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| Advocacy and Independence By Robert H. Colson JANUARY 2005 - I have followed with some interest first the SEC’s 2002 attempt to restrict tax services that auditors provide their clients and, more recently, the deliberations of the PCAOB and its Standing Advisory Group (SAG). This is an interesting problem because, on the one hand, CPAs have for a long time demonstrated their value as tax preparers and advisors, and, on the other hand, the advocacy relationship at the heart of tax services runs counter to the independence expectations for auditors. This problem persists in part because the basic advocacy approach of CPAs to tax services was formed before the securities acts of 1933 and 1934, which changed the fundamental nature of accounting and auditing but did not affect taxation.The Proprietary Perspective Before the securities acts, the proprietary theory of accounting guided financial accounting. The job of the accountant was to value the ownership interests of the proprietor, usually for distribution or settling-up purposes. Under this approach, the accounting was performed from the perspective of the proprietor, which was effective and efficient until the dramatic expansion of the American domestic capital markets in the first quarter of the twentieth century rendered the identification of the proprietor essentially impossible. Accountants were independent of management and accounted objectively for the proprietary interests, from whom they were not independent. The separation of management and ownership in the American public company, coupled with the diffusion of ownership and the ready transferability of ownership interests, created fundamental problems with the accounting model. The changes to the model in the late 1930s involved focusing on accounting for the transactions of the entity rather than the ownership interests of the proprietors. Without a defined perspective to guide the accountant, there arose a demand for standardizing the accounting for transactions by different entities. Changing Meaning of Independance In this new environment, the meaning of independence also changed because accountants no longer could point to a proprietary interest for which they were the agent. Instead, they began to adopt a neutral position, still reflected in the Code of Professional Conduct, in which serving the public interest means that they take no one party’s interest. Although some of these ideas about entity accounting and independence as complete neutrality existed before the securities acts, they were not necessarily generally accepted. The Sixteenth Amendment passed in 1913, 20 years before the securities acts of 1933 and 1934. Because the amendment gave the federal government power to tax incomes, it was natural for the relatively new profession of accountancy, whose primary purpose was to account for income to be distributed to owners, to become involved in the preparation of tax returns and in the rendering of tax advice. Within a short time, at least by 1916, there was a major debate among accounting leaders at the American Association of Public Accountants (now the AICPA) about whether they should be advocates in tax practice, like attorneys, or independent and objective as in their accounting practices. (The distinction between accounting and auditing was not as clear then as now.) In what I understand was a very close vote, the advocates won. And accounting history was made. In 1919, the AAPA also adopted ethical standards that permitted the receipt of contingent fees for tax work, which was later rescinded after the securities acts. The rationales for this standard were that accepting such fees made accountants more like attorneys and aligned their interests more closely with their clients’. The prohibition of contingent fees, unless fixed by a court, continued until a change in the early 1990s, in response to Federal Trade Commission complaints, created more ambiguous standards. The SEC chief accountant, in a recent letter to the AICPA, indicated the commission’s displeasure with the way some accounting firms used the change to rationalize contingent fees for tax preparation when there was merely the probability of administrative or judicial involvement. Advocacy Versus Independance Can the advocacy culture and the independence culture exist simultaneously for the same client? Can an accounting firm be convincingly independent in its audit responsibilities and also convincing advocates in its tax services? It is easier for most observers to conclude from appearances that advocacy will trump independence in a business relationship. In the past, when CPA firms received most of their revenues from accounting and auditing services, it was natural for them to develop a firm culture that exercised advocacy with restraint. Now that many firms generate far more revenues from tax preparation and advice, additional steps may be needed to safeguard the independence culture necessary for auditing. The PCAOB made important decisions about auditors and tax services for public company clients at its December meeting. I’ll be interested to see if their approach will provide a new answer to this old question.
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