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It is generally recognized that such knowledge is best gained through actual audit experience over a considerable period of years,
This level of expertise would be substantially dissipated by a system of periodic rotation. Furthermore, the costs of audits would increase because of frequent duplications of startup learning time and development of a background data base that underlies every audit.
CPA firms have for many years rotated their personnel on audit engagements to bring fresh viewpoints to bear on the audit process.
This is accomplished on a gradual basis which permits the retention of continuity, thereby avoiding many of the disadvantages that would result from the rotation of firms.
To the extent that there are advantages to be gained by rotation, they are largely achieved by these alternative procedures of systematically bringing new personnel into audit engagements.
When all of these factors are considered, it seems likely that, on balance, a requirement to rotate audit firms would weaken rather than strengthen the effectiveness of auditors and the costs of audits would be increased.
Accordingly, the proposal should not be adopted because it would be, in our view, counterproductive.
A second proposal that is often advanced by the profession's critics is that the scope of services of auditors be restricted to preclude those services which are perceived to create adverse pressures on the objectivity and integrity of auditors.
There are varying opinions among the critics as to what specific services should be prohibited and whether the restriction should extend only to audit clients or to all clients regardless of whether audits are performed for such clients.
Among the services which have been cited as posing a threat to auditor independence are the following broad categories:
1. Advice leading to management decisions and assistance with systems and their implementation.
2. Preparation of accounting records or financial statements which are subsequently audited by the preparing firm.
The concern underlying both of these categories is that an auditor may be biased in reporting on the reliability of financial statements based upon the results of decisions or systems in which he played an advisory role or assisted in their implementation.
It is alleged that under such circumstances an auditor would be reluctant to concede that his advice or assistance to the client had been faulty.
This reluctance would be evidenced by expressing a favorable opinion on financial statements that failed to reflect any adverse results of the auditor's services to the client.
No doubt the providing of nonaudit services to audit clients could create some potential for conflicts that might affect the objectivity or integrity of auditors.
Indeed, even judgments made as a part of conducting an audit could cause an auditor to be defensive about such judgments in a succeeding audit when events may have proved him wrong.
But the risks of impairment of objectivity or integrity are so minimal in relation to the benefits that accrue from providing nonaudit
services that prohibition of such services would be unwarranted and undesirable.
Consulting services help management to achieve efficient business operations, and auditors are uniquely qualified to provide them because of their knowledge gained through observation and analysis of the activities of a wide range of clients.
In addition, the insights gained by auditors in providing consulting services are highly beneficial to the effectiveness of their audits.
The quality of audit judgments frequently depends on the application of expert knowledge about business operations and practices.
The argument by critics that auditors cannot audit their own work, consisting of nonaudit services, misses the main point of an audit, which is to obtain a degree of confidence regarding management's financial representations from someone outside the control management.
An auditor does not fall under the control of management simply by rendering nonaudit services.
Thus, his ability to lend credibility to financial statements should not be diminished. To the contrary, he will know more about the client and its affairs and is likely to be a more effective auditor.
All of the foregoing factors, coupled with the fact that auditors serve many clients and provide all these services from the posture of an outsider contractor, tend to keep pressures on their objectivity and integrity within acceptable limits.
On balance, then, the disadvantages would far outweigh the benefits if auditors were precluded from providing nonaudit services to their audit clients.
Most of the other suggestions of critics are directed at changing the fact that auditors are appointed and paid for their services by their audit clients.
Some have proposed that auditors be paid out of a pool of funds created by assessments against companies subject to audit.
This misses the principal issue since it is the appointment of the auditor which counts rather than how he is paid.
Others ahev suggested that a Government agency have the power to appoint and dismiss auditors or that all audits be conducted by Government employees rather than by members of a private profession,
These proposals are so drastic that if they were adopted they would virtually destroy any vestiges of a private profession.
Such an invasion of the private sector by Gɔvernment would not seem warranted in the light of the many achievements of the public accounting profession and the advantages of its retention.
Indeed, there is no assurance that a Government bureaucracy would perform the audit function nearly as well as the private profession does.
Furthermore, transfer of the audit function to a Government agency runs the risk that it may be used for partisan political purposes.
Short of converting the private profession to a Government function there would seem to be no practical alternative to the present system under which auditors are appointed and paid by their clients. In any event, the pressures that stem from a fear of dismissal and loss of fees are probably not nearly as great as might be contended by critics of the profession.
Also, the countervailing pressures which have been previously cited are of such magnitude that any drastic changes in the present system would seem to be unwarranted.
To sum up, auditors cannot practice their calling without being exposed to pressures upon their integrity and objectivity.
Senator HARTKE. Excuse me for interrupting, but I am going to ask you to continue with the rest of your statement with our counsel while I go and vote.
Mr. Olson. To define and proscribe all such situations would be impracticable.
The pressures that accompany normal relationships with clients are offset by powerful countervailíng restraints. These include the possibility of legal liability, professional discipline involving revocation of the right to practice, loss of reputation, and the inculcated resistance of a professional to any infringement upon his basic objectivity and integrity.
In deciding which types of relationships should be prohibited, both the magnitude of the threat posed by a relationship and the force of countervailing pressures have to be weighed.
Such judgment should be based on whether reasonable men, having knowledge of all the facts and taking into consideration normal strength of character and normal behavior under the circumstances, would conclude a particular relationship and would pose an unacceptable threat to an auditor's objectivity or integrity.
The profession has applied these criteria in establishing its prohibitions of relationships between auditors and their clients. It believes that those prohibitions are adequate to assure the independence of auditors.
The profession has also taken steps to minimize the pressures on auditors by urging the establishment of corporate audit committees and assisting in the development of reporting requirements on changes in auditors.
Safeguards to assure a high level of performance have also been imposed by adopting and carrying on extensive quality control review programs and requiring continuing professional education by practitioners,
In short, the profession is doing all that can reasonably be expected to assure that a high level of independence is maintained by auditors.
However, no procedures or system or constraints, whether self-imposed or invoked by government, can provide a guarantee of zero defects.
Even though there have been failures in the performance of auditors they have been miniscule in number in relation to the overall volume of audits performed.
When failures have occurred, they have rarely involved impairment of objectivity or integrity.
In almost all instances audit judgments were found to be faulty in the light of hindsight; audit procedures were not effectively applied, or generally accepted accounting principles had not been sufficiently narrowed to deal appropriately with new forms of business transactions.
None of these shortcomings would have been cured by the rotation of auditors, restrictions on the scope of services of auditors, different methods of appointment or remuneration of auditors or transfer of the audit function to a governmental body.
The problems that have been encountered are, to a large extent, inherent in the difficulties in accounting for and reporting in a highly condensed format on the operations of large complex corporate structures.
Impairment of the independence of auditors is not a principal or fundamental cause of the few shortcomings that have been encountered in audited financial statements.
Auditors have, overall, displayed a remarkable degree of objectivity and integrity in fulfilling their role and are likely to do so in the future without changes in the present system of constraints.
We realize that many issues other than the role and independence of auditors might be brought up at these hearings on which the AICPA has expertise.
We, of course, stand ready to be of whatever assistance we can and look forward to working with the committee and its staff.
Thank you very much.
While I am sure the chairman would like to pursue a number of your points at some length, we were prohibited by the Senate to go beyond noon.
[The statement follows:]
STATEMENT OF WALLACE E. OLSON
THE INDEPENDENCE OF AUDITORS
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 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 more widely recognized as essential to the continuing health of the economy. The availabiilty 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 financial statements is indispensable to fulfilling this need. Thus it is important that CPAs perform in a manner that warrants widespread confidence in their work.
During the last decade, there have been increasing expressions of doubt about whether CPAs were, in fact, performing a satisfactory level in their capacity as auditors. Criticism of the profession has been voiced by a variety of interested parties including financial analysts, financial reporters, academics, government officials and CPA's themselves.
The critics have not always clearly stated the basis of their concerns or expectations but their principal complaints generally fall into two broad categories :
1. Audits have not been sufficiently effective in alerting users of financial statements to material irregularities and impending financial disasters.
2. Financial statements prepared in conformity with generally accepted accounting principles have not adequately portrayed economie reality.
These criticisms stem largely from the collapse of several large companies during the late 1960's and early 1970's and hundreds of lawsuits against CPA firms in those and other cases. Some of these business failures involved management fraud which was not detected by the auditors. Some frauds involved management's distortion of the substance of complex business transactions by arranging them in a form that complied with generally accepted accounting principles but violated their intended result.
It is important to note, however, that the great majority of unanticipated business failures have come as a surprise because of honest misjudgments about future business prospects. The miscalculations about markets for bowling alleys, franchising, commercial aircraft and real estate developments are but a few examples of one of the major causes of business failures in recent years.
More recently, the revelations about corporate bribes and illegal political contributions have raised further questions about the performance of auditors and whether they should be responsible for detecting and publicly disclosing illegal corporate acts. In addition, the energy crisis has resulted in challenges to the reliability of the financial reports of the oil and gas companies--a development which, in turn, reflects growing skepticism about the work of the auditors.
All of these concerns appear to reflect a pervasive feeling that auditors are not sufficiently independent of their clients. Since the usefulness of the auditor's work depends on his independence in appearance as well as in fact-it is imperative that the expressed doubts concerning independence be fully explored and satisfactorily resolved. The balance of this paper is devoted to that objective. No attempt is made to deal with the adequacy of existing auditing and accounting standards or the methods of their development. These are subjects which deserve extensive and separate treatment. The focus of this paper will be on the degree to which the application of auditing and accounting standards is affected by pressures on auditors that might impair their independence.
THE CONCEPT OF AUDIT INDEPENDENCE
An understanding of the concept of audit independence requires a knowledge of the basic reasons why audits are useful. Users of financial statements who are not in a position to satisfy themselves directly as to their fairness must have some means of obtaining reasonable assurance. 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 the business enterprise, but is as free as possible from the influence of its management and owners and from other conflicts which might impair his objectivity. Once these conditions have been satisfactorily met, the outside auditor is uniquely qualified to make an expert investigation and add credibility to the financial statements. 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 to keep in mind when considering how far an auditor ought to go in providing services to an audit client. This will be examined in more detail later in this paper.
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 :
1. Financial interests in connection with a business entity which is the subject of an audit.
2. 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.
These relationships are described in more detail in Rule 101 of the Institute's Rules of Conduct which is attached as Appendix A. This rule has been further elaborated on by a series of interpretations and rulings of the Ethics Committee of the AICPA, copies of which are attached as Appendix B.
The rule recognizes that it is the nature of an auditor's relationship with his client that determines whether he is satisfactorily impartial. Thus, in examining