Commentary: Auditors And Clients: Too Close For Comfort

It seems like a simple enough concept: An accounting firm should be free of influence from the companies it audits. But recent accounting breakdowns at Livent, Cendant, and other public companies are heating up debate over whether today's auditors are independent enough. "Accounting firms would prefer we think these are isolated instances and we don't need to do anything," says Lynn Turner, chief accountant at the Securities & Exchange Commission. But he adds: "We have to do something to make sure the auditor is skeptical."

On Feb. 8, industry officials did something to address the most basic issue of auditor independence--the fact that outside auditors are often hired and fired by the same finance executives whose work they review. An SEC-sanctioned panel recommended a host of measures that would shift the oversight of auditors to outside board directors on the audit committee.

But while the surprisingly forceful recommendations are good, they only begin to scratch the surface. Key issues concerning the links among an auditing firm, its accountants, and its client companies have not been addressed. How to define an auditor's independence, for example, or what makes for a conflict of interest, are not even raised. If the SEC is serious about putting muscle into the weak guidelines that currently govern ties between auditors and their clients, plenty of work remains.

The main focus of the panel's recommendation was a proposal that the auditors of any company listed on the New York Stock Exchange or NASDAQ report to a board audit committee of knowledgeable independent directors. If adopted, that means the audit committees would select, evaluate, and, when necessary, replace the auditors. To flush out potential conflicts, auditors would also be required to "disclose relationships or services that may impact [their] objectivity and independence" to the audit committee. "It's a very bold initiative--a substantial change from what's out there now," says Patrick S. McGurn of Institutional Shareholder Services, an adviser to large investors.

And that's not even the most controversial part. Today, auditors are required only to report that a company's books conform to "generally accepted accounting principles"--they don't have to point out if its accounting is too aggressive or inappropriate. But under the proposal, auditors would have to discuss the quality of a company's accounting--and explain the judgment calls that management makes in tallying its results.

That's why the first big challenge will be to ensure that the proposal retains its teeth as it is debated over the next couple of months. Although the heads of both the NYSE and National Association of Securities Dealers helped to shape the recommendations, their passage will require the adoption of new listing standards. That means that some 9,000 listed firms and the exchanges' boards will get to weigh in. "They are going to be under a lot of pressure," says SEC Chairman Arthur Levitt Jr.

Even if that challenge is met, more are waiting. First up will be to clarify the extremely murky definition of what constitutes a breach of auditor independence. One key issue worrying the SEC is the potential for problems when auditors from outside accounting firms go to work for their corporate clients. As compensation for chief financial officers skyrockets, such career moves are increasingly common. Just as tough an issue: the conflicting interests involved when an auditing firm also provides consulting advice to a client. With Big Five accountants getting ever more revenue growth from high-margin consulting, the SEC's Turner worries that auditors may be less vigilant with their consulting clients.

JOB-HOPPING RULES? The current proposal doesn't directly address either of these issues, but it is likely to fuel the already raging debate over how to solve them. A second SEC-sanctioned group, the Independence Standards Board, is soon expected to outline new auditor guidelines, starting with the problems raised when an auditor jumps to a client. Since the obvious solution--barring a job-hopping auditor from working on the books of a former client--may run afoul of right-to-work laws, the Independence Standards Board is also considering requiring a company to change accounting firms when it hires a former auditor.

Some would go further. Nell Minow, a principal for activist investor the Lens Fund, argues that all companies should be required to shift accountants every five to seven years to "get a fresh perspective on things."

Although such an extreme move would likely run into massive resistance from companies and auditors alike, the industry does need to show that it can come up with workable, effective solutions itself. And it needs to do so fast. Richard H. Walker, head of enforcement for the SEC, says future SEC accounting lawsuits will probably target players other than corporate management. Auditors and audit committees are likely to top the list.

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