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Why Accountants Should Be Banned From Providing Consulting Services To Audit Clients

When the Supreme Court, in a case concerning Arthur Young (now merged into the Big 5 firm Ernst & Young) said that auditors are "public watchdogs," it meant that auditors are supposed to work on behalf of investors and the public interest, not act as management's lapdogs. Yet, as the Enron case shows, the lack of auditor independence can lead to catastrophic consequences for investors and the markets.

Auditors have grown overly reliant on consulting business from their clients. According to a recent study by University of Illinois professor Andrew D. Bailey, among 563 companies examined under new SEC disclosure rules, only two paid no non-audit fees to their auditor, and, on average, clients reported paying their accountant $2.69 in fees for non-audit services for every dollar spent on audit fees. In some cases, however, the imbalance was far greater. In the most extreme examples, Puget Energy paid PricewaterhouseCooper $17 million for non-audit fees and just $534,000 for its audit, and Marriott International Inc. paid $30 million to Arthur Andersen for non-audit services, compared with only $1 million for its audit. (See "Further Reading," CFA White Paper, below.)

The lure of this enormous compensation for non-audit services is the reason that the SEC, in 2000, proposed rules severely restricting auditors from providing consulting services to their clients, to ensure that their "public watchdog" role came before their self-enrichment goal. The SEC began its proposal with the following statement:

"Independent auditors have an important public trust. Every day, millions of people invest their savings in our securities markets in reliance on financial statements prepared by public companies and audited by independent auditors… If investors do not believe that the auditor is truly independent from the issuer, they will derive little confidence from the auditor's opinion and will be far less likely to invest in the issuer's securities. Fostering investor confidence, therefore, requires not only that auditors actually be independent of their audit clients, but also that reasonable investors perceive them to be independent."

The SEC went on to say: "We have become increasingly concerned that the dramatic increase in the nature, number, and monetary value of non-audit services that accounting firms provide to audit clients may affect their independence."

PIRG and other consumer groups believe that an outright ban on non-audit services to audit clients is a better solution than allowing some non-audit services subject to unworkable rules. Nevertheless, the SEC's proposed rule outlined four-"governing principles" that serve as a test of whether or not auditor independence is impaired by other relationships between the auditor and the client:

"The four principles incorporate situations that we believe reasonable investors would agree impair an auditor's independence. They are when the auditor:
· has a mutual or conflicting interest with the audit client,
· audits the accountant's own work,
· functions as management or an employee of the audit client, or
· acts as an advocate for the audit client."

Did Andersen violate any of the 4 governing principles? In 2000, Enron paid Arthur Andersen $25 million for audit services and $27 million for consulting services, including development of a computerized financial system for conducting Enron's internal audit. Andersen, then, as outside auditor, audited its own work. Other aspects of the Enron-Andersen relationship also apparently violated the SEC's principles.

The problems aren't limited to Andersen. In January 2002, the SEC censured another of accounting's Big 5 firms, KPMG,
http://www.sec.gov/news/press/2002-4.txt "because it purported to serve as an independent accounting firm for an audit client at the same time that it had made substantial financial investments in the client. The SEC found that KPMG violated the auditor independence rules by engaging in such conduct."

Andersen's role in the Enron collapse makes it a poster child for the need for auditor independence and the need for Congress to pass legislation banning provision of non-audit services to clients.

-- Andersen raised questions about Enron's financial reporting as early as 1997, yet failed to insist on a restatement of its books that would have reduced 1997 earnings from $105 million to $54 million, under pressure from Enron management.
-- Its auditors and other accountants had permanent offices in Enron's building.
-- Its staff wore Enron golf shirts, attended Enron parties and ski trips and generally were difficult to tell from Enron staff.
-- Enron's Chief Accounting Officer and Chief Financial Officer were both Andersen alums.

Further Reading On Auditor Independence And Oversight

Proposed Federal Legislation To Establish Accounting Independence and Oversight

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