How Can We Become Truly Independent?

By William R. Brown

I believe that there are at least two significant reasons why we as accountants may not be considered truly independent: 1) companies pay our audit fees, thus creating the possibility for compromise; and 2) Wall Street’s expectations.

That said, I wish to relate a story to you concerning an experience that I had about thirty years ago. I don’t think things have changed much since that point in time.

The story begins when I walked through the purchasing department of a large appliance discount operation, where I was working on an audit engagement, when someone from management said, “Hey, Brown, you messed up our earnings per share with that $1.35 per share number you came up with.” (As if the figure was my own creation.) I didn’t have the foggiest idea what he was talking about. At the time, I was a young senior accountant on a large audit engagement of a publicly held company and, having had little experience with the market, was not aware of its expectations.

It was true that I had calculated a $1.35 per share just that previous afternoon and the only one who I thought knew about it was the company treasurer. Later that same morning, I was asked to re-review the bad debt provision as well as the inventory for additional possible obsolete items. The request puzzled me because, based upon field visits from our audit manager, I thought that everything was in reasonably good shape. I was in the process of wrapping up the audit and putting the finishing touches on the financial statements.

When I approached the company controller about the request, he immediately gave me two journal entries affecting the two aforementioned accounts with supporting schedules. I wasn’t sure what to think. I had found the work papers of my assistants, who performed the audits on these two areas, to be acceptable, subject to a few minor follow-ups, and I believed, at the time, that they had done an airtight job.

After finishing the review of the journal entries and supporting schedules and accepting the reasonableness of the schedules and the supporting data, I posted the entries to our trial balance and changed the pencil draft of the financial statements. I recomputed the earnings per share and came up with a $1.32 per share. I informed the treasurer and controller of the new per share amount and left for the day.

The following morning as I passed through the purchasing department, the same person from management told me I had done a good job with the revised earnings per share. Needless to say, I was taken aback. I hadn’t the slightest idea how this person already knew about the revision and I wasn’t sure why three cents per share amounted to such a big deal.

Of course, as the years have gone by I have grown a little wiser and realize why earnings per share are so important to management. The fact that Wall Street likes to project earnings and per share amounts puts an awful lot of pressure on company management. This is not the first time this issue has been raised, and while some steps have been taken, nothing substantive has been done to help auditors be truly independent.

I propose a solution.

The Regional Federal Reserve Banks should establish a new department to collect the audit fees that would be assessed from publicly held companies. Taking into consideration any unusual matters, the assessed fee would be based upon the immediate prior year’s fee, and put into an audit fund. An initial assessment also would be made for the staffing of this department, its computer equipment and space, etc. To help auditors be truly independent, companies would pay an overhead charge to this fund on an annual basis.

When spread across all the companies in a region, I think that the initial cost of this department would be overshadowed by its future benefits. Some regions probably would come up short while others would have a surplus. Regions could share with one another to balance things financially, or they could require an additional special assessment to bring about the balance.

Depending on where their headquarters are based, all of a region’s publicly held companies would make payments to that regional bank. Any fee adjustments for current year audits would have to be documented by the audit firm and reviewed by the staff at the regional office before processing, if applicable.

I think most of us know that if a company pays the audit fee directly to the auditor, it opens the door to compromise by the auditor, facilitating the public perception that there is a conflict of interest. However, if an independent third party paid the audit fee, then I believe that auditors would feel more comfortable with their responsibility of protecting the public interest. When it comes to management’s motives and possible attempts to manipulate earnings, auditor’s would be free to utilize their auditor training and exercise their natural inquisitiveness.

We’re all aware that management receives incentives to reach certain levels of earnings and the temptation to manipulate is great. Therefore, auditors should be familiar with management’s motives. Our profession possesses all the necessary tools to perform a first-rate audit, but in order to do this auditors’ hands need to be untied.

Let me conclude by saying that in addition to changing the current fee structure for auditors, Wall Street needs to stop putting undue pressure on company management by projecting earnings and then holding companies hostage to those projections. I understand that the Street wants to know which companies are the best so that it can advise investors appropriately. However, the sort of pressure Wall Street applies can cause management to stray from reporting the so-called “true” numbers and lead to hiding things from auditors and tockholders.