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Mr. BARVEAUX. We will supply those for the record.
Mr. Olson. Mr. Chairman, I am pleased to have the opportunity to appear before your committee today to present certain views of the accounting profession which have a direct bearing on the broad question of corporate chartering which is the subject of these hearings.
I am the president of the American Institute of Certified Public Accountants, which is the sole national organization of certified public accountants with a membership approaching 120,000.
In announcing these hearings on corporate rights and duties, Senator Magnuson stated :
In these hearings we will explore the historical development of the corporation in American society, the present role of the corporation, the degree to which present laws are capable of properly controlling giant national and multinational corporations, and the need, if any, for new laws to govern these corporations.
Although the temptation is great to discuss all of these questions in some detail, I believe the time of the committee might best be utilized during my testimony by allowing me to focus on the single subject of the importance of the role of independent auditors in relation to corporations and the nature of auditors' independence.
The work of the public accounting profession in recent years has attracted a high level of attention within the business community and governmental circles.
This increased interest and visibility has resulted in large part from a growing recognition of the importance of obtaining assurance regarding the reliability of corporate financial statements.
As the Nation's economy has grown in size and complexity the Federal Government has found it increasingly necessary to engage in more extensive planning and control.
At the same time, our system of capital formation and the functioning of our capital markets have become widely recognized as essential to the continuing health of the economy.
The availability of reliable financial data is necessary to the establishment of sound economic policies and the maintenance of capital markets which attract a broad base of investors.
The CPA's role as auditor of corporate financial statements is indispensable to fulfilling this need. Thus, the work of auditors is very relevant to your deliberations about the role of corporations in our society.
The public responsibility of the certified public accountant is clear. His work product must serve the needs of a wide range of users of financial statements which include credit grantors, corporate shareholders, potential investors and the public at large.
To meet these needs he has a duty to advise corporate management and boards of directors with respect to the fairness of their financial statements in accordance with generally accepted accounting principles.
Because of this public responsibility and the fact that independence is the touchstone of the auditing profession, I will devote the rest of my testimony to the relationship between auditors and their corporate clients.
This particular subject is especially important since it has been proposed by the Corporate Accountability Research Group that the existing relationship be altered to provide for the rotation of auditors on a predetermined schedule.
* The attachments Appendices A-C are in the Committee files.
In considering this proposal it is necessary to discuss the fact that auditors are sufficiently independent without the imposition of a rotation requirement which, on balance, we believe would do more harm than good.
An understanding of the concept of audit independence requires a knowledge of the basic reasons why audits are useful.
Because those who are responsible for the representations in financial statements are employees or principals of the issuers, they cannot be expected to be unfailingly impartial in portraying the financial condition and results of operations of their respective business enterprises.
Thus, the users of financial statements must look to others to gain a greater measure of confidence that statements are fairly presented.
It is this need which is met by the examination conducted by an external auditor and by his professional opinion as to whether the financial statements are presented fairly in conformity with generally accepted accounting principles.
In order to fulfill this role, the auditor must be someone who is not only outside of the business enterprise, but is as free as possible from the influence of it management and owners and from other conflict which might impair his objectivity.
Under these circumstances, the more an auditor is involved in the work which enters into the preparation of financial statements, the greater will be his knowledge of their content and fairness of presentation in conformity with generally accepted accounting principles.
This is an important fact which we should keep in mind when considering how far an auditor ought to go in providing services to an audit client. I will examine that question in more detail in a few moments.
To assure that auditors maintain a satisfactory posture of impartiality, the profession has included a rule in its code of ethics which prohibits two types of relationships with audit clients:
First, financial interests in connection with a business entity which is the subject of an audit.
Second, serving the audited entity in a capacity which would cause the auditor to be in fact or essentially equivalent to being an officer, director, or employee of the entity.
The term “independence” has been traditionally used by the profession to describe the required integrity and objectivity of auditors and it is those qualities which are the essence of professionalism.
However, auditors cannot practice their calling and participate in the world's affairs without being exposed to situations that involve the possibility of pressures on their integrity and objectivity.
To define and proscribe all such situations would be impracticable. To ignore the problem for that reason, however, and to set no limits at all would be irresponsible.
It follows that the concept of independence should not be interpreted so loosely as to permit relationships likely to impair the auditor's integrity or objectivity nor so strictly as to inhibit the rendering of useful services when the likelihood of such impairment is relatively remote.
I would now like to describe more specifically some of the prevalent types of relationships and pressures that have a bearing on where the line should be drawn to maintain an appropriate degree of independence on the part of auditors.
Certain relationships have long been regarded as posing such a serious threat to the independence of auditors that they have been prohibited under rule 101 of the profession's code of professional ethics.
Under this rule auditors are prohibited from expressing opinions on the financial statements of a client if, with certain qualifications, they :
First, have any financial interest in the client.
Second, have a material joint, closely held business investment with the client.
Third, have a loan either to or from the client.
Fourth, are connected with the client as a promoter, underwriter or voting trustee, director, officer, or in a capacity equivalent to a member of management or an employee.
Fifth, are trustees or executors of trusts or estates having any financial interest in the client.
Sixth, are trustees for any pension or profit-sharing trust of the client.
These prohibitions have received a high degree of compliance within the profesison and are being rigidly enforced. Accordingly, the relationships described under the rule need not be examined further except to note that in some respects the proscriptions have been made exceptionally stringent to facilitate their enforcement.
Among the relationships which are not prohibited and which are perhaps most frequently cited by the profession's critics as a basis of concern are the fact that auditors:
First, are appointed and paid by the clients which they audit.
Second, provide a variety of nonaudit services that entail acting in the role of advisor or advocate for their audit clients.
Inherent in the first of these concerns is the suspicion that auditors might unduly favor a client's wishes when making difficult judgments in the course of an audit.
The concern is based on the assumption that the fear of losing a client and the resulting effect on the auditor's income or prestige is sufficient to cause him to be less than objective.
The second concern arises from the belief of some that providing services in the role of advisor or advocate to an audit client will, in some instances, result in an auditor having to pass judgment on the reporting of financial data that is a result of his own advice or actions in behalf of the client.
The type of services most frequently cited as causes for alarm involve acting as an advisor on matters that are furthest removed from the traditional field of accounting.
Consulting on matters that are more directly related to accounting seems to generate less concern. This ambivalent attitude toward consulting appears to indicate that competence rather than independence is what is being questioned.
Other types of relationships with clients which are not prohibited are those which are purely social in nature. While it is recognized that
a close personal friendship between an auditor and a principal officer of the client could pose a problem, it would be difficult to know where to draw the line of impropriety.
All of the relationships with audit clients described above--whether currently prohibited or not-hold at least some potential for eroding the objectivity or integrity of auditors.
To argue otherwise would be less than realistic. However, an appraisal of the impact of these pressures on the performance of auditors must take into account the countervailing pressure which influence auditors to maintain their independence.
It should be recognized that elimination of all conflicts of interest is generally not practicable in any area of economic or social life. The objective should be to reduce the potential risks to an acceptable level.
There are two general factors that would normally cause auditors to resist pressures in their dealings with clients.
The first of these is a strong sense of personal probity and professional pride that is inculeated in every CPA as part of his professional training
The second is the fact that CPA's typically serve a large number of different clients and are, therefore, not beholden to any single client for their livelihood.
However, the independence of auditors does not depend solely on these traditional conditions. They are augmented by some very powerful forces. Principal among these are the threat of lawsuits and the risk of losing the rights to practice.
The scores of lawsuits against auditors, spawned principally by business failures, have caused great concern among CPA firms.
Confronted by the ever-present threat of litigation, auditors would be foolhardy in the extreme to risk their careers by being less than objective in performing their audits.
They also face possible loss of their rights to practice by revocation of their CPA certificates by State boards of accountancy.
This threat and the exposure to legal liability generate pressures of such severity that they would normally be expected to prevail over the impact of most types of relationships with audit clients.
The profession has also instigated and supported a number of important programs and procedures to enhance the ability of auditors to resist pressures on their independence.
The profession's disciplinary machinery imposes sanctions for violations of its code of professional ethics. This can result in the impairment of an auditor's reputation and his ability to attract and retain clients and staff.
The establishment and strengthening of corporation audit committees composed of nonmanagement directors has long been advocated by the American Institute of CPA's.
This effort has now gained considerable momentum and promises to provide substantial safeguards to protect the freedom of auditors from undue management influence.
The American Institute of CPA's also worked closely with the SEC in urging and assisting in the development of that agency's requirements that information on changes in auditors be included in form 8K, Reports of Registrants.
This reporting requirement is designed to disclose those cases in which auditors were dismissed because they did not agree with management's financial statements and were unwilling to express an unqualified opinion unless the statements were changed.
The position of auditors is strengthened by this procedure because management is more inclined to seek agreement than to engage new auditors and explain its actions in a public report.
Another important safeguard is provided by the program of quality control review employed within CPA firms. Partners or independent reviewers who have not been directly involved in a specific audit evaluate the judgments and work of those who have performed the audit 'before a report is issued.
These reviews are supplemented by post release reviews of samples of audits performed by operating offices of the firms.
Such intrafirm reviews of the quality of the work of operating offices are conducted periodically by teams of qualified audit personnel, generally partners, from other operating offices of the firm.
Similar quality control reviews of firms are also being carried out either independently or under a program sponsored by the AICPA.
Under the program, reviews are conducted by either other CPA firms as a professional engagement or by panels of auditors drawn by the AICPA from other firms.
The combination of these mechanisms, coupled with the penalties which can be imposed for inadequate performance, provide a formidable defense against the possibility that an auditor will yield to pressures which might tend to impair his objectivity or integrity.
As a result, the number of cases in which auditors have clearly succumbed to a client's demands at the expense of the public interest has been exceedingly small.
This is not to say that there have been no failures in the execution of audit procedures nor any defective judgments exercised in gray areas in which the appropriate accounting and reporting was difficult to determine because it depended on the outcome of future events.
In any profession, it would be unreasonable and prohibitively expensive to impose a standard of zero defects and this is especially so with respect to the auditing of financial statements.
The existence of fallibility in execution, however, should not be misconstrued as incontestable evidence that auditors lack objectivity or integrity.
In addition to these restraints against loss of independence, a number of more radical steps have been proposed by critics.
One such proposal is that companies should be required to engage new auditors every 3 to 5 years. It is asserted that required rotation would provide auditors with greater freedom from influence by management because their limited tenure would minimize fear of losing a client.
At first blush, a rotation requirement might seem beneficial in bolstering the independence of auditors. However, a considerable price would be paid for such a requirement.
The most effective audits are generally performed by auditors who have acquired a thorough knowledge of the business entity under review.