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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 inculcated in every CỔA 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 num. ber 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.
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 Government 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 countervailing 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.