SEC Auditor Independence Requirements

Abstract

INTRODUCTION In June 2000, the SEC issued Proposed Rule S7-13-00, Revision of the Commission's Auditor Independence Requirements (hereafter the Proposed Rule). The Proposed Rule primarily deals with five areas related to auditor independence: * governing principles for determining when an auditor is not independent, * financial relations with an audit client, * employment relations with an audit client, * provision of nonaudit services for or in alliance with an audit client, and * disclosure of fees for nonaudit services. The SEC cited recent developments in the business world and the auditing profession as the impetus for the Proposed Rule. These developments include increased business and financial relationships between auditors and their clients, the increase in dualcareer families and mobility of accounting professionals, and changes in the magnitude and nature of nonaudit services (SEC 2000a, Section I). A senior member of the SEC staff asked the Financial Accounting Standards Committee of the American Accounting Association (hereafter the Committee) to respond to the Proposed Rule. Given the importance of auditor independence to financial reporting and the Committee's charge to respond to requests for input on issues related to financial reporting, we agreed to this request. In preparation for writing the comment letter, the Committee read academic articles, financial press articles, documents prepared by the Independence Standards Board, the text of testimony given by individuals in SEC public hearings, and the text of speeches made by SEC officials, including former Chairman Arthur Levitt and Chief Accountant Lynn Turner. This article summarizes the content of the letter submitted by the Committee to the SEC in October 2000. (1) The article first discusses foundations for the Committee's views. The Committee's views are presented next, organized according to five primary areas covered by the Proposed Rule. Within each area, we discuss the Proposed Rule, summarize any related research, and present the Committee's view on the Proposed Rule. The concluding section of this article briefly notes differences between the Proposed Rule and the final rules issued by the SEC in November 2000. FOUNDATIONS FOR THE COMMITTEE'S VIEWS The Committee's views are based on results of empirical academic research, views previously expressed by the Committee, and several assumptions about the persons and entities involved in or influenced by financial statement audits. The relevant empirical academic research is discussed below for each area of the Proposed Rule. Additionally, three views previously expressed by the Committee guide its general views on the Proposed Rule. The first view is that concepts based standards are preferred. (2) The second view is that, where possible, standard setting should be the responsibility of independent private sector standard setters who are chosen for their technical expertise. (3) The third view is that the goal of rulemaking and standard setting should be the development of clear and operational guidelines that apply as broadly as possible across jurisdictions. (4) Finally, the Committee's views are based on the following assumptions. 1. Auditor independence is desirable because it is an input to reliable financial statements. That is, auditor independence increases the quality of the audit, which in turn increases the reliability of the financial statements. Auditor independence is not, however, an objective in and of itself. 2. Good quality audits require both competence (expertise) and independence. These two qualities have direct effects on actual audit quality, as well as potential interactive effects. In addition, financial statement users' perceptions of audit quality are a function of their perceptions of both auditor independence and expertise. 3. The auditor is an expert and a professional. …