Proposals to Improve the Image of the Public Accounting Profession

By Franklin Strier

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The impact of the scandals on investor confidence was striking. In October 2002, the General Accounting Office (GAO; now the Government Accountability Office) issued a report on the impact of nearly 700 financial statement restatements by public companies between January 1997 and March 2002 due to audit failures and accounting fraud. Those restatements resulted in an estimated loss to the shareholders of the restating companies of $100 billion. The report states that investor confidence in June 2002, one month before the enactment of the Sarbanes-Oxley Act (SOX), “was at an all-time low due to concern over corporate accounting practices.” Monthly surveys indicated that 91% of respondents agreed that “accounting concerns are negatively impacting the market” and 71% agreed that “accounting problems are widespread in business.”

Viewed from a larger perspective, the conflicts of interest at the core of the corporate accounting frauds can be characterized as a corporate governance issue. Corporate governance is monitored by several gatekeepers, internal and external. The primary internal gatekeeper is the corporate board of directors. Internal auditors, in-house legal counsel, and audit committees are other internal corporate governance gatekeepers. The external influences are many and include external auditors (i.e., CPAs), government (e.g., the SEC) and nongovernment regulators (e.g., the New York Stock Exchange), investment bankers, and security analysts.

When it comes to the reliability of public company financial statements, however, the reality is that an auditing firm is, by far, the most competent and best-situated gatekeeper. Corporate directors and officers are often the source of the accounting irregularities and can usually negate objections or warnings by other internal gatekeepers. Regulators are typically too far removed and may lack the necessary expertise to detect the problem at any given company.

What Led to the Breakdown?

Nonauditing revenue and conflicts of interest. Beginning in the 1970s, client loyalty faded and the auditor-client relationship changed. Auditing became a low-profit activity as research found that clients increasingly searched for the lowest prices and the loosest standards. Yet competition for audit clients rose in the 1980s despite declining profit margins for auditing, because of the high profitability of the numerous new consulting and other nonaudit services being offered. With this enticement, the financial incentives for auditors to become advocates for their clients’ accounting practices were stark and undeniable. A conflict of interests inevitably arose. How audit firms responded laid the groundwork for the recent scandals.

These new services put pressure on the independence of the auditors, especially the large firms—and, as the Supreme Court indicated in the Arthur Young case, independence is the polestar for auditors. In some cases, the expansion of CPA firms into the new and highly lucrative nonauditing services for audit clients, sometimes referred to as horizontal integration, clearly compromised their objectivity. SEC Chairman Arthur Levitt was a prominent critic of these arrangements, claiming that “auditors did not want to do anything to rock the boat with clients, potentially jeopardizing their chief source of income” (Take on the Street, 2002).

As the major firms grew through horizontal integration, they dominated the profession. Former employees went to work within the industry, amplifying the already significant influence the major firms had over the accounting institutes, most notably the AICPA. The hegemony of the major firms led some to believe that the profession did not have an independent voice (E. Kliegman, “The Demise of the Profession,” Accounting Today, Jan. 27, 1999). The startling growth in nonaudit services precipitated a pervasive perception that public accounting firms lacked independence from their biggest clients [Zeff, “How the U.S. Accounting Profession Got Where It Is Today: Part II,” Accounting Horizons, 17(4), 2003]. The major firms, who had the most at stake, vigorously opposed reforms proposed by the Public Oversight Board to eliminate the growing conflicts of interest arising from auditing and consulting for the same client.

The unwillingness of the profession to address the problems created by its conflicts of interests was discussed, in devastating detail, in a SEC draft report, commissioned by then–SEC Chairman Levitt and published by The Wall Street Journal (J. Weil and S. Paltrow, “Peer Pressure: SEC Saw Accounting Flaw,” Jan. 29, 2002). The report describes how peer reviews of the major firms found numerous instances of auditing improprieties due to conflicts of interests that cast serious doubt as to the auditors’ independence. Despite the severity of their findings, the reviewing firms always gave positive feedback in the public parts of the review, including a review of Arthur Andersen’s professional standards by Deloitte & Touche just before the Enron scandal.

The SEC’s draft report was highly critical of the peer review process. Beyond simply changing the process of auditor oversight, it recommended changes in the way accounting and auditing standards are set. (In this regard, it was an augury of SOX reforms.) But the SEC’s project was shelved when Levitt was succeeded as SEC Chair by Harvey Pitt in August 2001.

WorldCom’s June 2002 announcement that it had overstated earnings by $3.6 billion led to the passage of the SOX legislation. The AICPA and its allies thus tried to weaken the implementation and enforcement of the law. It was critical for them to find the right person to head the PCAOB. When it was found that John Biggs, the retiring head of TIAA-CREF and the initial candidate to head the PCAOB, might favor the PCAOB’s writing its own rules (most important, a ban on consulting services for audit clients), the AICPA lobby and its allies in Congress and the White House pressured Pitt to rescind the offer (Levitt, Take on the Street, and R. Kuttner, “So Much for Cracking Down on the Accountants,” BusinessWeek, Nov. 18, 2002).

Prior to his appointment to the SEC, Pitt had represented both the AICPA and the Big Five. He was the principal author of the AICPA’s 1997 white paper opposing the SEC’s proposal to severely curtail the consulting work that accounting firms could do for companies they audit. This impression was reinforced when he rescinded the PCAOB offer to John Biggs and instead appointed William Webster, a former head of both the CIA and the FBI. When Webster’s involvement with U.S. Technologies, a troubled company for which Webster had served as chair of the audit committee, became a front-page scandal, both Pitt and Webster were forced to resign their respective positions.

Audit partner compensation. The pressure to accept unduly aggressive and questionable “earnings management” when a client was also a source of consulting revenue was reinforced by auditor compensation policies that rewarded partners who generated the most business rather than those who delivered the highest-quality audits (American Assembly, The Future of the Accounting Profession, 2003). In her book about her service at Arthur Andersen, former ethics consultant Barbara Toffler observed that auditors were punished if they required a restatement of a client’s financial reports (Final Accounting: Ambition, Greed and the Fall of Arthur Andersen, Broadway Books, 2003). Consulting-oriented compensation systems further tempted the accounting gatekeepers to forfeit their autonomy.

Reduced auditor liability. Beginning in the 1980s, managers increasingly used earnings management to meet Wall Street analysts’ expectations, often with auditor approval (M. Stevens, The Accounting Wars, Macmillan, 1985). As a result, auditors increasingly found themselves targets of lawsuits. Thereafter, auditors would approve aggressive statements if the increasingly complex and prescriptive accounting rules from FASB were followed to the letter. If the rules were followed, the financial statements were fair, or alternatively, if the practice was not prohibited, it was permitted. The now-infamous special-purpose entities used by Enron to keep liabilities off the balance sheet were allowed under GAAP.

The major firms obtained Congressional passage of the Private Securities Litigation Reform Act of 1995, which reduced plaintiffs’ incentives to sue secondary participants such as auditors (see Zeff, 2003). A sharp increase in the number of earnings restatements followed in the late 1990s. Restatements by the companies listed on the NYSE, Amex, or Nasdaq tripled between 1997 and 2001, according to the GAO. Of the restatements from 1997–2002, 39% were attributable to premature recognition of income.

The battle over stock option expensing. For years, an intense battle was waged over the accounting treatment of stock option compensation. The widespread use of nonexpensed stock options is generally thought to have led to inflated stock market valuations, excessive compensation, accounting frauds, and bankruptcies. Inasmuch as corporations do not write checks when granting options, they argued that there is no cost and, thus, nothing to expense. (Options do have a cost to other shareholders, because once exercised, they dilute the value of existing shares.) In 1994, FASB considered the nonexpensing of options to be deceptive accounting, and was prepared to put out a rule that would require that companies expense options at their fair market value. But strong lobbying by the business community and the accounting profession defeated the proposal in 1994 and effectively kept it off the table until the recent corporate scandals.

In the aggregate, this history describes a profession that has taken no substantive steps to resurrect its former image as a trusted public fiduciary. Despite its role in financial scandals and eroding investor confidence, it has instead sought to find safe harbors in FASB, GAAP rules, and liability-limiting legislation.

Reforms. The principal governmental reform vehicle of public accounting, of course, has been SOX, with its major restrictions on public auditors and creation of the PCAOB. Auditors are prohibited from offering eight specific types of consulting or other nonaudit services to their audit clients. In addition, the lead audit partner must rotate off an audit every five years. Another restriction seeks to resolve the “revolving door” phenomenon by requiring that “the CEO, Controller, CFO, Chief Accounting Officer or person in an equivalent position cannot have been employed by the company’s audit firm during the one-year period preceding the audit” (section 206).

All of these measures, however, fall short of more far-reaching and effective measures. For example, auditors can still provide tax and other nonprohibited services to audit clients if the audit committee approves. The SEC had proposed adding tax compliance and planning services to the list of prohibited services, but backed off after harsh attacks from accounting firms (J. Glater, “SEC Backs Rules for Auditors, Revised from Original Plan,” The New York Times, Jan. 23, 2003). It is also a curiosity why the law allows the PCAOB to grant specific exemptions from the eight prohibited nonaudit services.

With respect to rotating the lead auditor partners, a more effective reform would have been to bar the entire audit firm and not just the lead auditor. The SEC had originally proposed requiring all partners on the audit team, not just the lead auditor, to rotate every five years, but, again, backed off under pressure.

If the law is to be effective in preserving and fostering auditor independence, the rotation periods should be as short as possible and cover the entire firm. While annual rotation may not be economically feasible, rotations longer than two years would likely compromise the “total independence from the client at all time” mandated by The United States v. Arthur Young et al. [(1984) 465 U.S. 805].

The ban on former auditors is also inadequate. A mere one-year ban is insufficient to prevent conflicts of interest. Moreover, there is no bar on transfers from the auditor to higher-level positions within the former audit client that are directly below positions such as the CEO, CFO, and controller. Last year’s auditor, for instance, can immediately become an assistant vice president of accounting, wait a year, and then step up to one of the restricted positions.

The most substantial reform of SOX, and one that largely overcomes the deficiencies of sections 201, 203, and 206, is the reinvigorated role of corporate audit committees under the new law. SOX section 301 requires that an audit committee composed entirely of independent members of the board of directors be directly responsible for the appointment, compensation, and oversight of outside auditors. The audit committee is charged with resolving the management-auditor financial reporting disagreements that result from conflicts of interest. The audit committee is independently funded and must establish “whistleblower” procedures for handling complaints, including anonymous submissions by employees. Furthermore, the committee has the authority to engage outside counsel and other advisors it deems necessary to fulfill its duties. At least one member of the audit committee must be a financial expert; finding qualified individuals who are independent may prove difficult.

SOX clearly made inroads in reducing the potential conflicts of interests for auditors. But SOX can also be criticized for what it did not do. Conspicuous by its absence was any attempt to resolve the options-expensing battle (although that was eventually done by FASB). And while it removed some opportunities for acquiescing in accounting irregularities, SOX did not strengthen any deterrence to do so for those opportunities that remained. Specifically, it left the Public Securities Litigation Reform Act of 1995 nearly untouched. As long as a corporate governance gatekeeper has a financial tie to a corporation, as does an external auditor that also provides nonauditing services to its client, there will remain the need for a gatekeepers’ gatekeeper.

This appraisal of SOX’s ineffectiveness was supported by the findings of a recent survey of executives from multinational corporations (J. Whitman, “Sarbanes-Oxley Begins to Take Hold,” The Wall Street Journal, March 25, 2003):

• Only 9% agreed that SOX “is a good and adequate response to problems in accounting and reporting.”
• Only one-third agreed that SOX will “restore investor confidence.”
• Half of finance chiefs and managing directors agreed that SOX will have “no impact” at all.

Regarding the accounting treatment of stock options, in 2004 FASB proposed a rule mandating the expensing of stock options. And the opposing forces, including the public accounting industry, again mounted a counterattack through proposed Congressional legislation. This time, however, the proposal survived and took effect in June 2005. The new rule did not mandate a method for expensing use, but nearly 300 public companies had already voluntarily decided to expense options when the standard took effect [C. Schneider, “Who Rules Accounting,” CFO 19(10), 2003].

Proposals

If dissatisfaction with public accounting ethics and practices—influenced in no small part by the public image projected by the profession—crosses the threshold of tolerance in the investing community, new restrictive or punitive legislation would be possible. For example, SOX could be amended to preclude auditors from the most lucrative consulting services for audit clients. Additionally, auditor liability for accounting fraud or other irregularities could be expanded.

But remedies imposed by legislation and regulation have innate limitations. They can, for example, be financially onerous or otherwise impracticable. Ideally, needed remedies could be fashioned by the auditing profession alone or in conjunction with the regulatory body. Recently, the 103rd American Assembly of Columbia University convened to consider the future of the profession in light of its current problems. There were 57 individuals from the top ranks of business, government, academia, and the accounting profession. Their report (2003) makes certain recommendations addressing the following issues.

One recommendation seeks to restore the importance of the quality of audits by establishing different systems of compensation incentives for audit partners. Emphasis should shift from rewarding those who generate new business and the cross-selling of nonaudit services to those who perform top-quality audits. The Assembly suggests that the PCAOB verify the quality of audits.

Another recommendation seeks to disabuse financial-report users of the common misconception that a proper audit can determine with a high degree of precision whether management has accurately portrayed a company’s finances—what the Assembly refers to as “the illusion of exactitude.” While this reliance may have been more defendable for traditional companies, in a knowledge-based economy, a large percentage of corporate assets are intangible, requiring estimates and assumptions. Valuation of these assets inescapably involves management subjectivity, and the auditor’s review requires judgment rather than the formulaic application of rules.

To shatter the “illusion of exactitude” with regard to financial statements, the report recommends the adoption of a variety of new reporting formats and new attestation standards for auditors. Auditors would continue to use the current wording to vouch for concrete, nonspeculative items, such as historical costs. But for speculative items that don’t have usable historical costs or reliable market prices, a more limited attestation standard regarding procedure could be used; for example: “The corporation’s judgments regarding estimated fair value used a clear and seemingly reasonable process.” The auditor’s statement would not attest to the estimate itself. Some values may be presented as a range of numbers, like management forecasts. The overall goal is greater financial-statement transparency.

The logic behind this recommendation is sound. Whether government, investors, or creditors would accept it is another matter. It shifts the burden of making new and subtle distinctions to the users of financial statements. Recognizing that the adoption of new reporting formats and varying CPA attestation standards may create uncertainty and unpredictable reliance, the report also recommends reduced auditor liability. The caveat is that although a tradeoff of greater transparency for reduced liability is also reasonable, it would not, on that basis, conduce renewed investor confidence, which, in the current climate, is the overarching immediate objective.

The last recommendation is the most obvious, most essential, and, perhaps, most elusive. It is simply that the Big Four should reassert the prominence of ethics and professionalism. The American Assembly’s report exhorts them to “maintain a culture in which the only acceptable behavior is the most ethical.” This was once self-evident, but has become obfuscated. Before the scandals, Arthur Andersen had long been recognized as the gold standard among CPA firms for integrity and high standards. Its self-destruction is a metaphor for the tarnished image of a once proud profession and a clarion call for rededication to its primary, fiduciary role.

The Image of the Profession

The appearance of a public accountant’s independence from client manipulation is of critical significance to investor confidence. Yet notwithstanding recent financial scandals that have tarnished its reputation, the profession has done little to restore that confidence. Rather, its overall performance bespeaks a continuation of acting in its clients’—and its own —financial interests, instead of the public interest. If the profession is to avoid public condemnation—and, perhaps, restrictive new remedial legislation or regulation—it would be well served to return to its previous emphasis on ethics, professionalism, and independence from client influence.