By Guest commentary Friday, March 21st, 2014

By Steven Mintz

The Public Company Accounting Oversight Board, which oversees public company audits in the U.S., is concerned that auditors are not independent of their clients. Since independence is the bedrock of the profession, any crack in that foundation threatens the value of the audit and there may be consequences for investors and creditors, who rely on accurate and reliable financial statements.

The concern about audit independence — the question of whether the performance of non-audit services for an audit client impairs audit independence — is an old one. For years the profession has claimed that independence is not impaired. Accounting firms claim it does not present a conflict of interest, although they are often soft on clients when audit issues arise because they don’t want to risk losing lucrative non-audit services by going against the client on an audit issue.

Overseas, the European Parliament is expected to vote in April on legislation that would cap non-audit services provided by a company’s auditor at 70 percent of the audit fee. At least 300 companies in the U.S. and Europe paid their auditors as much for add-on services as they did for audit work, according to public filings from the past two years.

The capping of non-audit fees, I believe, will not accomplish its goal. It is an attempt by the government to interfere in the marketplace for professional services. Non-audit fee controls are fraught with danger for the public interest. The possibility exists that the firms will cut down on staff providing the non-audit services by sending in less experienced and/or a smaller numbers of staff, thereby compromising audit quality. And auditors may simply recover from the non-audit fee controls by charging clients for whom audits are not performed higher fees when non-audit services that are currently banned (i.e., information systems design and installation) are performed for that client.

One example of the imbalance between fees received for audit and non-audit services is that HSBC Holdings PLC paid its auditor, KPMG LLP, $208 million for “other services” between 2010 and 2012. That’s more than five times as much as the U.K. bank paid the firm for auditing its books. HSBC claims it only uses KPMG for extra services when it can benefit from the firm’s historical knowledge of the bank and when its independence won’t be compromised. That seems appropriate to me.

The accounting profession has ethical standards in place to control for a possible loss of independence. These include assessing whether the client has assumed responsibilities for the services, adequately overseeing performance, evaluating the client’s adequacy and results and accepting responsibility for the results.

I do not dismiss the concerns of regulators about possible impairments of independence. In fact, in January 2014, accounting giant KPMG agreed to pay $8.2 million to settle SEC allegations that it had violated rules intended to keep outside auditors from getting too close to their clients.

So what’s the answer to the continuing battle between the accounting profession and securities regulators about audit independence issues?

In the European Union, one proposal suggests that audit firms be spin off from their non-audit divisions and operated solely as audit practitioners. Proponents argue that audit firms can’t be independent as long as they provide (often-lucrative) non-audit services. Doing so represents a conflict of interest, the argument goes.

Opponents argue that many talented individuals will be pushed out of the profession by such rules. I personally believe such reform may lead to larger fees for such services, which is unfair to a client who should have an ethical right to choose a preferred provider of non-audit services.

Another proposal is for the government to transfer responsibility for financial audits of companies to a governmental agency. Under this proposal, companies would contribute to a fund used to compensate the government auditor. A company’s contribution to the fund would be determined by the expected complexity of the company’s audit. The government agency would be responsible for auditing only publicly traded companies. My problem with this proposal is that a governmental agency won’t perform as well as the marketplace — it may be bureaucratic, slow-moving and inefficient.

The answer always comes down to the ethics of individuals and the firms that provide non-audit services for audit clients.

The accounting profession has established ethical standards to counteract any threats to independence and recommends measures that build in safeguards to prevent threats from compromising independence.

Just because there may be an occasional lapse in independence, such as in the KPMG case, doesn’t mean we should throw out the baby with the bath water. If the rules need to be tightened, then the profession should do so through the deliberative process that has served the business community well for decades.

• Steven Mintz is a professor in the Orfalea College of Business at Cal Poly San Luis Obispo. He writes an ethics blog at www.ethicssage.com.