

First, the CPA profession has long demonstrated itself to be composed of individuals with a high level of integrity. Second, there is evidence that some accounting services considered incompatible with audit under Sarbanes-Oxley may not affect independence in appearance for nonpublic companies. Because independence in fact deals with the accountant’s thought process, no one other than CPAs themselves can definitely assess whether they are truly objective in fact. Finally, a comparison of the responses of CPAs providing audit and review services and the responses of CPAs that do not can remove the individual economic motive.

Smaller CPA firms may fear that auditor rotation and making certain services incompatible with financial statement engagements could result in lost business that could seriously damage their ability to survive. The following quote from one respondent expresses a desire for less government intervention:

The AICPA has stringent rules in place. The government or nonprofessionals can unnecessarily and ineffectively complicate legitimate small business operations and [generate] ridiculous costs. Accountants do not automatically give up their independence by performing nonaudit services. Each CPA must honestly assess [his] own position and if [he is] not “in fact” independent must withdraw from the engagement (or refuse it). Honesty and integrity cannot be replaced or substituted by the government.

It is interesting that CPAs that provide auditing services are generally less inclined than nonauditor CPAs to think that some of the independence provisions of Sarbanes-Oxley should be implemented in the nonpublic arena. Is this reluctance a concern about the audit process or a fear of upsetting current business relationships with clients? Both are important concerns that must be dealt with in a manner that protects the audit process while minimizing the disruption of smaller firms providing services within the accounting profession. Too disruptive a change could cause an upheaval of business relationships that would destroy many small accounting firms. However, too little action could eventually result in a loss of trust in the CPA profession.

Objectivity is difficult to prescribe. Primary emphasis must be placed on guidelines that will prevent accountants from losing objectivity by inadvertently becoming too closely tied to their clients. The opinions expressed in this survey should help in understanding the true independence in fact of the CPA in financial statement engagements. It can also be said that auditors see themselves as more independent than nonauditor CPAs. This might indicate that financial statement users might find auditors even less independent than do nonauditor CPAs. The result is that some aspects of the Sarbanes-Oxley Act, at least with regard to audits, may be seen as essential by state regulators. There is less evidence of a need for the act’s provisions to apply to reviews and compilations.

Jeffrey S. Zanzig, PhD, is an assistant professor at the college of commerce and business administration, Jacksonville State University, Jacksonville, Ala.
Dale L. Flesher, PhD, is a professor in the school of accounting at the University of Mississippi.

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