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FINANCIAL AUDITING: THE NEED FOR FULL INDEPENDENCE

The market system rests upon the assumption that companies provide accurate information to investors. It is the auditors' duty to ensure that corporate financial reports accurately conform to a set of uniform standards. Although it has the power to promulgate accounting and auditing standards (a responsibility it delegates to the Financial Accounting Standards Board), the SEC does not audit corporations.

According to the GAO one in ten publicly traded companies had to restate their earnings between 1997 and 2002 because of accounting irregularities. According to a study by the Huron Consulting Group, the overall amount of restatements only dropped slightly the first year after Sarbanes-Oxley -- dropping from 330 to 323 between 2002 and 2003.

It is widely recognized that the failure of auditors to curb the epidemic of accounting fraud is attributable to the big accounting firms' conflicting role as consultants to their audit clients, pointing to the need for truly independent audits.

Unfortunately, the much-vaunted Sarbanes-Oxley accounting reform law that President Bush signed with great fanfare failed to establish the complete independence of financial audits. Although Sarbanes-Oxley prohibited certain forms of consulting by auditing firms, it allowed for others, including tax consulting. In addition, certain restrictions on consulting were watered down during the SEC's subsequent rulemaking.

According to the Wall Street Journal, even after selling off their consulting arms, "accounting firms continue[d] to advise on everything from management processes to tax-minimization strategies to corporate finance to the security of clients' computer networks, obtaining more than an estimated 50% of revenue from non-auditing sources. Remaining business lines also include compensation consulting, litigation support and personal financial planning for wealthy clients. Some firms even have small broker-dealer units, offering corporate-finance and merger advice." ("Accounting Firms Are Still Consulting," by Cassell Bryan-Low, Wall Street Journal, September 23, 2002)

Industry journals such as Accountancy Age report that although the Big Four accounting firms have divested themselves of their consulting arms, they are looking to step back into the consulting arena in 2005, once the terms of the sale agreements lapse.

"If we want honest financial accounting, we need to truly eliminate conflicts of interest," says accounting professor Don Moore of Carnegie Mellon University. "We must bar audit firms from providing other services to clients ... in the absence of reforms that control conflicts of interest, more failures of auditor independence, more false profits, and more financial scandals are inevitable, no matter who heads the accounting oversight board" established under the SEC by Sarbanes-Oxley. (See "An Honest Account," by Don A. Moore, Wall Street Journal, November 13, 2002)

Specific ways to make auditing completely independent were proposed at the height of the accounting fraud epidemic, but received little support from Congress. Business Week, for example, proposed that "all publicly listed corporations contribute to a fund that pays for accounting firms to audit their books. That would effectively end the fundamental conflict of interest accountants now face when they must police the very companies that pay their fees." (See "The System Needs Fixing, Mr. President," Business Week (editorial), July 15, 2002)

The Conference Board’s blue-ribbon Commission on Public Trust and Private Enterprise concluded that auditing firms should ultimately be barred from providing services to the same clients which create a conflict of interest: "[P]public accounting firms should limit their services to their clients to performing audits and to providing closely related services that do not put the auditor in an advocacy position, such as novel and debatable tax strategies and products that involve income tax shelters and extensive offshore partnerships."

The Investor, Shareholder, and Employee Protection Act of 2002 (H.R. 3795), would establish a Federal Bureau of Audits at the SEC. Described as a way to ensure that investors are guaranteed to receive accurate information.

Related Proposals:
Accountability for Auditors Act of 2002 (H.R. 3617). Would withdraw certain benefits of the Private Securities Litigation Reform Act from auditors that perform non-audit functions.

For More Information:
Financial Oversight of Enron: The SEC and Private-Sector Watchdogs Excellent report by Senate Committee on Governmental Affairs (10/7/02)
"Financial Statement Restatements" Trends, Market Impacts, Regulatory Responses and Remaining Challenges (GAO-03-138), October 2002
PCAOB Roundtable on Auditor Independence and Tax Services

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