SEC Analysis - SEC wins audit war.

After almost a year of internecine wrangling, veiled threats and postponed deadlines, last week’s pronouncements from Room 6600 at the Securities and Exchange Commission headquarters were not as restrictive as the profession had initially anticipated.

The discussion on auditor independence has come a long way since SEC chairman Arthur Levitt launched his crusade to safeguard investor confidence in financial reporting and re-assert the ‘perceived’ skewed balance between managing an audit business and marketing non-audit services.

And despite the scaled-down proposals, most judge the new rules as a victory for Levitt.

The revised rules substantially limit the amount of consultancy work, particularly IT consultancy, large accountancy firms can offer their audit clients. But, they do not as feared prohibit firms from offering a number of non-audit services, which management have always maintained would strangle their ability to compete with other industries.

Although opponents criticised the drive to modernise the framework as spurious since it was based on perceived conflicts of interest. Levitt’s counter to this was, as one of the profession’s own put it more than five decades ago, ‘the accounting profession must be like Caesar’s wife. To be suspected is almost as bad as to be convicted.’

Besides Ernst & Young, which sold off its consulting arm to the French firm Cap Gemini, and PricewaterhouseCoopers which announced plans to split, the largest of accountancy firms had a great deal to lose. Firms will still see profit margins drop in the wake of the updated regulation, but to what extent remains to be seen. Nevertheless, they can continue to develop and offer non-audit services provided the firms’ management team informs its audit committee. Such a framework already exists in the UK.

This together with restrictions on financial investment in audit clients by those who work on, or would be perceived as able to influence the audit work, has been welcomed by the investor community and most firms.

So, it would appear the prolonged and bitter battle is over. Not so.

Big Five involvement in discussions on how to improve independence rules may have slightly numbed the expected body blow to the Big Five’s future.

All have come out in support of the proposals, but many firms are still left with a bittersweet taste.

While it would appear that the rest of the world moves towards a principles-based approach to ensure impartiality in the profession, US regulators are adamant about retaining a written rule method.

KPMG, Arthur Andersen and Deloitte Touche Tohmatsu, the three most vociferous opponents of the SEC’s proposals, are more than just a little disappointed.

Neil Lerner, head of risk management at KPMG, says: ‘The UK and Europe are already ahead of the US in many of the rules the SEC now seeks to implement. KPMG still regards principles as a better basis for regulation than lists of prescriptive rules.

When Graham Ward, president of the English ICA and IFAC board member, visited Harvard’s Business School recently, he also tried to highlight the deficiencies of hard and fast rules, promoting instead a code of professional conduct based on principles, which he claims to be much stricter than a written rulebook.

Also an adversary of the SEC’s original proposals, the American Institute of Certified Public Accountants favours a less prescriptive approach.

Levitt, however, does not agree. ‘While principles may sound “high-minded,” the lack of precision may not address the level of uncertainty as to which services are permissible and which ones are not,’ he says.

Lou Salvatore, CEO of Andersen Worldwide, says: ‘While we haven’t yet seen the precise language of the entire rule, the principle concerns raised throughout the comment period have been addressed.’

Despite Arthur Andersen’s divorce from Andersen Consulting, now called Accenture, it retains a lucrative consulting service and has maintained a fighting spirit towards the SEC. PwC and E&Y put forward a compromise in September, which would prevent auditors offering larger, IT-based consultancy services to clients.

E&Y sold off its consultancy arm to French firm Cap Gemini in a #7bn deal earlier this year and PwC was negotiating with Hewlett Packard on the sale of its consultancy arm until a week ago when the talks collapsed.

And despite the SEC’s turnaround, CEO James Schiro confirmed PwC would go ahead with restructuring plans announced at the beginning of this year. In fact, PwC was very upbeat over the finalised rules on auditor independence.

‘The new rule the SEC has approved will provide greater certainty, enhanced investor protection, much-needed transparency and the flexibility to adapt our business.’

PwC’s conciliatory mood is notable. Until recently the firm was part of the united front against the SEC proposals. After all, the investigation into auditor independence was driven forward after the revelation that more than half of PwC partners in the US were in breach of the existing independence regulations.

Deloittes’ initial response to the revised rules is somewhat guarded.

‘We have not seen any specific rule language yet, but we hope to have the opportunity to review it in the very near future because of its significant technical content,’ says a statement posted on its website.

The battle may have ended for SEC chairman Arthur Levitt, the SEC’s longest standing commissioner, and the only one who dared to confront the Big Five with stricter rules since the 1980s, according to US papers.

And irrespective of who wins the race to the White House – the US president appoints the SEC chairman – Democrat Levitt is expected to step down before his tenure ends in 2003. His successor will be left with the task of enforcing the new rules, but observers suspect a Republican-led SEC to be much less activist.

Most of the profession is happy to see the end of the protracted debate, some for less obvious reasons. Deloittes Martyn Jones, technical partner, is looking forward to more debate on the ‘real issues’.

‘Maybe the time is coming for people to stand back and say ‘are we looking at the right issues?’ says Jones. ‘The SEC is dealing with perception issues even though there’s not much evidence to support this. A large percentage of problems are due to profit recognition. Are companies under pressure to report too soon?’

This, of course, is another debate and one that only starts now.

WHAT THEY SAID …

Speaking at the second SEC public hearing, English ICA president Graham Ward (right) said: ‘There is no evidence that the provision of non-audit services has resulted in a decline in the quality of the audit.

‘Seeking to enforce internationally a rule-based approach designed for the US economy and US domestic law would do little to achieve high quality and objective auditing throughout the world.’

Deloittes’ CEO Jim Copeland said: ‘To divest the intellectual capital of a highly integrated firm by splitting it up would be the wrong way to go. It would not, in my judgement, solve any of the public policy issues that the SEC is concerned with.’

SEC chairman Arthur Levitt said: ‘Nothing guarantees a short-lived and uncertain future more than eroding the very cornerstones on which America’s marketplace rests. In that light, it baffles and sorrows me to see an apparent willingness by some to discount the very ideals that give the profession its credibility – a willingness to reap the benefits of this public-mandated franchise, but largely ignore the premise of its responsibilities.

Auditors are sometimes encouraged to “go easy” on a judgement call, or “look the other way” when it comes to accounting sleight of hand, all in the name of boosting revenues.’

‘This constitutes something unique to the Big Five – a completely independent global auditing firm,’ said PwC CEO James Schiro on the announcement in February that the firm was committed to separating its audit and consultancy divisions.

TIMELINE

September 1998 – SEC chairman Arthur Levitt begins crusade against accounting abuses

10 January 2000 – widespread violations of auditor independence rules by US partners and staff members at PricewaterhouseCoopers revealed by SEC internal review

January 2000 – new set of independence quality controls for auditors introduced by SEC

February 2000 – the SEC forces the resignation of PricewaterhouseCoopers head of transaction services Geoff Westmore after an internal discovery revealed he was the brother-in-law of the financial controller of media giant Reuters – an SEC-registered company audited by PwC

March 2000 – interviews regarding independence issues conducted at Big Five firms by SEC teams

May 10, 2000 – SEC chairman Levitt announces proposals to modernise rulemaking. Levitt makes veiled threat to force Big Five to split

23 June, 2000 – Lord Sharman, Liberal Democrat peer and former chairman of KPMG International, launches attack on SEC

27 June, 2000 – the SEC approves the publication of a rule proposal to modernise the rules governing auditor independence.

30 June, 2000 – 75-day consultation process to gauge public opinion launched by the SEC.

26 July, 2000 – First SEC public hearing held

29 August 2000 – the deadline to receive comments for those wishing to testify at the September 20, 2000 public hearing on auditor independence extended to September 12, 2000

August 2000 – The SEC looks into PwC action in auditing a real estate investment trust while it was helping the company make acquisitions, according to a prospectus the trust filed

August 2000 – SEC announces second hearing on audit rule changes.

August 2000 – The chairman of Ernst & Young, one of the few big players supporting the SEC’s original effort to tighten auditor independence rules, reportedly publicly criticises the agency’s rule proposal

13 September 2000 – KPMG, Arthur Andersen and Deloitte & Touche write to the regulator demanding careful examination of SEC plans

September 2000 – Federal Reserve governor Lawrence Meyer and former chairman Paul Volcker testify at SEC public hearing on its proposed new audit independence standards on September 13

15 November, 2000 – SEC votes on audit independence regulations.