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What SOX Says to CPAs? [Every Auditor’s Dilemma]



Every Auditors DilemmaAccounting firms don’t live on audits alone. Virtually all accounting firms perform some sort of consulting or advisory services (such as tax-related work) in addition to carrying out the audit function. When these advisory services are rendered, the question of independence emerges. Can an audit firm objectively examine financial statements prepared by management while relying upon management to renew a lucrative consulting contract? This is an ongoing dilemma that Sarbanes-Oxley [SOX] attempts to address. The auditor independence provisions of SOX were strongly influenced by the fact that Arthur Andersen received $25 million in audit fees and $27 million in consulting fees from Enron in the years prior to its bankruptcy filing. The SEC has high expectations for the accounting profession and views the auditor’s opinion as an important instrument in protecting the public. The agency has stated that the auditor’s opinion “furnishes investors with critical assurance that the financial statements have been subjected to rigorous examination by an objective, impartial and skilled professional, and that investors, therefore, can rely upon them”.

In order to ensure that auditors are “objective, impartial and skilled,” Sarbanes-Oxley [SOX] and the corresponding SEC rules impose upon them the requirements that I discuss in post. Enjoy!



One Year Cooling-Off Period to the Whole Audit Team

It used to be that accounting clients openly recruited members of an outside audit staff to fill positions in their own accounting departments, which explains why a lot of CFOs and controllers started as auditors.

Now both SOX and corresponding SEC final rules require a one-year cooling-off period before any member of an audit engagement team can go to work for a former audit client. This cooling-off period is intended to prevent undue influence on audit quality. The concern is that a former member of the audit team may attempt to influence that team in order to benefit his or her new employer.


Services That Cause Conflicts Are Prohibited

After SOX, many auditors find that they may have to choose between performing an audit OR performing other equally lucrative services for a client. Most banned services are related to consulting or advisory services that could create a conflict of interest for independent auditors. Ouch!

Under SOX Section 201 and SEC Regulation SX Rule 2-1(c) (4), auditors are no longer permitted to provide the following types of services to the clients they’re auditing:

  • Bookkeeping: Auditors can’t keep books, maintain accounting records, or provide other related services to a client. Doing so destroys the auditor’s independence, as defined by SOX and SEC rules. If bookkeeping services weren’t prohibited, auditors would potentially be auditing records and financial statements they themselves prepared.
  • Information systems: An auditor can’t help a company design or implement financial information systems because ultimately the auditor must evaluate those same systems for control and compliance. Prior to SOX, installing and maintaining computerized accounting systems for large clients were very lucrative consulting services offered by many big accounting firms. Since this activity was first banned in 2000 (prior to SOX), many accounting firms have sold off their computer consulting divisions.
  • Appraisal and valuation services: These systems involve determinations of fairness and reasonableness of exchanges of property and money. The value assigned to these assets directly affects the balance sheet and other financial statements.
  • Actuarial services: Because actuarial services involve a determination of amounts recorded in the financial statements, auditor involvement can lead to a conflict of interest if questions regarding the audit arise.
  • Internal audit outsourcing services: Sometimes a company needs extra manpower to perform its accounting functions and may hire a third party service provider for this purpose. Examples of outsourced services include payroll, internal audit functions, or financial information gathering. Because these outsourced services are related to some of the information that must be audited, auditors can no longer perform them for the clients they audit.
  • Management functions: Auditors can’t act temporarily or permanently as directors, officers, or employees of an audit client.
  • Human resources: Auditors can’t act as so-called headhunters and help the client company find or do background checks on candidates for positions in managerial, executive, or director positions.
  • Broker-dealer, investment advisor, or investment banking services: Auditors can’t act as brokers, promoters, or underwriters on behalf of a client they’re auditing, nor can they assist in making investment decisions.
  • Legal services: Auditors can’t provide any service to audit clients that could be provided only by someone licensed to practice law.
  • Expert services unrelated to audit: Auditors can’t give their clients expert opinions on matters that may be the subject of the audit. For example, an auditor can’t write his client a memo containing his opinion about a regulatory issue.


What economic impact does the list of prohibited services have on the accounting profession as a whole? It means that the large accounting firms simply work for more companies, and the companies themselves work with multiple accounting firms.


Auditors Should Get Prior Permission For Potential Conflicts

Services not banned outright by SOX Section 201 and the SEC rules may be permitted if auditors jump through the right hoops. If a service isn’t on the prohibited list, such as tax services, for example, it’s permitted if the auditor gets permission from the client’s audit committee before doing the work.

The SEC rules require that the company disclose on its financial statements any fees it pays to its auditors. Companies must separately disclose fees they pay their auditors to perform audit and non-audit services.

Tax services are one area in which audit firms have been given some leeway. Generally, an audit firm may give tax-planning services and advice to a client but can’t represent the client in a pending tax proceeding.


Change Partners!

Both SOX and SEC rules prohibit long-term client/auditor relationships. Specifically, they limit the time that a partner can serve on a client’s audit to five consecutive years. Apparently, the SEC and Congress have determined that the value of experience is outweighed by the risk of losing one’s objectivity.


Wait Seven Years To Shred

SOX introduces a seven-year storage rule for accounting firms; they must retain all records relevant to the audits and reviews of any companies that file reports with the SEC.

Records that can’t be purged or shredded under SOX Rule 802 include work papers as well as electronic records that contain conclusions, opinions, analyses, and financial data related to the audit or review. Specifically, the SEC requires accounting firms to retain any documentation that’s “inconsistent” with conclusions reached by the auditors in the course of the audit.


Recognize When Auditors Are “Impaired”

It’s the job of a company’s audit committee to identify situations in which an auditor’s independence is impaired and recommend appropriate action. Under the new stringent standards introduced by SOX, what happens to auditors whose independence is somehow compromised? A violation of the independence rules may result in a company being forced to change auditors midstream, before the audit is complete. This interruption in the process can result in considerable cost to the company for duplicative services. If the auditor’s impairment isn’t remedied during the audit, the consequences may be even worse — financial statements may be required to be restated or reissued.

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