| CPA
Independence, Present and Future
My
last two columns have discussed the origins of CPA independence
and its development as the foundation for CPA ethics. In essence,
independence at the turn of the 20th century referred to an
objective, neutral, unbiased state of mind, with restrictions
on the accountant being an advocate for, a manager of, or
an investor in a client entity. The general expectation was
that an accountant would take the perspective of the business
owners.
Entity
Focus and the Appearance of Independence
Two
developments that began in the 1930s—federal legislation,
which created the demand for a national set of accounting
principles, and the general acceptance of Paton and Littleton’s
entity and going-concern assumptions, which focused accounting
on the transactions of the entity rather than on the value
of its owners’ interests—changed the cultural
setting for accountants’ independence. Over the next
three decades, independence came to mean a neutrality of
interest implemented through the commitment to standards:
An accountant did not take the owner’s interest, management’s
interest, government’s interest, or any other interest;
first allegiance was to standards in order to serve the
public interest. The independence standards developed during
this time primarily addressed the appearance of independence,
especially financial interest in clients and family connections
to client management.
In
the last 25 years of the 20th century, the appearance of
independence rose in importance because of developments
in the equity markets, the consolidation of public company
audit firms, and the expansion of their consulting and nonlegal
advocacy services to clients. The Independence Standards
Board attempted to bring order by creating a set of independence
principles for auditors. Public-policy setters eventually
concluded that any potential conflict of interest for an
auditor tarnished the appearance of independence.
The
SEC also faced a double-edged sword. On the one hand, it
wanted company management to take complete responsibility
for functions often outsourced to auditors; on the other
hand, it wanted auditors to adopt an investor protection
orientation. Auditor independence became the lever to accomplish
both. Today, the appearance of a potential conflict of interest
in the mind of investors is enough to impair independence.
The
most striking change to auditor independence, however, has
been who determines whether an auditor is independent. For
most of the history of independence, the accounting professional
was the focal point. Independence was part of the accountant’s
code of professional conduct, and CPA firms tracked the
requirements of independence for every client.
The
Sarbanes-Oxley Act, however, essentially removed the accounting
professional from the decision-making process on independence
as it relates to scope of service issues by giving it to
audit committees. Audit committees determine whether any
work by the external auditor of an SEC registrant impairs
the appearance of independence. The effects of investment
and familial relationships on independence for SEC registrants
are covered in recent regulations that reflect an engagement
team approach.
In
the interest of common ethical standards, the code of professional
conduct tends to reflect changes in federal regulatory activity
for SEC registrants, albeit with some variations. The AICPA
and conforming state societies, including the NYSSCPA, adopted
an engagement team approach to auditor independence that
mostly mirrors the SEC’s regulations. In addition,
shortly after the Sarbanes-Oxley Act was passed, the AICPA
revised Rule 101-3 to deal anew with scope of service issues.
Revised Rule 101-3 places the burden on the CPA to ensure
that nonattest services do not create a conflict of interest
that would compromise the appearance of independence. It
originally took effect December 31, 2003, but the AICPA
recently postponed its effective date until December 31,
2004, with early adoption encouraged.
Individual
Responsibility
Over
the last century, independence has evolved from a focus
on state of mind to a focus on appearance. Nonetheless,
the ethical accountant will continue to be alert to situations
that satisfy the requirements of independence in appearance
but may impair independence in fact. The most common case
of such a situation occurs because an accountant becomes
so close to the client as to be unable to function objectively.
The independence rules and the oversight of audit committees
for public companies cannot plumb an individual’s
feelings.
Although
an audit committee may determine when the appearance of
independence is impaired, no one other than the individual
CPA can determine when impairment of independence in fact
occurs. CPAs with the highest ethical standards will act
responsibly when they know that independence in fact is
at risk.
Responsible
individual actions are the bedrock of professionalism. Regulations
prohibiting certain services because they impair the appearance
of independence should be understood and followed, but they
cannot substitute for the more fundamental ethical responsibility
to remain independent in fact.
Robert
H. Colson, PhD, CPA
Editor-in-Chief
rhcolson@nysscpa.org
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