VIEWPOINT : While Auditors Watch Clients, Who Should Watch Auditors? : The Profession Needs Additional SEC Regulation

Efforts such as those at the California State Board of Accountancy to raise auditing standards through a process of peer review deserve encouragement and praise. They reflect a sincere attempt by principled professionals to raise the standards of their profession.

However, it would be a serious mistake to conclude that the task of correcting accounting and auditing deficiencies belongs in the hands of 50 separate state boards of accountancy, without additional action by a federal regulatory authority.

Such an approach is at odds with U.S. securities laws and does not promote the efficient and effective functioning of a national securities market. A national market demands uniformly high standards--an outcome that is unlikely to result from separate action by individual state boards of accountancy.

The federal securities laws passed in 1933 and 1934 reflected a recognition that the U.S. economy was nationally integrated. The effectiveness of the securities market was assumed to require a free flow of high-quality information. A supervising commission--first the Federal Trade Commission and, in 1934, the newly created Securities and Exchange Commission--were given authority to provide for such high-quality information by specifying rules for financial reporting and auditing.

The programs to improve auditing performance undertaken by the California State Board of Accountancy attest to the SEC’s failure to do what Congress expected of it--to develop firm rules for financial reporting and auditing.

Transferred the Initiative

By 1937, the SEC had transferred the initiative to develop those rules to the national accounting society, the American Institute of Certified Public Accountants, which still retains the role of setting auditing standards. Authority for setting financial reporting rules was transferred to a private-sector organization, the Financial Accounting Standards Board in 1972.

The SEC refuses to accept financial reports by corporations unless an accounting firm attests that an audit, conducted according to generally accepted auditing standards (GAAS) established by the Auditing Standards Board of the AICPA, found that the client firm’s statements were put together according to generally accepted accounting principles (GAAP). This effectively has given both GAAS and GAAP the force of law, and they have been recognized in the courts as standards to be applied to the performance of accountants and auditors.

Transfer of the rule-making initiative to accounting practitioners themselves produced serious results. In the process of creating standards, practitioners had to keep in mind that they would be judged against these standards.

It can be argued that today’s fuzziness on what constitutes adequate auditing exists because practitioners set their own standards. The SEC should have done the job itself--for everyone’s sake, including the practitioners--and ought to take it back as soon as possible.

Responsible to Many

Accountants really are responsible to at least eight groups: the client, the client’s shareholders, the SEC, state accountancy boards, the general public, the accounting profession, their own accounting firm, and to themselves.

Self-interest and public interest can sometimes clash. For example, accounting firms supply both auditing services and management advisory services (MAS). When corporate performance based on MAS consulting advice is unsatisfactory, there could be a temptation for an accounting firm to bend the rules.

On the one hand, obligations to the public, the profession, and the government demand that accountants avoid any possible conflict of interest. On the other, billings for management consulting services probably approach a quarter of a billion dollars annually for some Big Eight accounting firms; it is easy to rationalize that kind of business opportunity.

Public misconceptions of the role of auditors is not the main problem for the profession. More often, the problem is either the auditor’s failure to detect items that should have caused alarm or the failure to properly handle negative information that was picked up during an audit.

For example, E. F. Hutton’s auditors raised questions about the now highly publicized overdrafting from the company’s bank accounts. But they contented themselves with a statement from Hutton’s general counsel that the overdrafting uncovered by the auditors was legal. That kind of response by auditors is hardly surprising. After all, the client pays the auditor’s bill. It’s not good business for auditors to get clients in trouble with the law by reporting them to the authorities.

Lack Government Mandate

Auditors, however, have a responsibility to the government under the securities laws, despite the fact that they are not official government representatives. (In some countries, they are.) Without a clear government mandate to act in a specific manner, accountants operate under great uncertainty.

The situation has become further complicated because of legal actions taken against auditors. Lawsuits have proliferated in part because of auditors’ ambiguous and possibly irreconcilable responsibilities.

The efforts of the state board of accountancy in California may be motivated to some extent by the alarming increase in lawsuits against accountants. But such efforts are not without risks or complications. For example, can audits reviewed by the state board be used to compromise accountants in negligence actions?

The entry of state boards into the rule-making arena thus points up the uncertainty in which accounting and auditing are practiced in the United States. The problem is not too much federal regulation. The problem is that the responsible agency, the SEC, has refused to provide regulation that is needed.