Auditing Ethics among Public Accountants - Essay Example

Auditing Ethics among Public Accountants INTRODUCTION A major issue currently facing the accounting profession is the effects of changes in organizational structures on Auditor professionalism and ethical standards. Public accountants, like other professionals, historically worked in professional partnerships or sole proprietorships. For many years professional accounting associations effectively controlled the form of Auditor organizations through explicit, formal restrictions. Non-Auditor ownership of public accounting firms was prohibited and "holding out" or advertising as a Auditor was restricted to those employed by one of these firms. However, auditing or attestation is the only professional service for which Auditors have a legal monopoly and the right to place restrictions on the form of practice. Professional associations are therefore unable to dictate the organizational forms through which nonauditing services, such as tax preparation and consulting, are provided. In the past few years several publicly held "consolidators," including American Express and H&R Block, entered the public accounting market by acquiring the nonattestation practices of Auditor firms. Given that the performance of attestation engagements is restricted to traditional Auditor firms, the consolidators developed a variety of approaches that allow the Auditor firm and the financial services corporation to legally coexist subsequent to the consolidation of their practices. In cases like American Express, the employees of the Auditor firm work for the consolidator corporation, and the Auditor practice leases office space and employees from the corporation to perform attestation engagements. In other cases like H&R Block, the employees continue to work for the Auditor firm, and are leased on an as-needed basis to the consolidator corporation. The Auditor firm partners still sign the audit reports and are usually employed by both the consolidator corporation and the Auditor firm, giving them dual employment status (Independence Standards Board [ISB] 2003). These arrangements, commonly referred to as alternative practice structures (APS), raise concerns about auditor independence and objectivity. Questions arise over issues such as appropriate compensation schemes for partners with dual employment status, potential financial relationships between the public corporation and audit clients of the Auditor firm, and whether independence requirements should be extended to non-Auditor supervisors of Auditor employees (ISB 2003). Because it can be argued that, in substance, public corporations are performing audit engagements, at a recent New York State Board of Regents Conference on the Professions, the public accounting profession was criticized for allowing audits to be performed through these types of organizational arrangements (Huefner 2000). Previous discussions of the consolidation movement focus primarily on the implications of APS arrangements for auditor independence (Huefner 2004). This article suggests that corporate ownership poses additional threats to Auditor professionalism and ethics. For example, if consolidation places Auditors under the effective control of nonprofessional managers of publicly owned corporations, it may place greater emphasis on commercialism and profitability, in lieu of traditional professional values such as objectivity and integrity. As consolidators grow in size and influence, they may adopt strategies aimed at modifying accepted standards of performance in public accounting. THE CORPORATIZATION OF PUBLIC ACCOUNTING If the current consolidation movement continues, for the first time a significant number of Auditors who serve the public will be employed by commercial corporations and controlled by nonprofessionals. The public accountant plays a greater role in serving and protecting the public interest than do other accounting professionals. Corporate employment may threaten the ability to appropriately discharge this responsibility by creating and rewarding a more commercial orientation among Auditors. Most concerns expressed in the accounting literature regarding the effects of corporate ownership focus on potential impairments of auditor independence and objectivity. However, greater commercialism has the potential to undermine professional standards for other public accounting services as well. Commercial corporations may pressure Auditors to be more aggressive in generating revenues from tax preparation services, leading to advocating more aggressive return positions in the hope of satisfying clients. Corporate managers may also place more emphasis on the cross-selling of other products and services to Auditor firm clients. An often-cited benefit of acquiring Audit firms is that it allows financial service corporations to provide their clients with "one-stop shopping" for all their financial needs (Craig 2000). Despite this potential convenience, an increased emphasis on selling commission-generating products to Auditor firm clients may lead to a loss of public confidence in Auditor integrity and objectivity. Some observers see the pressure to sell a variety of products to public accounting clients increasing in publicly held corporations, due to greater pressure for earnings and profitability (ISB 2003). ORGANIZATIONAL GOVERNANCE AND CONTROL ISSUES A critical issue arising from corporate ownership of Audit firms is the effect of these new organizational arrangements on the supervision and control of public accounting work. Barley and Tolbert (1991) distinguish between two broad types of processes that meld organizations and professions together. The second process through which organizations and professions are integrated is the occupationalization of organizations, in which authority for organizational functions becomes vested in particular occupational groups. Until recently, large public accounting firms were similar to bureaucratized occupations. Although clear divisions of labor existed in these organizations as a result of specializing in audit, tax, or consulting, they were staffed and administered primarily by Auditors. As firms expanded into nontraditional services, expertise of other sorts became highly valued, eventually leading to increased prevalence of non-Auditor owners or pseudo-owners. Because all U.S. jurisdictions still require that licensed Auditors own at least a simple majority of the equity interests in public accounting firms, though, these firms are still controlled by members of the accounting profession. APS arrangements raise questions about organizational governance and control. Although attestation practices must be maintained in Auditor firms, professional services units that provide tax preparation, financial planning, and consulting may have an organizational status similar to professional departments within corporations. However, unlike most professional departments that grew from within, these new units were from autonomous professional groups imported into corporate bureaucracies. For instance, theories of ethical decision making in organizations commonly acknowledge the influence of organizational value systems on individual decision making and behavior (Hunt and Vitell 1986). Perhaps the most immediate concern arising from corporate ownership of public accounting practices is the potential impact on auditor independence and objectivity. Auditing or attestation is a stronghold of professional autonomy in accounting, due to proscriptions against non-Auditor ownership of auditing firms. However, the advent of alternative practice structures poses the threat of corporatization of the auditing profession, in economic substance if not in legal form. The issue of auditor independence within traditional Audit firms is the topic of much recent discussion and concern among regulators (POB 2000; SEC 2000). THREATS TO INDEPENDENCE Questions are often raised about whether the "separate practice" units used in APS arrangements are in fact separate, or whether the acquiring company exerts effective control over related Audit firms (Goldwasser 2003). The employment of Audit Firm partners by Public Co., coupled with the fact that most of the audit revenues are transferred to Public Co. in the form of "lease payments" for employees and administrative services, suggests that Public Co. has a significant degree of control over Audit Firm. If this is the case, and Public Co. is permitted to have financial relationships with Audit Firm clients, then the potential to degrade independence and objectivity is great. The problem could be further exacerbated if Audit Firm partners own stock in Public Co., which is normally the case (ISB 2003). Under these circumstances, Audit Firm partners also have an incentive to avoid disputes with the audit client in order to maintain nonaudit revenues and maximize the value of their stock holdings. Recent research suggests that the threat of disciplinary measures such as negative peer review results serves as a significant deterrent to unethical behavior by Auditor/auditors (Shafer et al. 2003). Consequently, if Auditor/auditors are supervised by corporate managers not subject to independence requirements, the potential for conflict between organizational and professional values is relatively high. To illustrate the types of relationships between financial service corporations and clients of affiliated Audit firms that could impair auditor independence and objectivity, consider the following scenarios (ISB 2003): 1. A broker/dealer subsidiary of Public Co. wishes to sell financial products, such as mutual fund shares, to a client of Audit Firm. Under these circumstances, Public Co. would earn commissions prohibited for Audit Firm. 2. A financial institution subsidiary of Public Co. could make a loan to a client of Audit Firm. Audit Firm is prohibited from making such a loan directly, since it gives the firm a vested interest in the financial well being of the client. 3. An accounting subsidiary of Public Co. desires to provide bookkeeping services for Audit Firm clients. Audit firms cannot provide extensive accounting or bookkeeping services for publicly held audit clients, since this places them in a position of opining on their own work. 4. A subsidiary of Public Co. wants to provide retirement plan management services for Audit Firm clients, which could entail having custody of plan assets and authority to make investments of those assets. Such services violate independence if performed by Audit Firm, because they involve functions similar to those of a client employee or manager. CURRENT AND POTENTIAL SAFEGUARDS The potential for conflicts of interest prompts some observers to suggest that Public Co. not be permitted to have any relationships with Audit Firm clients that are proscribed for Audit Firm itself (ISB 2003). The Commission's definition of "accounting firm" includes any entity engaged in the practice of public accounting that furnishes reports or other documents filed with the SEC, and all of the organization's departments, divisions, parents, subsidiaries, and "associated entities" (SEC 2000). Also included in the SEC guidance on this issue are three letters dated November 2, 2004, addressed to employees of American Express Financial Advisors, Century Business Services Inc, and H&R Block Business Services (SEC 2004). These letters indicate that, pending further guidance from the ISB, "any accounting firm and the acquirer...of that accounting firm that employs any accountants that work on SEC clients of the accounting firm should continue to fully comply with the SEC's independence requirements" (SEC 2004). In the latest revision of its Code of Professional Conduct, the AICPA (2001a) shifts from a firm focus to an engagement team focus in the definition of "covered members" for purposes of determining independence on attestation engagements. Under the new rules, covered members include: (1) individuals on the attest engagement team; (2) individuals in a position to influence the attest engagement; (3) any partner or manager who provides more than 10 hours of nonattest services to the attest client; (4) any partner practicing in the same office in which the lead attest engagement partner practices; (5) the firm, including its employee benefit plans; and (6) any entity that can be controlled by a covered member (AICPA 2001a). The definition of "member" in an APS includes all individuals who qualify under the above rules, regardless of whether they are permanent employees of Audit Firm or they are leased from Public Co. or another entity. 1. Direct Superiors. All independence restrictions that apply to members also apply to Public Co. employees who are direct superiors of members. Direct superiors are defined as persons who can directly control the activities of either Audit Firm partners or Audit Firm employees with managerial positions in an Audit Firm office that participates in a significant portion of the engagement. In addition, all independence restrictions are extended to all entities that can be significantly influenced by direct superiors. 2. Indirect Superiors and Other Public Co. Entities. All independence restrictions are also extended to indirect superiors and other Public Co. entities, but only if their relationships with the audit client are material. To establish materiality for relationships between indirect superiors and an audit client, all such relationships must be aggregated and assessed in relation to the indirect superior's net worth. In the case of relationships between other Public Co. entities and an audit client, all such relationships are aggregated and assessed in relation to the consolidated financial statements of Public Co. In addition, indirect superiors and other Public Co. entities should not be able to exert significant influence over audit clients, and no Public Co. entity or employee can be connected with an audit client as a promoter, underwriter, voting trustee, director, or officer. Some question whether the AICPA rules are sufficient to ensure auditor independence (ISB 2003). The rules permit subsidiaries of Public Co. to provide nonaudit services to clients of Audit Firm, provided the amounts involved are not material to the consolidated financial statements of Public Co. Under the AICPA rules, indirect superiors of audit partners could also own "immaterial" stock investments in an audit client. There are other measures that could be taken by the consolidators to mitigate auditor independence concerns. For example, in its Discussion Memorandum on APS, the ISB (2003) identifies potential safeguards designed to preserve auditor independence and objectivity, including the following policies: 1. Management of Public Co.'s professional services subsidiary by Auditors. This policy is founded on the belief that licensed Auditors are more likely to understand ethical standards and work to preserve the professionalism of the independent auditor. Auditor managers may also offer some protection against pressure from non-Auditor corporate employees. 2. Separate Auditor management of Audit Firm and the professional services subsidiary of Public Co. This suggestion is based on the belief that, if top management of Audit Firm is also responsible for promoting the financial interests of the corporate entity, then this could lead to conflicts between organizational and professional duties. For instance, Auditors with dual management responsibilities might be motivated to compromise audit quality in order to increase revenues from nonaudit services provided by the corporate entity. 3. Separate and distinct names, logos, and marketing for Audit Firm and the professional services subsidiary, to maintain the appearance of auditor independence. When the entities serve joint clients, they could also use separate engagement letters and invoices. 4. Flexible employee leasing and administrative agreements that allow Audit Firm to choose between hiring its own staff and administrative personnel, purchasing these services from Public Co., or purchasing them from other providers. 5. Adoption of quality control standards by the professional services subsidiary to ensure that all employees closely associated with Audit Firm understand auditor independence requirements. USER PERCEPTIONS OF INDEPENDENCE In addition to threats to actual auditor independence, APS arrangements may reduce public confidence in the integrity and reliability of audited financial statements. Professional auditing standards recognize that independence in fact and appearance is critical for maintaining public confidence in the financial-reporting process (AICPA 2001b, AU 220.03). In an APS, the Public Co. may provide virtually all the professionals and resources to perform the audit. Under these circumstances, the ability to maintain public confidence in the audit process is questionable, particularly when the financial statement users are aware of financial or other relationships between Public Co. and the audit client (ISB 2003). The SEC addressed this issue by requiring disclosure of instances where the percentage of audit hours spent on an engagement by persons other than full-time, permanent employees of Audit Firm exceeds 50 percent (SEC 2000). Such disclosures provide information that market participants may consider relevant in evaluating auditor independence. This article argues that the emerging trend toward corporate ownership of Audit firms has important implications for professionalism and ethics in public accounting. If Auditors are under the effective control of nonprofessional managers of publicly owned corporations, then professional ideals may be subordinated to organizational objectives such as commercialism and profitability. Assessing the effects of the transition of public accounting practice from organizations owned and operated by professionals to publicly held financial service corporations requires detailed study of the social and economic structures of these organizations. Future research on the effects of this transition on Auditor professionalism and ethical standards should provide insights into the benefits, if any, of the classic professional model that proscribes non-Auditor ownership of public accounting practices. 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