State Senate Committee Holds Second Hearing on Post-Enron Auditor Independence

CPAs Comment on Proposed Legislation to Reform the Profession in New York

By Dennis O’Leary

ALBANY—A second public hearing on the independence of certified public accountants in the post-Enron era was conducted on Feb. 26 by the New York State Senate’s Higher Education Committee, chaired by Sen. Kenneth LaValle.

Kevin J. McCoy and Katharine K. Doran, members of the New York State Society of CPAs Board of Directors, and former NYSSCPA President and current chair of the Ethics Committee of the International Federation of Accountants (IFAC) Marilyn Pendergast testified.

In response to Sen. LaValle’s statement that the public has lost faith in the CPA profession and that “gatekeepers” have become “secretkeepers,” Pendergast stated, “…Responsibility for the Enron affair cannot be laid at one door. The company and its management, the auditors, banks, analysts, regulators and standard setters are among those who will be challenged, and some or all will be found wanting.”

But Pendergast recommended, on behalf of the IFAC, that public members be included on bodies that regulate the profession. She also proposed mandatory peer review of firms that engage in attest services with compliance requirements and principles-based independence standards.

Pendergast, however, stressed that independence safeguards will depend on the size of the firm and size of the client.

“There is a big difference between firms that audit SEC (Securities and Exchange) clients and local firms,” she said.

With respect to principles-based independence standards, Pendergast maintained that “certain activities generally create threats that are so significant that the only options are avoiding the activity or refusing to perform the assurance engagement.” Pendergast said these activities include:

• Determining which recommendation should be implemented. n Reporting, in a management role, to those charged with governance.
• Valuation of matters material to the financial statement that involve a significant degree of subjectivity.
• Making management decisions as to employment of client personnel.
• Promoting or underwriting assurance client services.

On the specific provisions in Sen. LaValle’s legislation, bill S.6269, Pendergast pointed out that the proposed mandatory rotation of audit firms every seven years would have the unintended consequence of eliminating the best-qualified auditor. With respect to a two-year ban on employment of an auditor with the audit client, she said the senators should consider the position the person has with the auditing firm. Also, businesses in small communities could be harmed if they could not get the services as they grow their businesses, she noted.

McCoy called upon state legislators to carefully evaluate the impact of any legislation on local community entities. On the issue of the ability of audit firms to provide non-audit services to their clients, McCoy focused on audits and non-audit services to nonprofit organizations and governmental entities. McCoy’s firm audits more than 20 government entities and 75 nonprofits that receive state or federal funding; some of them issue bonds that could be considered publicly issued.

If Sen. LaValle’s proposal to generally prohibit auditors from providing non-audit services were adopted, “these entities would be forced to obtain various types of consulting services from other sources,” McCoy said.

To make his case, McCoy spoke of a local county that has been a firm client for more than 30 years and that has asked his firm to advise the director of finance or county manager “on various issues related to budgets, personnel transactions with other local municipalities and even income taxes.” He also spoke of two local charter schools that have asked his firm “to assist them by providing several non-audit services, including the filing of the application for tax-exempt status.”

McCoy emphasized four points to the senators regarding the proposed ban on non-audit services to the audit client.

• On an annual basis, McCoy’s firm’s fees from non-audit services are small in relation to the audit fee.
• McCoy’s clients find that the ability to request non-audit services from his firm simplifies the process and limits their cost of obtaining this information.
• In McCoy’s opinion, the audit clients should not be required to spend excessive amounts of time educating another consultant about their organization’s operation, history and management structure.
• Most local nonprofits and governments lack the depth of management necessary to develop certain non-audit skills, unlike a large publicly traded company.

With respect to the proposed mandatory auditor rotation, McCoy said this would create a burden on local governments and nonprofits because they would lose auditors with experience in providing audits to these entities. Also, the number of firms that specialize in nonprofit and government audits is limited. “The question as to whether reducing the length of an auditor-client relationship will enhance the creditability of the audit does not have an answer. Enhancing creditability should not be the only concern,” McCoy said. “The major concern should be how to develop better audit and reporting standards so that transactions that add to the possibility of business failures are discovered and appropriately disclosed. Nonprofits and governments rarely experience the problem of a major business failure…I am concerned that a continuous process of rotation may add to the problem by forcing nonprofits and government to engage auditors who may not have the depth of experience that others have. In addition, the burden of training a new auditor in the operations of an organization would undoubtedly add costs to the audit process.”

McCoy also spoke against the two-year restriction on employment of the auditor with the audit client.

“Once again, I feel this will have a significant negative impact on local nonprofits and governments. They will lose the ability to hire the best qualified,” he said. “I have never been aware of a case where a staff person was hired or offered a job because the client considered them to be audit friendly.”

Doran, a partner in a regional firm in Albany, urged the senators to consider the effect of this legislation on closely held businesses in New York.

“The relationship between a certified public accounting firm and a closely held business is very different from that of a publicly traded company, requiring different standards and regulations,” she said.

“In most cases, the partners, owners, managers and lenders are known users of the CPA firm’s services,” and the relationship with the closely held business begins before the audit service is needed, Doran noted. “They might seek advice with the start-up of their business, or they might seek tax advice before they require any attest services because they do not have an internal accounting staff. Frequently, we are asked to assist in hiring internal accounting personnel, because the client is confident that we can evaluate the skills needed to fill the position. If closely held businesses were required to obtain tax services or human resource consulting services from another accounting firm, the costs could be substantially more to businesses in New York state.

“To ask small businesses to meet SEC requirements that prohibit the auditor from providing a number of non-audit services would impose financial burdens on the small business and is unnecessary,” she said.

Doran gave support for mandatory peer review of all CPA firms that perform audit and attest services in New York state, and she explained the current peer review process required by any firm conducting audits in accordance with government auditing standards. Doran also said she favors licensing of all CPA firms and enhanced oversight by the New York State Board for Public Accountancy.

At the end of the hearing, Sen. LaValle expressed appreciation for the witnesses’ testimony and announced that he intends to conduct a third hearing for testimony by a representative from the SEC. No date has been scheduled for this hearing.