Proposals to Improve the Image of the Public Accounting Profession

CPA Journal, The, Mar 2006 by Strier, Franklin

The past five years have witnessed a widely perceived ethical breakdown of a trusted fiduciary institution that has been at the epicenter of a number of financial scandals: the public accounting profession. Although Arthur Andersen received the most notoriety, the entire profession was stigmatized. Enron, WorldCom, Global Crossing, Tyco, and other corporate collapses were widely seen as a failure of the profession, which is commonly viewed as a public watchdog of the honesty and accuracy of corporate financial statements they audit.

The impact of the scandals on investor confidence was striking. In October 2002, the General Accounting Office (GAO; now the Government Accountability Office) issued a report on the impact of nearly 700 financial statement restatements by public companies between January 1997 and March 2002 due to audit failures and accounting fraud. Those restatements resulted in an estimated loss to the shareholders of the restating companies of $100 billion. The report states that investor confidence in June 2002, one month before the enactment of the Sarbanes-Oxley Act (SOX), "was at an all-time low due to concern over corporate accounting practices." Monthly surveys indicated that 91% of respondents agreed that "accounting concerns are negatively impacting the market" and 71% agreed that "accounting problems are widespread in business."

Viewed from a larger perspective, the conflicts of interest at the core of the corporate accounting frauds can be characterized as a corporate governance issue. Corporate governance is monitored by several gatekeepers, internal and external. The primary internal gatekeeper is the corporate board of directors. Internal auditors, in-house legal counsel, and audit committees are other internal corporate governance gatekeepers. The external influences are many and include external auditors (i.e., CPAs), government (e.g., the sec) and nongovernment regulators (e.g., the New York Stock Exchange), investment bankers, and security analysts.

When it comes to the reliability of pubhe company financial statements, however, the reality is that an auditing firm is, by far, the most competent and best-situated gatekeeper. Corporate directors and officers are often the source of the accounting irregularities and can usually negate objections or warnings by other internal gatekeepers. Regulators are typically too far removed and may lack the necessary expertise to detect the problem at any given company.

What Led to the Breakdown?

Nonauditing revenue and conflicts of interest. Beginning in the 1970s, client loyalty faded and the auditor-client relationship changed. Auditing became a low-profit activity as research found that clients increasingly searched for the lowest prices and the loosest standards. Yet competition for audit clients rose in the 1980s despite declining profit margins for auditing, because of the high profitability of the numerous new consulting and other nonaudit services being offered. With this enticement, the financial incentives for auditors to become advocates for their clients' accounting practices were stark and undeniable. A conflict of interests inevitably arose. How audit firms responded laid the groundwork for the recent scandals.

These new services put pressure on the independence of the auditors, especially the large firms-and, as the Supreme Court indicated in the Arthur Young case, independence is the polestar for auditors. In some cases, the expansion of CPA firms into the new and highly lucrative nonauditing services for audit clients, sometimes referred to as horizontal integration, clearly compromised their objectivity. sec Chairman Arthur Levitt was a prominent critic of these arrangements, claiming that "auditors did not want to do anything to rock the boat with clients, potentially jeopardizing their chief source of income" (Take on the Street, 2002).

As the major firms grew through horizontal integration, they dominated the profession. Former employees went to work within the industry, amplifying the already significant influence the major firms had over the accounting institutes, most notably the AICPA. The hegemony of the major firms led some to believe that the profession did not have an independent voice (E. Kliegman, "The Demise of the Profession," Accounting Today, Jan. 27, 1999). The startling growth in nonaudit services precipitated a pervasive perception that public accounting firms lacked independence from their biggest clients [Zeff, "How the U.S. Accounting Profession Got Where It Is Today: Part Ð," Accounting Horizons, 17(4), 2003]. The major firms, who had the most at stake, vigorously opposed reforms proposed by the Public Oversight Board to eliminate the growing conflicts of interest arising from auditing and consulting for the same client.

The unwillingness of the profession to address the problems created by its conflicts of interests was discussed, in devastating detail, in a sec draft report, commissioned by then-sec Chairman Levitt and published by The Wall Street Journal (J. Weil and S. Paltrow, "Peer Pressure: sec Saw Accounting Flaw," Jan. 29, 2002). The report describes how peer reviews of the major firms found numerous instances of auditing improprieties due to conflicts of interests that cast serious doubt as to the auditors' independence. Despite the severity of their findings, the reviewing firms always gave positive feedback in the public parts of the review, including a review of Arthur Andersen's professional standards by Deloitte & Touche just before the Enron scandal.