University of Mississippi eGrove American Institute of Certified Public Association Sections, Divisions, Boards, Teams Accountants (AICPA) Historical Collection 1997 Serving the public interest : a new conceptual framework for auditor independence (draft) American Institute of Certified Public Accountants Independence Standards Board Follow this and additional works at: https://egrove.olemiss.edu/aicpa_assoc Part of the Accounting Commons, and the Taxation Commons Serving The Public In ter est: A N ew Conceptual Fram ew ork F or A uditor Independence October 2 0 , 1997 TABLE OF CONTENTS PAGE I. Introduction and Executive Summary.............................................................................................1 II. Historical and Institutional Framework.......................................................................................... 13 A...........................................................................................................................................Overview 13 B.......................................................................Early Development of the Concept of Independence 17 C...................................................................... The Concept of Independence in the Securities Laws 20 D....................................................................................................Self-Regulation by the Profession 25 1 ........................................................................................................Early Development: 1880-1945 26 2 ................................................................................................The Maturing Profession: 1945-1980 28 3 ...................................................................................................................................... 1980-Present 32 E.......................................................Relative Advantages and Disadvantages of Today’s Approach 38 F............................................................................... The Problem of Appearance-Based Regulation 44 G..................................................................................................... Proposed Research Methodology 46 H................................The Misplaced Regulatory Focus on the Performance of Non-Audit Services 48 1. There is No Evidence that the Performance of Non-Audit Services by Accounting Firms for Audit Clients Impairs Independence in Fact........................................................................................................ 50 2 ................................................... ASR No. 250 and ASR No. 264 Indicate an Absence of Investor Concern Over Non-Audit Services..................................................................................................51 3 ..................................................... Insurers Today Perceive No Independence Problem Associated with Non-Audit Services................................................................................................................. 55 4 .........................................................Regulatory Focus on the Performance of Non-Audit Services Obscures Independence Issues and Disserves the Public Interest...................................................57 III. Economic and Other Determinants of Auditor Independence.........................................................58 A.The Economic Interest of Accounting Firms in Their Reputational Capital Provides a Powerful Incentive to S B................................................Firms Have Economic Incentive to Address the “Free Rider” Issue 66 2 C........................................................................ A Broad Scope of Practice Enhances Audit Quality 68 D.................................................................. A Broad Scope of Services Fosters Economies of Scale 74 E....................................... The Revolution in Information Technology is Increasing the Importance of Broad Scope of Services............................................................................................................. 76 F............................... The Revolution in Information Technology is also Increasing the Importance ......................................................................of Professional Service Firms’ Business Relationships 79 G..............................................A Broad Scope of Practice is Necessary to Attract the Best Recruits 80 H. Exposure to Liability and Professional Sanctions Provides a Complementary Deterrent to Compromising Inde I. Other Determinants of Auditor Independence..................................................................................86 J............................................................................................................................................ Conclusion 88 IV. Regulatory Policy Considerations.....................................................................................................88 A....................................................................................................Command and Control Regulation 89 1 .................................................................Technical Compliance Instead of Achievement of Goals 90 2 ...............................................................................................................Cost-Ineffective Regulation 96 a) ..................................................................................................................Informational Efficiency 97 b) ..........................................................................................................Rigid Rules, Dynamic Reality 98 3. Motivations of Regulated Entities 99 4......................................................................................................The Myth of Eliminating All Risk 100 B..................................................................... An Alternative Approach - Enforced Self-Regulation 103 C....................................................................................Implementation of Enforced Self-Regulation 105 1 .....................................................................................................................Federal Securities Laws 105 a) ...................................................................................................................Sections 204A and 15(f) 106 b) .......................................................................................................................................... Rule 17j-l 107 2 ...........................................................Community Reinvestment Act (“CRA”) Performance-Based Standards........................................................................................................................................ 108 3 ...............................................................................................................................EPA’s Project XL 110 3 4. OSHA's Maine 200 Program 111 5..................................................Nuclear Regulatory Commission Regulation of Operator Testing and Plant M aintenance.......................................................................................................................................112 D........................................................................................................................................................Conclusion 115 V. Proposal for a New Conceptual Framework..........................................................................................116 A...........................................................................................................................A Principles-Based System 117 B......................................................................................................ISB Guidelines on Independence Issues 125 1 Materiality 126 2 Safeguards 128 3. Public Policy in Special Cases..................................................................................................130 C.................................................................................................. ISB Principles and Illustrative Guidelines 131 1 Auditors and Firms should not be Financially Dependent Upon an Audit Client...................................................................................................................................................132 2 Auditors and Firms should not have Conflicting Interests .......................................................................that would Affect their Objectivity with Regard to Matters ............................................................................................................... Affecting the Financial Statements. 133 3 Auditors and Firms should not have Relationships with, or Engage in Activities for, Clients that would Entail Making Managerial Decisions or Otherwise Serve to Impair an Auditor's Objectivity..................................................... 136 VI. Conclusion....................................................................................................................................................139 I. Introduction and Executive Summary The Independence Standards Board (the "ISB") was established in May 1997 with the mission of developing "a conceptual framework for independence applicable to audits of public entities which will serve as the foundation for the development of principles-based independence standards." This White Paper is submitted to the ISB on