Remember back last summer, when Harvey Pitt vowed to run a kinder, gentler Securities and Exchange Commission than his predecessor, Arthur Levitt?
With Enron and all that has come after, last summer might as well be a lifetime ago. The audit firms are finding little sympathy at the SEC or even on Capitol Hill these days. On July 24, a Senate-House conference committee agreed upon the most sweeping changes to securities law, corporate governance, and the regulation of auditors since the Securities Exchange Act of 1934. Not even the legendary lobbyists for the big auditors could water down Sen. Paul Sarbanes's (D-Md.) bill in conference committee. Meanwhile, Pitt, who has had to recuse himself from more than a few SEC investigations in the past year because of his former ties to business, has been fighting to hold on to his post. Since the calls for his resignation started, he has been sounding less kind and gentle by the day.
Pitt's problems mark the end of an era. The Sarbanes-Oxley Act, which passed both the House and the Senate by huge majorities and was signed into law on July 30, is intended to fundamentally change the relations between public corporations and their auditors. It will place new restrictions on the services that auditors can provide for their clients, and it will establish an independent board to oversee the industry for the first time in its history.
Congress isn't the only purveyor of new regulations affecting auditors. The New York Stock Exchange will prohibit auditors of listed companies from serving on the boards of clients for five years. Meanwhile, Nasdaq-listed companies will be prohibited from hiring former auditors at all levels for three years. "No one could have imagined all the changes that have happened and are still happening in the industry," says Ed Nussbaum, CEO of Grant Thornton LLP, which, with $342 million in revenues last year, will be the sixth-largest audit firm in the country after Arthur Andersen officially ceases operations on August 31. "It's mind-boggling."
The ultimate responsibility for financial statements may lie with corporate managers, but by any measure, the audit firms have failed miserably in their role as financial watchdogs. And with their profession about to undergo a major overhaul, they have been a very quiet voice in the reform debate. "There's a void of leadership in the audit industry," says Michael H. Sutton, a former chief accountant at the SEC who testified in the Sarbanes hearings. "The firms are all in defensive mode."
For corporate executives, that defensive mode already means tougher, more-expensive audits and less wiggle room when it comes to the interpretation of accounting rules. "If anything, [the auditors] have become overly conservative," says David Banks, head of corporate communications at First Data Corp. The Sarbanes Act is no immediate cure for a deeply shaken market, but it may go a long way toward fostering a more independent and adversarial role for auditors of public companies. "It's a very different environment from nine months ago," says Nussbaum. "Instead of focusing on whittling down our fees, senior executives and audit committees are challenging us to make sure we're doing an adequate job."
An Auditor by Any Other Name
In the past two decades, the accounting firms have ventured far beyond their humble roots. While they have always provided some degree of nonaudit services to clients, the opportunities for new business have exploded in the past 20 years. With the spread of information technology, the biggest auditors became designers and implementers of IT systems. They expanded their tax, legal, and investment advisory services, and branched out into all manner of management consulting work. Since SEC auditor-independence rules enacted in November 2000 began requiring firms to disclose their sources of revenue, the magnitude of the industry's transformation has become apparent. A survey conducted by the Investor Responsibility Research Center found that 72 percent of the $5.7 billion in fees paid by 1,200 public companies to their auditors in 2000 was for nonaudit services.
In his seven and a half years as SEC chairman, Levitt tirelessly pushed the issue of auditor independence, arguing that corporate audits were being compromised by the firms' growing reliance on other sources of revenue. Indeed, in the broader offering of professional services by the audit firms, the actual audit has arguably become a loss leader to land more lucrative consulting contracts. "Some firms used to refer to audits as a commodity," says Nussbaum. "No one believes that now."
The American Institute of Certified Public Accountants (AICPA) has long argued that no evidence exists that the provision of consulting services has ever resulted in a tainted audit, but there is certainly an apparent conflict of interest. "Independence in appearance is as important as in fact," says Charles Mulford, an accounting professor at the Georgia Institute of Technology. "Even if there's a wall between the consultants who might design and implement a system and those who audit the statements, appearances matter."
The Sarbanes Act lists eight distinct services that firms will no longer be allowed to provide to their audit clients, and it gives the new oversight panel the authority to prohibit other services as it sees fit. It also requires that corporate audit committees preapprove all services provided by auditors to the company.
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