auditors to examine or verify every transaction would be too expensive for the benefits obtained. Accordingly, they use the following approach: (1) They review the procedures the company follows and (2) they make tests of transactions and account balances. In following this approach, the auditors (1) review a client's internal procedures designed to safeguard its assets and properly record its transactions, (2) examine on a test basis physical assets and supporting documents, and (3) obtain independent outside confirmation of certain transactions--all for the purpose of forming an opinion as to the fairness of presentation of the information in the client's financial statements in conformity with generally accepted accounting principles.

The auditor is alert for unusual transactions which could materially affect the company's financial statements. When he becomes aware of such transactions, he investigates them until he is satisfied that they have been accounted for and disclosed in conformity with generally accepted accounting principles.

An audit is not a 100 percent verification of every receipt or disbursement for a year; it is not a guarantee that every amount shown in the financial statements is correct; it is not an assurance that every asset of the company has been properly accounted for and that none is missing; and it is not a representation that all employees are honest and that nothing irregular has occurred during the year.

The Staff and others who would put upon the independent audi tor the responsibility for absolute "accuracy of financial data" and absolute responsibility for detection of fraud or illegal acts do not understand the nature of an audit or the relation of audit costs to benefits which can be obtained. In testing and examining selected items, and searching for material unusual items, the auditor cannot be a guarantor. He relies upon

the company's internal controls in determining the extent of his procedures. Even when the company's internal controls are well conceived and applied, however, integrity of management is necessary to protect against fraud. When management is honest, an owner, investor, lender, or regulatory agency has the greatest assurance as to the fairness of financial statements.

The independent auditor provides a critical function--an independent and objective examination of financial statements and an expression of his opinion thereon.

The Staff charges that auditors lack independence: "This Study finds little evidence that they serve the public or that they are independent in fact from the interests of their corporate clients." To the contrary, a principal contribution of the public accounting profession to the capital markets--in fact, a primary reason for the existence of the large firms--has been independent and objective reporting on the financial statements of publicly held companies. The concept of independence is fundamental to the accounting profession.

In addition to the personal attributes of integrity and objectivity--independence as a frame of mind--the profession has also dealt with the appearance of independence and, for this reason, is constrained by several written codes of ethics, some private and some governmental.

The AICPA's Code of Professional Ethics includes a comprehensive set of rules, interpretations, and rulings that require the Institute's members to avoid situations that would create conflicts of interest or bias, either in appearance or in fact.

5 This subject is discussed in greater detail in Chapter 2,

beginning on page 31.

This code is stringent and more restrictive than any of the codes of ethics of the executive, legislative, or judicial branches of the U.S. government, whose employees should be just as responsible to the public interest as are CPAs. The accounting profession's code of ethics seeks to avoid conflicts of interest by prohibiting financial interests and other circumstances which could give rise to the conflict. On the other hand, the government's approach generally is to require disclosure of the circumstances, such as a financial interest, giving rise to potential conflicts of interest, but not to prohibit continuing the financial interest.

The Staff Study alleges that performance of management advisory services by an independent accounting firm for its audit clients compromises the firm's independence by creating a "professional and financial interest in a client's affairs which is inconsistent with the auditor's responsibility to remain independent in fact and in appearance." Further, the Staff suggests that an auditor "may be placed in the position of auditing his own work."

Providing management advisory services is a natural function of independent auditors. In doing an audit, auditors frequently become aware that a client's internal controls, recordkeeping procedures, or methods of accounting for certain transactions can be improved. Management advisory services typically result in recommendations leading to improved accounting systems. Effective accounting systems help managements improve the reliability, timeliness, and availability of financial information, improve accountability in their organizations, and do their accounting more economically. Such improvements, in turn, benefit shareholders and other users of financial statements.

The Staff appears to believe that independent auditors, in the process of providing management advisory services for

audit clients, make decisions that management should make.

This is not true in our firm's practice. All our management advisory services engagements are conducted under a policy requirement to refrain from making our clients' management decisions.

The Staff Study cites not a single case in which providing management advisory services had contributed to a failure of audit performance either because the auditor's independence was impaired or for any other reason. We do not know of any such case. We are confident that there are a great many cases where the providing of management advisory services has improved the accounting systems of our clients and thereby enhanced the reliability of financial reports by those clients.

Prohibiting auditors from providing management advisory services would deny the businessman an important source of specialized professional advice based on his auditor's existing and substantial knowledge of his operations.

The Staff Study suggests that the major accounting firms dominate various professional organizations and somehow conspire to benefit unfairly the managements of their corporate clients.

The accounting profession consists of a number of firms of widely varying sizes. The large firms have developed in response to a public need for auditing assurances with respect to the financial statements of large multinational companies.

These large firms, which compete actively for their clients, are capable of applying, on a worldwide basis, the discipline of

6

This subject is discussed in greater detail in Chapter 3, beginning on page 47.

their organization and consistent auditing procedures to the various components of multinational companies. The firms, thus, obtain an overview of significant financial transactions of the entity, which improves the firm's ability to fully understand these transactions, and report on the entity's consolidated financial statements. The public interest would not be served if audits of multinational companies were conducted by a consortium of small firms. They would lack the discipline of the one-firm approach, and the ability to achieve consistency in auditing on a worldwide basis.

Further, large firms are independent when there are disagreements with major clients because no one client is critical to a firm's financial or professional well-being. We have no client we would not be willing to give up if we lost confidence in the integrity of its management.

Recognizing their public responsibilities, large accounting firms invest substantial portions of their revenues to recruit outstanding students, to provide extensive and continuing educational programs, to perform significant review and other quality control procedures, and to encourage their people to participate in professional activities aimed at improving the quality of auditing standards and accounting principles. These firms are active and essential participants in contributing their views to the process of setting auditing standards and accounting principles and resolving complex issues.

The Staff asserts these firms conspire in setting accounting and auditing standards. In fact, in the setting of accounting and auditing standards, our firm frequently disagrees with the positions of other firms, and the large firms often disagree with each other. Surely, they do not speak with a single voice.

The Staff alleges our contributions to the standard-setting process represent an effort to benefit our clients' selfish in