Hearing Testimony:
Auditor Independence

UNITED STATES SECURITIES & EXCHANGE COMMISSION

HEARING ON AUDITOR INDEPENDENCE

Wednesday, July 26, 2000

9:00 a.m.

Before:

ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner

United States Securities & Exchange Commission
William O. Douglas Room
450 Fifth Street, N.W.
Washington, D.C. 20549

PERSONS PROVIDING TESTIMONY

John D. Hawke, Jr., Comptroller of the Currency

J. Michael Cook, former Chairman and CEO,
Deloitte & Touche

Rick Antle, Professor of Accounting,
Yale School of Management

John C. Coffee, Jr., Professor of Law,
Columbia University Law School

Paul B.W. Miller, Professor of Accounting
University of Colorado at Colorado Springs

John H. Biggs, Chairman, President and CEO, TIAA-CREF

Ray J. Groves, former Chairman and CEO, Ernst & Young

J. Terry Strange, Vice President, Global Managing Partner
for Audit, KPMG

Joseph F. Berardino, Managing Partner,
North America Assurance and Business Advisory Practice

Robert Garland, Audit Practice Partner,
Deloitte & Touche U.S.

Jack T. Ciesielski, R. G. Associates, Inc. and Publisher,
The Analyst's Accounting Observer

William T. Allen, Chair, Independence Standards Board

John C. Bogle, Member, Independence Standards Board

Robert E. Denham, Member, Independence Standards Board

Manuel H. Johnson, Member, Independence Standards Board

George Loewenstein, Professor of Economics and Psychology, Carnegie Mellon University

Max H. Bazerman, Professor, Kellogg Graduate School of Management, Northwestern University, and Fellow,
Harvard Business School

Douglas R. Carmichael, Professor of Accounting,

Bernard M. Baruch College, City University
of New York and former Vice President, AICPA

Curtis C. Verschoor, Research Professor, DePaul University

Dan L. Goldwasser, Vedder, Price, Kaufman & Kammholz

Alfred M. King, Chairman of the Board,

Valuation Research Corporation

Nimish Patel, Pollet & Richardson

SEC STAFF PARTICIPANTS:

David Becker, General Counsel

David Martin, Director, Division of Corporate Finance

Lynn Turner, Chief Accountant

Jonathan Katz, Secretary, Hearing Officer

C O N T E N T S

Opening Statements by the Chairman and Commissioners

Sessions

Session One

Presentation of John D. Hawke, Jr.

Session Two

J. Michael Cook

Session Three

Rick Antle

John C. Coffee

Paul B.W. Miller

Session Four

Ray J. Groves

John H. Biggs

Session Five

Robert Garland

J. Terry Strange

Joseph F. Berardino

Session Six

Jack T. Ciesielski

Session Seven

William T. Allen

Manual H. Johnson

Robert E. Denham

John C. Bogle

Session Eight

George Loewenstein

Max H. Bazerman

Douglas R. Carmichael

Curtis C. Verschoor

Session Nine

Dan L. Goldwasser

Alfred M. King

Nimish Patel

P R O C E E D I N G S

CHAIRMAN LEVITT: I'd like to welcome everyone this morning to the first public hearing on the Commission's proposals to modernize the rules that govern auditor independence.

This is an important initiative during a pivotal time for the accounting profession. Product line expansion, firm consolidation and structural reorganizations amidst an intensely competitive environment have very real ramifications for the independence of the public accounting profession.

Some say that the time is now for reasonable action. Others say no steps whatsoever are needed or even warranted. Whatever the views expressed I earnestly hope we will all see the value, at the very least, in having a fully informed and constructive public dialogue on an issue that is so central to the health of our financial markets. Timely, open and civil discussion can only advance the public interest.

There is an honest disagreement whether recent developments in the accounting profession merit, warrant modernizing the rules, but given what's ultimately at stake, the confidence of America's and the world's investors, surely we can come together in good faith and argue this rule proposal on its merits.

That's why the Commission has convened today, to listen and to learn. And I hope this hearing and others will make clear this is not an exchange only between a segment of the profession and the Commission.

As you will see and hear today, many public officials, CEOs, financial analysts, those in the legal and academic communities, in government and investors both large and small care deeply about the independence of the accounting profession.

They know the indispensable role a critical unbiased eye plays in giving investors comfort and faith in the numbers. In recent years, whole economies around the world have faltered because of lax standards and inadequate attention to the fundamentals of high quality financial reporting.

In this country, investors have lost billions of dollars through financial frauds that were driven by an overriding desire to meet the expectations of the short-term at the expense of solid performance over the long term.

More than anyone else it is the independent auditor who stands guard in defense of the public interest. It is his duty and his unique franchise to protect and honor that interest.

That's why I look forward today and over the next few weeks and months to a thoughtful, fair and open dialogueamong all market participants on this vitally important subject.

I'd like to turn now to Commissioner Hunt.

COMMISSIONER HUNT: Thank you, Mr. Chairman. Good morning, ladies and gentlemen. These are contentious issues and have been for years. There are strongly held views on each sides of these issues. I hope we can resolve them sooner rather than later.

I think everybody agrees that some reforms of our rules with respect to independence are needed. The big question is the extent of the scope of the reforms that are needed, and I hope we can get some meaningful discussion, as the Chairman said, from practitioners, members of the industry and members of the public to help us go forward and, first, do no harm, and to reform our rules in a meaningful and intelligent way.

So I look forward to the testimony. Thank you,

Mr. Chairman.

CHAIRMAN LEVITT: Commissioner Carey.

COMMISSIONER CAREY: Thank you, Mr. Chairman. I'd like to express my thanks to everyone for participating today and also my thanks to the staff of the Office of General Counsel and the Office of the Chief Accountant in making this hearing possible. I know a lot of hard work went into that.

I'd just like to start out by saying that ourmarkets attract capital because investors have basic confidence in the integrity of our markets. Quality financial information and meaningful disclosure fuel that confidence.

Auditor independence is a crucial component of the financial reporting system that lies the foundation of our market strength. That said, the primacy of our position in the world of quality financial reporting cannot be assumed as a given.

The accounting world has changed and continues to change to meet the demands of today's corporate environment, and the role of the independent auditor remains critical. Rules designed to ensure auditor independence in fact and appearance must respond to marketplace realities if the rule are to remain effective and fair.

So we face an important and complex issue today. I recognize that there are compelling and rationale arguments on all sides of the auditor independence debate. Your comments are a value part of the rule-making process, and I welcome your input in the form of both comment letters and testimony.

Thank you all for coming today.

CHAIRMAN LEVITT: Commissioner Unger.

COMMISSIONER UNGER: Ditto. I think my colleagues have said it all, and we have a short schedule and a lot ofvery impressive witnesses. The debate has been going on for years. I haven't been a part of it, so I am looking forward to being a part of it now, and I'd like to welcome the witnesses and thank them for their time.

Session 1

CHAIRMAN LEVITT: I would like now to call on our very distinguished first witness, Comptroller John D. Hawke, Jr.

MR. HAWKE: Chairman Levitt and Commissioners, I'm honored to have the opportunity to participate in today's hearing on the Commission's proposal to revise the rules related to auditor independence. I believe the Commission's proposed rule deserves careful consideration by all interested parties, and I applaud you for this initiative.

In my oral statement, I'll focus on some trends we're seeing in the relationships between external auditors and national banks and my concern about those trends. My written statement includes a broader discussion of the importance of independent external and internal audits for the safety and soundness of the banking system.

It's indisputable that independent auditors play a critical role in maintaining public trust in our financial markets and in the integrity of corporate financial statements.

Accordingly, ensuring not only the independence of external auditors but also the appearance of independence isvitally important for investors and other users of financial statements, including bank supervisors.

It's also important to recognize that the factors that influence independence may be extremely subtle and difficult to identify and that the consequences of an impairment of independence may be difficult to document.

In a sense, independence may really be more of a state of mind than a legal status, and thus building safeguards for independence can present difficult challenges. In an ideal world, the external auditor should be free from any extraneous influences and motivations that might cause it to express anything less than its frank and forthright opinion.

The Commission's proposed rule would comprehensively modernize and strengthen the standards for determining independence. Most relevant to the OCC's concerns, the proposal would establish the standard that an external auditor would not be deemed independent if it provided internal audit services for an audit client or an affiliate of an audit client subject to certain limited exceptions. This part of the proposal is of great importance for bank supervisors, and we support its adoption.

Recently, we've seen a growing number of national banks out-source some or all of their internal audit functions to auditing firms. This practice raise concernsthat bank management and examiners must carefully assess.

Specifically, banks' board of directors and senior management must understand that these arrangements don't relieve them of their responsibilities for establishing, maintaining and operating effective independent audit programs.

Management and the board cannot allow out-sourcing arrangements to compromise the integrity or independence of either a bank's internal or external audit functions.

When a bank out-sources its internal audit function to the same firm that performs the bank's external financial audit, however, the possibility for inherent conflicts and impairments of auditor independence and auditor integrity is greatest.

Such arrangements introduce a number of risks, including, as the Commission has noted, questions about the independence of the external auditor both in fact and appearance.

In addition, these arrangements eliminate the normal checks and balances that could be expected to operate where the internal and external audit functions are performed independently, and they deprive management of the ability to have the bank's external auditors, perhaps the entity best qualified to do so, to evaluate the quality of the internal audit.

Currently, the OCC and the other banking agencies don't impose a blanket prohibition on a bank's out-sourcing internal audit work with the same external firm that audits its financial statements because we follow the SEC's and the AICPA's current rules and standards on auditor independence.

However, we discourage this practice and impose a number of safeguards and quality controls to address our supervisory concerns. Guidance is set forth in a 1998 Interagency Policy Statement as well as our recently issued Handbook on Internal and External Audits. And Mr. Chairman, we've provided copies of that handbook to the secretary for the Commission and its staff.

The OCC has seen a number of cases in which national banks have out-sourced internal audit to the same firms that provide their external audits, and several of these arrangements have involved larger institutions and have involved extensive planning, coordination and consultation between the bank's senior management and the auditing firm's senior partners.

While these arrangements incorporate the various safeguards outlined in the Interagency Policy Statement and have served to improve the quality of internal audits, I have strong reservations whether even these safeguards can sufficiently address the issue of external auditor independence.

The pressures and influences that may come to bear on external auditors who are also seeking to perform the internal audit function may be exceedingly subtle and may not be effectively addressed by objective safeguards.

Even more problematic are the out-sourcing arrangements that we're seeing among smaller community banks. In many of these cases, neither the bank nor the outside auditors have the staff or resources to institute the safeguards outlined in the Interagency Policy Statement.

While we recognize that banks in some smaller communities may have a limited range of external auditors to choose from, the maintenance of independence can be even more important in banks that lack the resources to manage their internal audit function effectively, and many of these smaller banks tend to be dominated by a single individual so that the presence of an effective and independent audit function is doubly important.

Having said that, I do have a concern about the impact of the rule on smaller banks. Under banking agency rules, banks with less than $500 million in assets are not required to have independent external opinion audits, although a substantial number, in fact, do.

I would be concerned if a rigid application of a rule against out-sourcing internal audit caused some smaller institutions to elect to forego independent external auditsin order to be able to continue out-sourcing internal audit functions to the same firm that had been using for external opinion audits. This is an issue that we'd like to discuss further with you as your work on the proposal progresses.

Given the important and evolving role that external audits and auditors play in national banks' risk management program, I believe the Commission's review of its auditor independence rule is timely and warranted.

This review is consistent with many of the discussions taking place among bank supervisors. It's an issue, for example, that the Bazel Committee on Banking Supervision has been taking up recently, and I applaud the Commission's efforts to address this important issue in a balanced and careful manner.

Although I'm very interested in the perspective that other participants in these hearings and commentators will bring to this discussion, I believe the SEC's proposal attempts to strike a reasonable balance in this area.

In particular, I agree with the Commission's initial view that a blanket prohibition on providing any consulting or non-audit services to financial statement audit clients may be unduly broad given the considerable expertise that audit firms can provide their clients.

With regard to arrangements involving the out-sourcing of internal audit to the external auditor, however,I believe there are serious risks that both the auditor's independence may be compromised, and the banks will be deprived of the benefits that can flow from having internal and external audit functions performed independently of one another.

In light of the importance that we place on the audit functions in the conduct of our supervisory responsibilities and given the subtlety of the pressures and influences that can come to bear, I believe the Commission's proposal on out-sourcing the internal audit to the external auditor is right on the mark and should be supported.

We look forward to consulting with you and the other banking agencies on this subject as the Commission moves forward with this proposal. Thank you.

CHAIRMAN LEVITT: Thank you very much. You've had a lifelong experience of dealing with banks. You've been counsel to banks, and you're the most important banking regulator in America today.

A good part of your testimony was devoted to this issue of out-sourcing. I wonder if you could, kind of, simplify it in terms of those who are not as familiar with bank accounting in terms of what you think the risk is and a practical description of how that risk might take form.

MR. HAWKE: Well, first let me say, Mr. Chairman, that none of the banking agencies has unlimited resources,and we have to deploy our examination resources in a way that most comports with our judgment of where the risks are.

In an institution that has a weak internal audit function or a weak external audit based on our evaluation, we are necessarily required to devote more of our resources to our examination of that institution than we otherwise would.

So we put enormous importance on the quality and independence of the audit functions both internally and externally. We evaluate both internal and external audit in determining how much of our resources to apply to a particular institution.

Evaluation is tremendously important, and we think it's important that a bank's external auditors be able to express their views on the quality of internal audit. That opportunity is lost where internal audit is out-sourced to the same firm that's doing the same external audit.

So the quality and independence of the audit function really lies very much at the heart of what we do.

CHAIRMAN LEVITT: Going back to the problems of the savings & loan era, can you recall any issues dealing with the out-sourcing of the audit?

MR. HAWKE: I can't recall issues relating to out-sourcing of the audit as such. Of course, I think a lot of the roots of the savings & loan problem of the late '70s really focused on accounting issues, but I wouldn't attributeit to a problem of impaired independence.

CHAIRMAN LEVITT: What do you think the motivation for the out-sourcing is? Is it purely economic, in your judgment?

MR. HAWKE: I think today our banks are under tremendous pressures to reduce their costs to be able to maintain high levels of return on equity. We're seeing cost-cutting at banks across the board.

One of the things that concerns us, as a general matter, is that cost-cutting pressures may lead not only to the out-sourcing of internal audit but to the reduction of the resources attributed to internal loan review.

So I think a lot of this is driven by the desire of financial institutions to reduce their costs.

CHAIRMAN LEVITT: Do you see this as a proliferating trend? Have you seen more of it in recent months than before?

MR. HAWKE: It's a trend that we're concerned about. Of our 50 largest banks, 8 out-source their internal audit, and 7 of those 8 out-source to the same firm that does their external audit. That's a pretty good chunk of the largest banks.

We did a survey in the Northeast region, and a third of our banks in the Northeast region out-source audit, and half of those out-source to the same firm that does theexternal audit.

We haven't surveyed our other regions, but if that ratio is typical of what's going on throughout the country, I think it's an issue that should present serious concerns.

CHAIRMAN LEVITT: Would you have any problem with the out-sourcing to firms that do not perform the internal audit?

MR. HAWKE: We don't have, obviously, an independence concern in that regard. We would want to make sure that management is still paying attention to the quality of internal audit. This is a key concern for management, and we would want to make sure that boards of directors and management didn't view their responsibilities at an end just because they had out-sourced an audit to an external firm.

CHAIRMAN LEVITT: Other questions?

COMMISSIONER CAREY: Do you feel that audit committees at the banks under your regulation are playing a sufficient role in monitoring these practices on the boards of the banks that you regulate?

MR. HAWKE: I would be reluctant to make an across-the-board judgment on the quality of audit committee performance. This is a subject, though, that we put a tremendous amount of importance on.

We think that both in dealing with the external auditors and particularly in assuring the independence ofinternal audit, the function of audit committees is critical. COMMISSIONER HUNT: Doesn't it bring to the argument, sir, that when an auditing firm performs outside functions, other functions for a client, it gets to know the client better and therefore can do a better audit?

MR. HAWKE: I think there is certainly something to the notion that the external auditors know the institution well and can perform an internal audit perhaps without some of the start-up learning and costs that might be involved if audit were out-sourced to a different external firm.

But I think that the price in the long run that one pays for that is not worth that efficiency.

COMMISSIONER HUNT: Thank you.

COMMISSIONER UNGER: You had said earlier that the firms or, rather, the banks that out-sourced their internal audit function are, perhaps, examined more closely. Are they considered more risky?

MR. HAWKE: They're not considered more risky, but when we're deciding how we deploy our examination resources, if we -- for example, in the compliance area, if we find that a bank's internal audit function is weak, we will not be able to rely on them to the same extent that we would if the function were strong in areas like compliance or any other area of internal audit, which means that we have to devote more examination resources to that area. Where a bank has astrong internal audit function, it gives a great deal of comfort.

COMMISSIONER UNGER: But are you saying that banks that out-source the internal audit function are weak?

MR. HAWKE: No.

COMMISSIONER UNGER: Okay. Not in every instance?

MR. HAWKE: No, not at all.

COMMISSIONER UNGER: So in the examination function of the banks that out-source their internal audit function, have you found problems with the institutions that have the same auditing firm perform the internal and external audit?

MR. HAWKE: Well, I can't say that we have found problems. But as I said in my testimony, these questions of independence are extremely subtle, and one doesn't easily come across concrete evidence that there has been an impairment of independence.

What we're concerned about is the lack of checks and balances between internal and external audit when both functions are performed by the same firm, and we're concerned about the subtle influences that work on the external auditor when they have an opportunity to capture that additional engagement.

COMMISSIONER UNGER: Right. Well, we have found actual instances where there are problems, and what I'm trying to quantify is whether you've found instances wherethere are problems when that relationship exists.

MR. HAWKE: Let me step out of the area of out-sourcing of internal audit and look at other areas. We have had situations where banks have out-sourced internal loan review to their external auditors, for example, and we have prohibited that because we think that's a violation of the independence rule. Loan review is a management function that should not be out-sourced to external auditors.

Also, we found that some auditing firms, in their consulting capacities, have worked with banks, particularly smaller banks, to get them into lines of business either through turnkey packages or consulting advice like securitizations and sub-prime lending where the issue of valuations becomes very important.

We have a concern where an auditing firm that's doing an external audit is also selling a package of services to a bank that would involve getting them up and running in the securitization business, for example, because of the lack of independent judgment on valuations.

COMMISSIONER UNGER: Right. And you're saying your concern is heightened because of the change or the repeal of Glass Stegall and the fact that the banks will be entering into new types of businesses, perhaps?

MR. HAWKE: Well, I think the broader of range of activities that a banking organization is performing the moreimportant particularly the internal audit function becomes.

COMMISSIONER UNGER: Thank you.

CHAIRMAN LEVITT: The staff has expressed concerns that when an auditor performs management functions in the banking arena, such as loan credit reviews or analysis, that that kind of service raises the independence issue again. I wonder how you feel about that.

MR. HAWKE: We completely agree with that,

Mr. Chairman. We think that those are management functions as to which management can't delegate its responsibilities. And where management functions of that sort are performed by the external auditor we concur that that does present a violation of the independence standard.

CHAIRMAN LEVITT: Do you see any increase in that kind of activity?

MR. HAWKE: I can't say that we've seen an increase in the out-sourcing of loan review to external auditors because we've made our position on that pretty clear. Our concern, as I said before, is about how pressures to reduce costs are leading to the out-sourcing of a number of functions that really are management functions. Loan review is one of them.

CHAIRMAN LEVITT: Well, you've been really very helpful and forthcoming and characteristically on point. We're very, very appreciative for you taking the time toexpress your views on this important subject.

MR. HAWKE: I appreciate the opportunity,

Mr. Chairman.

Session 2

CHAIRMAN LEVITT: The next witness is J. Michael Cook, former chairman and CEO of Deloitte & Touche, former head of the FAF, for years deeply involved in the profession and its relationship with the Commission and with the public. I'd like to welcome you back again, Mike, and we look forward with great interest to your views.

MR. COOK: Thank you, Mr. Chairman. Good morning to you and to your fellow commissioners and members of your staff. I appreciate your invitation to share some thoughts with you this morning on this very important matter.

To provide time for your questions, I would like to summarize my prepared statement and spend just a few minutes on what I consider to be two key issues; one, the need for Commission action with respect to this, and second, the possible effect on audit quality. For me, those are two very important issues.

There are four points in my written statement that I would just like to repeat without elaborating on them this morning. One is that restrictions on financial relationships with clients should, in my judgment, apply to every partner in a firm without exception.

Second, the Commission should be sensitive to anyconcerns that are expressed to you about possible gender bias in your proposed rules. I have no specific comments with respect to that, but I've heard that suggested. And certainly, if anyone raises that subject with you, I would think that you could give that careful consideration in terms of the opportunities for the profession to attract high talent men and women.

The definition of "advocacy" should be clarified, in my judgment, to exclude customary auditor/client relationships which do not threaten independence. And in this regard, I think of what are the normal byproducts of good audit recommendations from an auditor to the client to enhance their controls, improve the efficiency of their business, lawfully minimize the taxes they pay.

Those could, in a broad definition of "advocacy," be swept in. I think those relationships and those activities are entirely appropriate and do not affect independence.

Finally, required disclosure should focus on the dollar amount of services provided as they relate to the appearance of independence, if disclosures are to be required.

The disclosures should not be seen as second-guessing the appropriateness of the nature of the services being provided, and I would suggest that disclosure of modestamounts should not be required.

I indicated two key issues that I'd like to spend just a few moments on. The first is the question of whether there is a need for the Commission to be dealing with this subject and whether there is a need for rule-making.

As I'm sure you'll hear from many people, this issue of independence and non-audit services has been highly visible, a matter of some concern to the profession, to the Commission and to many others for many years.

I look back to Chairman McCloy at the onset of the Public Oversight Board more than 20 years ago cautioning about the possible impact of non-audit services on independence. And then we move forward 20 years later and find a full separate chapter on this subject in the report of the Panel on Audit Effectiveness.

The profession has, I think, diligently and appropriately sought to address these concerns over these years. Unfortunately, the profession has not been able to resolve them, and today the profession is, apparently, quite deeply divided over this issue.

Mr. Chairman, in your tenure, you have often looked to and worked with the private sector to find solutions to matters of concern to you and to the Commission as they relate to the capital markets. I certainly applaud that approach.

You and I had the experience of working rather closely together on one such issue, which was the restructuring of the financial accounting foundation to enhance the oversight of the accounting standards-setting process.

And while I think I still have a few bumps and bruises from that activity, the end result implemented in the private sector in coordination with the Commission was, in my judgment, right for all the parties, and it was a meaningful and constructive outcome to that issue.

I really do wish that such an approach could work for this issue. Regrettably, I conclude that that is not possible and that some action on the part of the Commission is probably the only practical and feasible way to deal with the issue.

Some believe and continue to suggest that SEC action is not warranted absent proof that independence, in fact, has been impaired by non-audit services.

To accept this position, one, in my judgment, would have to ignore the importance of the appearance of independence, which has been a fundamental precept of our independence standards, our professional standards, for almost 70 years.

I could not reach that conclusion or support that conclusion. In my judgment, our value as auditors is verymuch dependent upon our independence both in fact and in appearance, and the credibility we add to the financial reporting process cannot be compromised in any way.

My conclusion, therefore, is that the Commission's consideration of this issue at this time is both warranted and necessary. The status quo is not an acceptable answer.

And as an aside, as indicated in my statement, I would hope that there will be resolution of this issue and that that could be a first step toward restoring a more constructive partnership-like relationship between the SEC and the profession.

That relationship has not existed for some period of time. I think it's very important to the public that we both seek to serve, and I hope this will, in its conclusion, move us back in that direction.

For me, the second key issue to be addressed is the potential effect on audit quality. I believe the Commission must, and I'm sure you will, give very careful attention to the possible effects of rule-making on audit quality. And as my statement indicates, I see three aspects of this issue.

First, some have suggested that providing consulting services to an entity is absolutely essential to providing high-quality audit services to that same entity. In my judgment, that position is not supportable.

In recent years, 75 to 80 percent of all publicentities buy little or no consulting services from their auditors. The POB panel report includes a finding that where consulting services are provided to an audit client, in 75 percent of the cases, they are neutral or have no direct impact on audit quality.

Combine these factors, extrapolate the panel's findings to the universe of public companies, and you would conclude that in more than 90 percent of all audits, consulting services have no direct effect on the quality of the audit service either because they weren't provided to the client or because, if they were provided, they did not have any direct bearing on audit effectiveness.

And I would have to suggest that the quality of 90-plus, closer to 95 percent of all audits have certainly not been adversely affected by the absence of providing consulting services to those same entities.

The second assertion about the impact on quality to me is much more likely to be relevant and is much more difficult, and that is the assertion that the specialists necessary to assist and support the audit function may not be attracted to and retained by the firms for one of a number of reasons, including because certain services in their areas of expertise cannot be provided to the firm's audit clients or perhaps because consulting is separated from the firm as a consequence of limitations imposed on consulting services.

I'm not able to predict the likelihood of this outcome. What I would strongly suggest is that the Commission must seek the best evidence available to it to evaluate this assertion.

To date, one firm, one very large firm, has separated its consulting practice, and two others are reported to be well along in doing the same thing. Presumably, these firms have considered the effects of their actions on the quality of their audit work. I would presume with the attention given to this issue that that would have been considered at the appropriate levels of those firms.

As a board member and as a client of two of these firms, I'm quite sure that our audit committees will be asking them to provide us with appropriate information and assurances with respect to the continuity of their audit quality in view of the separations that have or will take place and the assertions that others make that quality will be adversely affected.

I would suggest that the Commission should ask the same question that an audit committee, perhaps, would ask of these firms for two reasons.

One, I think you should see if there is any reason for you to be concerned about the quality of the audit work done by these firms. There is a huge public interest in the effectiveness of their audits, and any reduction in thequality of their work as a consequence of these changes in their structure would be a very serious matter for you to consider.

Secondly, in asking them for comments with respect to the impact of these changes on the quality of their audits, their responses, I believe, concerning audit quality should then be compared to the assertions of other firms to the effect that they are unable or would be unable to maintain audit quality without keeping their consulting practices under the same roof in the same organization.

I thought about how to go about this and just offer a suggestion that perhaps it would be appropriate, if the Commission pleased, for the Public Oversight Board to be asked to consider making these inquiries and making these comparisons and reporting their finding and conclusions as a follow-up to the work of their Panel on Audit Effectiveness.

I believe that the panel had substantially completed its work prior to these changes taking place in the structure of one firm and the possible changes taking place in the structure of others.

And I would not assume that they took those things into consideration in measuring audit effectiveness, but the challenges that are being made to the quality of auditing certainly is a matter that does need your attention.

I believe the results of those inquiries would thenprovide important information that would enable the Commission to evaluate this issue and take it into full consideration before finalizing any rule amendments.

The third assertion, final assertion, often made about the quality issue is that these audit-dominated firms of the future will be unattractive and, therefore, will be enable to attract and retain the best and brightest people.

I'm a bit personally disappointed by this assertion, since it was just one of those firms or a firm very much like that that I joined about 35 years ago and that I found to be very challenging and very satisfying professionally for a 35-year career.

And I would suggest that that kind of firm is probably the one that attracted and retained the leadership of other firms, but I do recognize that times have changed. People have different choices available to them today than we might have had 20 or more years ago and that this can be a challenge for the future years of the profession. I would hope and I would expect that they would be up to that challenge, if necessary.

With those remarks, I'd be pleased to answer any questions that you'd like to ask.

CHAIRMAN LEVITT: First let me say I applaud you for your very candid, comprehensive analysis of this issue and a willingness to, kind of, stand against the wind.

What do you think the Commission can do to try to bring about a consensus resolution of these very, very divisive issues?

MR. COOK: Mr. Chairman, I would like to have an answer to that question. I tend to think that that answer may not be achievable, or that outcome may not be achievable. There are some very deeply-held differences of opinion.

They are motivated by professional concerns. They are linked to business issues and operating issues for individual firms, and I would think the likelihood of you being able to reconcile those differences in all instances is not very likely.

And I would suggest that, at the end, some different positions will remain, and you will have to make an appropriate choice between your belief as to what is necessary for the viability of the financial reporting process and what you think is most important for the viability of the auditing profession.

And I know that you will listen to all the evidence that is presented to you before reaching those conclusions. In the end, I would think you'll bring some items closer together.

I really would hope that you would be able to bring some degree of closure or at least narrow the gap with respect to this subject of audit quality because I just don'tthink it's acceptable for the public to be confronted with a situation where one group of firms is saying that audit quality is going to be seriously impaired and other firms are making changes in that same direction, raising questions in the mind of the public about the quality of auditing overall. I just think that that is an issue that has both substance and appearance ramifications that you need to hear more about.

CHAIRMAN LEVITT: I agree with that. I have no question, having served as chair of a variety of audit committees and having worked with nearly all of the firms that have a stake in this today that they are motivated by sound convictions.

These firms are solid, honorable professionals, and have done an outstanding job in providing America's markets with a reputation second to none. I think that all parties to this dialogue are honorably motivated, and I shall do all in my power to try to gain a better understanding of the different views that are out there today and, to the extent possible, to turn down the level of emotional rhetoric that surrounds this.

Many companies that I know of, perhaps most companies in America, simply don't employ their auditor to provide some of these services. Do you think that has impacted the quality of their audits in any way? Are theyless well-served than companies that use the same person or the same firm that provides those services?

MR. COOK: Mr. Chairman, I agree with the conclusion of the POB based on the work that they did, the Panel on Audit Effectiveness, that says that consulting services can enhance the quality of an audit.

And they found, I believe, in 25 percent of the particular audits that they looked at where consulting services were, in fact, provided a positive linkage between audit effectiveness and the nature of those services.

I think that can certainly be the case. I don't think it's a necessary condition for a high-quality audit. I think you can gain information and knowledge through a consulting process shared in an appropriate way with the audit team that will enhance their knowledge of controls or knowledge of systems, their ability to identify sensitive audit issues. I think that's entirely likely to be the case. I would believe, as they found, that that same knowledge can be obtained in other ways. It is not a condition precedent to a high-quality audit, but there can be positive benefits.

CHAIRMAN LEVITT: This issue, as you've said before, has been with us for many, many years, and you go back a long way in terms of the profession. Why do you think it's more at issue today than before, and what do you thinkthe motivation lies behind the divestiture of non-audit services by an increasing number of major firms?

MR. COOK: Well, Mr. Chairman, I think the -- I mean, I think the reason why it is receiving a higher level of attention today is the fact that financial reporting is, perhaps, more important today than ever.

The volatility of the markets, the sensitivity of the markets to financial information I think is at an all-time level, and I think anything that indicates concerns about that financial reporting process or the operations of the market is going to get more attention in this environment.

Coupled with that the firms have substantially expanded their consulting offerings both in terms of the magnitude of revenue that they generate from those offerings and the scope of services that they offering. Both of those have changed as their clients have sought more services and a broad of range of services from them over the years.

So you add those two together, the volatility of the markets, the focus, the investor losses when there are failures, and everybody wants to be as careful as they possibly can to be sure that all steps are taken that will prevent those situations. And anything that might even subject the problem is going to be scrutinized very carefully.

As to motivations, probably shouldn't speculate about that. I would suggest that firms who have chosen to separate, have done it or are in the process of doing it have probably been motivated by a combination of professional judgments about the direction that this issue is going.

They probably have recognized some business opportunities related to that, financial opportunities in monetizing segments of their practice. I would not be able to judge what proportion of their decision-making came from either of those sources, but I would believe that both business and professional considerations would have gone into that decision-making.

CHAIRMAN LEVITT: Over and over again we hear the objections to any kind of resolution, any kind of separation based upon where is the evidence of wrongdoing. How would you respond to that?

MR. COOK: Well, I do not have any personal experience in all my years in this profession, no personal experience that would provide that evidence to you.

And I'm proud of that on behalf of the profession that I don't know of any situation in which a particular audit has been compromised by the existence of other service relationships with an entity.

But I would say that to say that we should only be concerned about that, the appearance in fact, and not givedue concern to the appearance of independence would just not be the appropriate view. I think you need to listen, as you have, to differing views about the impact of this on the appearance of independence.

And if the judgment at the end of the day is that the appearance of independence has been substantially and negatively affected, that is a cause for consideration on this issue by the Commission, notwithstanding the absence of a particular instance where an audit has been compromised.

I also happen to agree with the analysis that says that you really are not going to be able to expect to find these specific situations, but I would hope that even if you could you wouldn't.

COMMISSIONER HUNT: Mr. Cook, I was troubled by your statement that said that you hope we could get back to a decent working relationship between the profession and the Commission and that you think that has been absent for some years, if not many years.

How do you mean that relationship has deteriorated in the recent past?

MR. COOK: Well, surely, if I used the word "decent relationship," I misspoke. I would just say that the relationship today is not as constructive and open and partner-like as I would hope that it would be.

I've been an observer of this for a long time. I've been a participant in it for a long time. I have my sense of when it has been at its best and when it has been not as good, and I would have to say that today the marks on the scorecard would be somewhat lower in terms of the quality of relationship in working through issues, the dialogue that would take place.

I did not suggest that it was broken, but it is not at its best right now.

COMMISSIONER HUNT: Well, you're not the first person who has said that, at least to me, and maybe to my colleagues here as well, and we'll see if we can work on that.

What do you think of the suggestion that before we do rule-making in this area we should let the relatively new ISB work?

MR. COOK: I assume -- and I'm really just not privy to any direct information on this subject, so I'm going to give a rather incomplete response. I said in my own statement that I might prefer other solutions to this issue than a regulatory response.

I would prefer resolution of any issue in the private sector and with the private sector standard-setting bodies, if that can possibly be achieved. I assume there are reasons why a conclusion has been reached that the ISB is not the forum for resolution of this issue.

I can see the complexities of a board having, in part, public members and, in part, members from leadership positions in the major firms who have differences of viewpoint even among themselves on this issue.

It may be the forum of choice but not the forum of practicality in terms of the ability to resolve it. I think I would be better served by saying that that question probably could be better addressed to others, but my general leaning would be to a private sector response to any issue, if that's possible.

COMMISSIONER HUNT: I appreciate that, and I appreciate the fact that differing views on some members of the ISB representing the firms which may make a resolution in that forum difficult, but you also mentioned that you didn't think we could come to a consensus with the profession on these issues.

MR. COOK: No. I said that I believe at the end of the day there will be differing views, honestly held legitimate differences of viewpoint with respect to these issues, and that's not unusual in any standard-setting or regulatory environment.

Somebody will, at the end of the day, have to listen to all those views and make a judgment about what is ultimately in the public interest, taking into consideration both financial reporting and the strength of the profession.

If you can reconcile all these issues, that would be a marvelous achievement, but I wouldn't rest on that possibility.

COMMISSIONER HUNT: You have the view, according to your statement, that you believe no partner, regardless of location or function, should have any financial interest in an audit client of the firm?

MR. COOK: Yes, sir.

COMMISSIONER HUNT: So L.A., New York make no difference?

MR. COOK: Not to me.

COMMISSIONER HUNT: Is that because of the appearance of a conflict of interest?

MR. COOK: I guess I've grown up with this rule so deeply embedded in my own sense of the right answers that I just don't feel comfortable with the notion that a partner in a firm in a different location could be talking to a business colleague about an investment in an audit client of the firm and not be bothered by that possibility.

I think, as a practical matter for the firms monitoring individual partner ownerships and aggregating ownerships for various tests that might be required, will itself be a challenge.

And further, I always believed in my own professional life that clients were clients of the entirefirm and should have access to all the resources of the firm. If people are precluded from serving clients because of their financial interest, that would go against my grain in terms of the way a firm should serve its clients.

COMMISSIONER HUNT: And you're not concerned that perhaps the partners would be precluded some from lucrative investments with some of the clients?

MR. COOK: I'm not. I find that there are ample --I always found in my own experience, although not much of an investor, but found ample opportunities to invest in attractive companies that were not clients of the firm. I wish they were all clients of the firm, but some of them, unfortunately, were not.

COMMISSIONER HUNT: And you think that your position is still practical in the huge growth of the firms recently?

MR. COOK: I do.

COMMISSIONER HUNT: Worldwide?

MR. COOK: Well, I think the definition of the "partner" in the firm, I think that has to take into consideration the structures of the organizations. I'm not trying to address the global issues.

That's just not an area that I have current involvement in or expertise that would add much to your dialogue on that, but I certainly would feel that way aboutthe domestic partnership of any firm.

COMMISSIONER HUNT: You didn't address this, but what do you think about multi-disciplinary practices?

MR. COOK: Well, I think multi-disciplinary practices can be very beneficial to --

COMMISSIONER HUNT: I know you wouldn't want any lawyers in your firm. I mean God forbid that should happen.

MR. COOK: No. I think -- I'm afraid that there are some lawyers -- I'm not sure I should admit this, but some lawyers who were very good friend of mine and very esteemed colleagues of mine --

COMMISSIONER HUNT: Remarkable admission for an accountant to make.

MR. COOK: I recognize that, but the truth has to come out.

COMMISSIONER HUNT: Well, thank you very much for your time. We really appreciate your comments.

MR. COOK: Thank you.

COMMISSIONER HUNT: It's nice to see you.

MR. COOK: Thank you.

COMMISSIONER CAREY: Mr. Cook, an additional follow-up on Dean Hunt's point. If you don't believe that any partner, regardless of function or location, can own stock in a audit client of a firm, do you think that there is a need for modernization of these rules to address thechanging nature of American families and dual profession couples in order to not unduly hinder their ability to make investments?

MR. COOK: I absolutely do. My view extends to the partners. It would not extend to spouses and 401(k)s and family members and other situations. I think these rules do take appropriate note of dual career couples and other changes in the work force that must be addressed as a practical matter.

I would not extend it to that, nor would I be troubled by a different standard for the partners of the firm and other members of their families. I can live with that difference.

COMMISSIONER CAREY: Am I correct in stating that it's your view that there may be some possible gender bias in the rule, as proposed?

MR. COOK: I don't have any awareness of that at all. A suggestion was made -- I'm sorry I can't retrieve this, but somebody either wrote or spoke about that issue. And because I have some experience with policies that are thought to be gender neutral but, in application, were found to be other than gender neutral, I would just caution that it's very important to the profession that we are able to attract and retain high talent regardless of gender, particularly if any of these assertions about theprofession being less attractive in the future. That would become even more important.

If anybody brings to your attention a particular situation which they believe would have that impact, I would urge you to give very careful consideration to it. My own experience has been things that I would never think of having that effect sometimes do. I have nothing specific to offer, though. I'm not aware of any bias whatsoever.

COMMISSIONER CAREY: Do you think there is any downside to codification of the four principles stated in the proposal?

MR. COOK: I guess, if you start with a natural aversion to rules and rule-making, you probably can see downsides in codifications and other things, but I don't have any particular concerns about the principles that are set forth with the exception of I do think the interpretation of the definition of "advocacy" can be taken too broadly and could shut down some communications and activities that are very natural and customary in business relationships that nobody would think of threatening independence. I'm not particularly concerned about that.

COMMISSIONER HUNT: Thank you, Mr. Cook.

MR. COOK: You're welcome.

COMMISSIONER UNGER: Mr. Cook, I just had two areas I wanted to follow-up on. In your discussion, in response toa question of the Chairman's about one of the factors that has changed the dynamics of this discussion, you said there was an increase in the magnitude of the consulting business of most of the accounting firms.

Do you have any sense of what the ratio is of audit to consulting services?

MR. COOK: My current information is based on what I read, not based on anything I know directly. But it's my understanding that the audit services today are in the 30 percent range for the largest firms and that consulting would be half or more of total revenues for those same firms.

COMMISSIONER UNGER: And I think you were saying that the consulting revenues were more substantial, and I guess you're saying that now, than the auditing revenues.

MR. COOK: Correct.

COMMISSIONER UNGER: Are you concerned or should we be concerned that if we go too far in a particular rule-making that, in fact, will drive the auditing function to be, I guess -- what's the word I'm looking for --disenfranchised, marginalized or to become less of the focus of the firm and that, in fact, the firms will then turn to the more profitable side of the business, the consulting, and we will then truly affect the integrity of the audits because there won't be any of the Big 5 firms engaged in performing these audits?

MR. COOK: Again, I don't have that particular concern. I think the growth in consulting has taken place in response to market factors and that auditing has become less dominant, perhaps, or less significant in the overall revenue of these firms just because of those market factors.

I think those audit practices within those firms are still very important. The quality of those practices is a matter of significant concern to the leadership of those firms. I do not believe, for one, that auditing has been in any way marginalized or diminished because of the change in the makeup of those revenues.

But that is a consequence of the markets. I would guess the more likely outcome without taking sides on whether the firm should or should not restructure is these restructurings seem to lead to a more prominent role, at least from a revenue standpoint, for the audit function in these revised firms. And to the extent that that is an issue, it would move it in that direction.

COMMISSIONER UNGER: So you couldn't really have one without the other? In other words, the firms wouldn't --you don't think the firms would eliminate the audit function in favor of the consulting function if it wasn't viable to do both together?

MR. COOK: I would not think so.

COMMISSIONER UNGER: The other question I had waswhat you were saying about the appearance issue, which I agree with, because I was sitting here thinking, no, we haven't found any smoking guns, and I think Comptroller Hawke said the same thing, yet there is that appearance issue, which lawyers are held to that standard.

And I know you don't want to put yourself in the same group as lawyers, but --

MR. COOK: That's okay.

COMMISSIONER UNGER: But as far as the actual synergies that are accomplished through the consulting plus auditing that I think you said does exist, then how do you perform both without having that appearance problem? Is it possible to do that?

MR. COOK: Well, I think the appearance problem comes into play on an individual client situation. I mean, there is nothing inherently inconsistent with having consulting and auditing in the same entity, services offered by the same entity.

There are other services over the years that have been provided by these firms which have not been provided to their audit clients, their SEC audit clients, because people agreed that they would be inconsistent with the appearance of independence.

Certain executive search activities, for example, have been prohibited for a long time, even though thoseservices can be provided by those same firms. I think the appearance of independence question comes into play when you're dealing with both types of services being provided to the same entity, and the question of magnitude and the nature of the services then has to be evaluated.

Whether provided by the same organization, as a business matter some people will suggest that it will be difficult for consulting to stay together in the firm if they are precluded from serving a large segment of the marketplace.

Others would say that there's an ample marketplace there; if they want to stay together, they can. That's a business matter, and different business people will see that different ways. But it's a business matter, not an appearance of independence matter.

COMMISSIONER UNGER: Thank you.

COMMISSIONER HUNT: If you're concerned about the appearance problem -- and I wholly agree with you on that --is there any concern on your part that if the trend continues for audit firms to also do consulting for those same clients that the importance of the consulting business could get to be such that an audit could be compromised?

MR. COOK: Well, compromised in fact I certainly would hope not, and I certainly have no reason to have that concern. Compromised in appearance is a different issueentirely, and certainly, as magnitude grows and breadth of services grow, the potential for appearance of independence to be impacted is greater.

I would point out it's not just because of the services that people are provided. It's, in part, because of the visibility of this issue. This issue is very visible. This issue is something that the Commission is speaking about, individual commissioners and the chairman are speaking about concerns about this issue.

Audit committees have been highly sensitized to this issue. Part of the appearance problem, candidly, is the amount of attention that this issue has brought forth, but I don't think that that can be turned off without some resolution of this.

I don't think it's just to say let's pretend this doesn't exist and all go back to doing what we were doing and not be concerned about appearance anymore, but the appearance issue is provoked by the intensiveness of the discussion, and that's why I say this matter has got to be resolved.

COMMISSIONER HUNT: And I guess finally, would it be okay with you if the firms stay together and Firm X did consulting work for audit client Y of another firm, and so you would have them doing the same function but not for an SEC audit client, not for their own SEC audit client?

Would that to you do away with the appearance of aconflict of interest?

MR. COOK: That judgment will be made by the individual firms, but that would be satisfactory to me. Yes, sir.

COMMISSIONER HUNT: Thank you, Mr. Cook.

CHAIRMAN LEVITT: If you were to head one of these firms today and it was decided that certain services could not be performed for audit clients but could be performed for non-audit clients, do you think that your firm's viability would be threatened?

MR. COOK: I've said to one of my colleagues on the way in this morning I've never felt so good about retirement until this issue came to the forefront, and I probably stopped thinking about some of those tough issues, at least as frequently as I used to think about them.

I don't know the answer to that question. I think you have to be very close to the workings of these firms on a day-to-day basis to know the intensity of the pressures for separations, the ability to recruit in the marketplace, the impact that these changes are having on that, the ability to retain key people in the consulting organizations.

Those pressures and the market pressures will ultimately decide this. I am just far enough removed from that that I'd prefer not to speculate on that issue.

CHAIRMAN LEVITT: But clearly, some firms believethat their viability would not be threatened by that separation.

MR. COOK: Oh, by the separation. The firms have clearly said their viability will not be threatened by the separation.

CHAIRMAN LEVITT: Yes.

MR. COOK: Others have said their viability --questioning whether viability can be maintained if everybody stays together.

CHAIRMAN LEVITT: You've been enormously helpful, and I think we all owe you a great deal of gratitude.

MR. COOK: Thank you.

Session 3

CHAIRMAN LEVITT: Okay. Before we begin this next panel, I'd like to say that with the experience of the first two witnesses it's apparent to me that in order to stay on schedule we're going to have to save some of the questions we had for witnesses and present them subsequently in writing to follow-up.

I'm particularly looking forward to this panel: Rick Antle, Professor of Accounting at Yale School of Management; John C. Coffee, Jr. -- who from my earliest days at the Commission has been enormously helpful to me personally and I think every Commission in terms of wise counsel -- he's Professor of Law at the Columbia University Law School; and Paul B.W. Miller, Professor of Accounting atthe University of Colorado at Colorado Springs, who has long been familiar with these matters, has written a classic work on the FASB. Welcome, and we're anxious to area from you.

Mr. Antle.

MR. ANTLE: Thank you, and I thank the Commissioners for hearing from us. As you said, I'm a professor and associate dean at the Yale School of Management. I have co-authored several publications on independence and scope of services.

More recently, I've worked with the SEC Practice Section of the AICPA and the Big 5 firms on a couple of matters related to the ISB. I know some of the staff knows my relationships with the firms.

I wanted to underscore the fact that today I'm here as an informed and concerned citizen. I'm not representing any person or not being compensated for my appearance today.

I want to confine my remarks to independence and the scope of services. In my view -- I'm going to begin, I guess, by a confession.

Having done my dissertation on auditor independence, I think I've been confused by this issue for probably more than 20 years now, ever since I first looked at it, things seem to swirl around. I think it's a very confusing set of issues. I think I'm beginning to figure out why, and that's one reason I wanted to talk to you today.

With the scope of services, there are really two major issues I think that we all ought to keep our eyes on. One is the integrity of the U.S. financial reporting system, and the other is the value added by non-audit services.

When I think about the integrity of the U.S. financial reporting system, to me, it comes down to this: We want auditors to have good incentives. And we can talk about what those good incentives are.

We want them to conduct thorough audits. We want them to reveal things that they think are incorrect. We want them to stand up to clients when they think that there's a reason to, but the bottom line is we want them to have good incentives.

When we think about the value added by non-audit services, I think we want to think about the fact that we'd like everyone in the economy to produce value added goods and services. That's what drives economic efficiency and economic growth, and we all have an interest in that as well. My understanding is that the Commission is charged only with protecting the integrity of financial reporting, but I hope that somewhere in this game that overall efficiency is an issue as well.

I want to talk just about those two issues. I'll begin with value added by non-audit services. I think that there's just a prima facie case that accounting firms haveadded a tremendous amount of value to the economy by providing non-audit services. There are a lot of different measures of this I've looked at.

Fees generated by non-audit services by these firms; I think in your document you even say that in 1999 it was $15 billion. In one of the responses that I made to the ISB, one of the figures that we had to produce or that Chairman Allen asked us to produce was, sort of, the gross margin per dollar of revenue for non-audit services.

Our estimate was that's about 20 cents, so about 20 cents of every dollar of revenue is gross margin before partner compensation back to the audit firms.

Now, the reason I mention that is I think when we think about the value added by these services we want to think about the profit produced not only to the firms that provides the services but to the clients themselves.

And I'm sure you could all do a rough calculation, if you figured that a client hires a firm expecting they'll roughly split the surplus that's going to be generated by the job, how much money that might be.

So the firms make money from offering these services, and we should presume that the clients also receive benefits. I know you've seen lots of data on the growth of the services in the past.

I have to say that when we look at the growth ofnon-audit services there's, sort of, two things that can come to one's mind. One is, "Oh my god, these firms are doing so many other things." The other is, "Look at the value being added in the economy as these services grow." I tend to think of the latter.

The key thing with value added by these services, though, I think is the economies of scope that are or are not present with the audit function. That's really why we're here. The real question is not how much value can you add by consulting, but how much of that value is driven by a tie with auditing.

That's really the key issue and certainly, I think, should be the key issue behind the Commission's thinking in terms of barring accounting firms from delivering non-audit services to their audit clients.

What are these economies of scope I'm talking about? Well, they're the values of the synergies that are generated by bundling services. I'll tell you now that as far as I know there's no systematic evidence as to the magnitude of these economies, just none that I know of.

The only thing I can have here is some intuition. One is I would observe that firms have been very successful incubators. These firms have generated not only a lot of revenue but a lot of different services that they've been able to find a niche for, and that, to me, indicates thatthere's some type of comparative advantage that the firms have in the market for non-audit services. That suggests an economy of scope.

The other thing I'd like to point out is I'd like to think about the experience with Arthur Andersen in particular. When Arthur Andersen -- when Andersen Consulting and Arthur Andersen split, as I recall, it left Arthur Andersen, the audit part, with virtually no non-audit services -- I'm not talking about taxes -- no non-audit services.

The evidence that I've seen suggests that Arthur Andersen audits has, sort of, completely -- or has re-grown that non-audit services business to the point where it's the virtual equal of their audit practice now.

You can think of this like a star fish. You can cut off the arm, but it grew back. Now, if you think about it, how were they able to do that? If there weren't some powerful economies of scope operating between their audit practice and non-audit services, how were they able to start from zero not that many years ago and re-grow a substantial presence in non-audit services?

I think that that again speaks to economies of scope. I personally would like to have some real evidence as to their magnitude.

We don't know whether the firms have a very smallcomparative advantage in the area and that's why they're able to really just take advantage of that, or whether their comparative advantage in offering non-audit services is really very large, and that's why it seems to be so easy for them to market these services.

So that's what I have to say about the value added of non-audit services. I'd like to talk a little bit about the integrity of financial reporting.

As I said, the integrity of financial reporting ultimately depends on auditors' incentives, and auditors' incentives originate from a lot of different sources -- the reputation they have in the marketplace and competitive pressures from other audit firms, regulation and professional discipline and not the least of which is civil litigation and criminal laws. All of these things form parts of auditors' incentives.

Really, the thing that I'd like to put out here is that incentives are really a joint product, if I can talk in the words of an accountant. They're really the joint product of all the forces that come together.

I really think it's, in a logical sense, impossible to isolate one feature and call it independence. I think we, sort of, have some vague notions that we know what constitutes good incentives. We try to label it. We try to go for it, but inevitably what happens is our rhetoric getsvery contextualized, and usually we end up with a lot of, sort of, thou shalt nots.

So the fact, I think, that auditors' incentives are a joint product of a lot of different forces results a lot of times, I think -- gets lost in our dialogue about auditor independence, and then we can start, sort of, moralizing about what independence might be.

Also, I think we get tempted to substitute concerns for evidence because we have hard time really isolating in on the issue that we're talking about.

Well, I have two real requests, since, I don't know, whoever taught me to speak said you shouldn't speak unless you have some agenda, and I definitely have one.

I really believe that there should be a thorough, systematic attempt to estimate the magnitudes of the economies of scope between audit and non-audit services before serious restrictions on the scope of services are imposed.

I'm very concerned that serious restrictions on the scope of services, that the effect of that would mainly be on the firms' ability to innovate new types of services and grow those services to a certain point.

My own intuition is that once they get so -- you know, once the services get so large and off and rolling and there's a market for them that it's not really that importantto have them tied back to auditing. That's my intuition.

But what I would believe to be the case would be that when firms are offering new services the first clients they probably have are their audit clients. That's just my intuition. I'd like to know if that's true and would like to know something about the dynamics of the growth of those services.

Again, the effect of banning audit firms from having certain types of non-audit services for their audit clients might be to inhibit their ability to innovate types of services and grow them in a way that makes our economy more efficient.

So I'd really like some thorough, systematic attempt to estimate the magnitude of these economies of scope. I think that that actually could be done. In my own mind, I think it should be undertaken by some serious economatricions and studiers of industrial organization along with some people that know the accounting profession.

I think it's going to be a study that's going to be pretty extensive and would have to get somebody's hands dirty because you have to really get down and understand exactly what services are being offered, where does it overlap with auditing, where does it not. I have some confidence that some of my colleagues in economics could perform that study.

I'd also request that whatever rules are adoptedthat they balance the economies of scope against whatever potential financial reporting costs there might be perceived to be; that is, a view towards the overall efficiency of what these firms provide.

Thank you.

MR. COFFEE: I prepared a statement, and I sent it down yesterday. I'm not sure that it has been distributed. So I'd like to indicate afterwards that I do have copies with me, although I think I gave it to the staff. I understand it came in late.

Now, let me confess at the outset that I'm not an accountant, although I've represented them in my professional career and have great respect for them both as individuals and as an aggregate group.

I am, therefore, going to limit my comments to the concept of the accountant as gatekeeper under the federal securities laws. That's something that I do think I understand.

And from that perspective, I note that in its first couple pages Release 7870 starts out by saying that the federal securities laws make the auditor a gatekeeper for public investors.

What I want to suggest to you is that once that concept of gatekeeper is understood and defined it does suggest there's a strong need for the kind of limitationsyou're talking about but perhaps some refocusing of those limitations that aren't quite as categorical.

Now, I would suggest to you that the concept of gatekeeper really refers both in law and economics to a kind of law enforcement strategy that understands that it's often easier to deter and to police the agent of the corporation rather than the corporation itself or its internal management.

Why is that? Well, simply enough because the corporate client often expects very large gains or expects to avert very large losses from engaging in a certain type of impropriety and will, therefore, take much more legal risks than will the agents who work for it. The agents have reputational capital and have careers that aren't wedded to that specific client.

Thus, the classic gatekeeper can be defined as someone who typically faces expected costs in the form of legal liabilities for not performing its duty that usually vastly are greater, that dwarf the expected benefits from any one client for, perhaps, shirking or perhaps acquiescing in management's desire to engage in a possibly shady or irregular practice. I'm talking about irregularities, not pure fraud.

Now, that's the classic gatekeeper, and the auditor typically fits that model. It had many clients. Theauditing revenues from any one client were small in proportion to its overall revenues, and it faced very significant legal liabilities if it didn't perform its duty to investors in the market.

That's the past. As Release 7870 reminds us, the world is changing rapidly. Now, Release 7870 focuses mainly on the changing revenues of diversified auditing firms that provide multi services to their clients, and it raises the possibility that as the majority of revenues come from non-auditing services more and more there's a danger that the audit partner may become more of a marketer of consulting and advisory services for his firm than auditing.

Similarly, the Panel on Audit Effectiveness, in its discussion of compensation techniques, has noted that there is some change in compensation practices that may make the audit partner rewarded increasingly for his success at cross-selling services than for his skills at auditing per se.

All of those raise the expected benefits from possibly blinking at irregularities or possibly accepting practices in a field where standards are often somewhat inevitable and somewhat subjective.

That's only half the story. What I want to focus you on where I don't think it's quite adequately covered in Release 7870 is that the legal risks, the liabilities, the expected costs facing the accountant who might be attemptedto shirk his duties in order to please management have vastly declined in just the last five or six years.

In other words, what keeps the gatekeeper invulnerable, incorruptible in the past was the margin between the high penalties and the low gains from deferring to management and engaging in impropriety.

But that has all changed. Release 7870 does a better job than I can in talking about the possible benefits from selling these services that are subject to management's pleasure and displeasure.

Let's focus for a second on the liabilities. There have been four significant developments just since 1994. They are, one, the passage of the Private Securities Litigation Reform Act, which has vastly increased the pleading standards and, in some circuits, the scienter standard, applicable to a securities class action.

That change particularly benefits the accountant because it's very, very hard to plead at the outset of a case of facts that give rise to a "strong inference of fraud" that a secondary participant like the accountant participated in some possible misconduct.

Secondly, there is the substitution of proportionate liability for joint and several liability. Personally, I think that was an excellent idea. I think it was long overdue. But it means it's no longer attractive tosue accountants because even if you're successful you're only going to get a portion of the total liability assessed against them, and that may not justify the cost. And plaintiffs' lawyers will tell you they think about that a great deal.

Third, during the '90s, litigation against accountants was shifting from federal courts to state courts because it was easy to sue on common law and negligence theories in state court.

However, the passage of the Uniform Standards Act in 1998 has meant that all of those suits in state court and all of those causes of action, whether they're asserted in state court or federal court, are now preempted and now gone, and the accountants have immunity to that extent.

Lastly, of these four changes, the Supreme Court in 1994 in the Central Bank of Denver case, eliminated totally the idea of aiding and abetting liability, which was the principal tool used to sue accountants by the plaintiffs' bar.

Yes, I understand that the SEC can sue, but private litigation involving aiding and abetting is gone. Now, what does this all mean on balance? I would generalize it this way:

Suits involving accounting irregularities are very common. Indeed, they may have increased since the passage ofthe '95 Act, but those suits today rarely involve the accountant, the outside accountant, as a defendant, and when they do they're often very easily and quickly dismissed.

It is not attractive to sue accountants. I'm not saying that it should be attractive to sue accountants. What I'm focusing on is the margin between the benefits and the cost, and today the accountant, as gatekeeper, faces greatly increased benefits through the existence of non-audit advisory services that are subject to the discretion of management, and it faces greatly reduced liabilities for the reasons I've just said.

Now, there's very little that the SEC can do about this reduction in liabilities, and I'm not suggesting that liabilities should always be maximized. But I'm suggesting that as the costs have gone down and the benefits have gone up the Commission does have to think about alternative regulatory strategies, including prophylactic limits of the kind that have been proposed here.

And these limits rest on two basic justifications. One is that the benefits from deferring to management have greatly increased, and the other is that the nature of these services involve the accountant serving, in my judgment, two different clients. This was stressed in the Panel on Audit Effectiveness dissenting statements.

They point out that the non-audit advisory servicesare really sold to management; whereas, the audit services are, essentially, for the shareholders and the investors, and there can often be conflicts between what investors want and what management wants.

And when you have two different clients, you may tend to defer to the client who is offering you the larger revenues.

Now, against that backdrop let me turn to my specific comments on Rule 2-01, and all I'm going to focus on is its critical Section 2-01(c)(4). Proposed 2.01(c)(4), essentially, gives you a list of prohibited professional services.

These are services that the auditor per se may not provide without in effect, sacrificing independence. And I'll call the common theme that links most of these services the self-grading problem; that is, it's said, I think properly, that an auditor should not be able to review its own work product or its own judgments or its own positions, and, to that extent, certain kinds of activities should not be provided.

I understand that as a principle, but I think the list in (c)(4) is at the same time both over-inclusive and under-inclusive. There are particular issues.

For example, there's a prohibition on what I'll call human resources services. That's in (i)(G). I don'treally believe that can be justified on the rationale given. I don't think there really is self-grading or review of your own work product if you were simply preparing standardized exams to test employees of the company. That's not an area that I think is sensitive.

I think the reason it has been included is that there's a general concern with non-audit services, and this is where I want to turn to my broader and more important point that I think (c)(4) is under-inclusive.

Ultimately, any professional service unrelated to auditing is problematic if, in the aggregate, the aggregate of these services produces revenues or the expectation of revenues that exceed the firm's auditing revenues from that client.

In other words, at this point, the management of the company begins to acquire a club with which to influence potentially the auditor. Thus, I think you have to look at all non-auditing services not as individual items exclusively but their aggregate impact.

Therefore, what I would submit is that the simplest standard would be to include an aggregate percentage test in 2-01(c)(4) which would say that if the provision of non-audit services to the client would give the auditing firm greater revenues or the expectation of greater revenues than its auditing services, then its independence is becoming suspect;it's entering the danger zone.

What the precise standard should be, the precise percentage, is an area where I think I would be quite tolerant, and I think there is room to consult other bodies, such as the Independent Standards Board.

I can understand a rule that says as long as your non-audit services did not exceed your audit revenues from that client that was permissible. As long as you had a ceiling on what you could get from non-audit services, then I think the aggregate problem, the problem that the margin that keeps the gatekeeper active and concerned about the investors' interest, would still be protected.

Now, what I'm suggesting is a somewhat simpler test. I understand that for certain kinds of services that involve self-grading or review of your own work product there should be a per se rule, but I think it has been over-stretched, extended a little bit too far in (c)(4).

And I would suggest that you substitute for it an aggregate percentage test, a test that says at some point, whether it's 80 percent of your audit revenues, 100 percent, maybe even 125 percent, then that's the point at which we think these other services will make the gatekeeper less a gatekeeper and more a marketer of cross-vending, cross-selling services.

Note that this rule does give firms a little bitmore flexibility. If there are great economies of scope, they would be able to realize them to a somewhat greater extent as long as they could market services not involving self-grading or review of your own work product up to some level equal to something in the ballpark of what your audit revenues are.

I'm not worried that an auditor who is getting an equal amount of non-audit and audit revenues will be corrupted.

I'm worried about a future in which the auditor expects a benefit ten times as great from non-audit services as from audit services, and at that point I think the audit partner is likely to become a specialist in the cross-selling of services. That danger is out there for the future.

Thank you.

MR. MILLER: Thank you for the opportunity to speak my mind. Those of you who know me know it takes little provocation to get me to do so.

With typical understatement, a few months ago I called the crisis in independence the most important one to hit the audit profession since McKesson. Now, I didn't realize at the time it was McKesson Part 1.

Anyhow, as I've struggled over the last few weeks to bring all of my thoughts together for this particular package, I was reminded of a story of C.S. Lewis who wrote along letter to a friend and then apologized at the end.

He said, "I'm sorry, but I just didn't have enough time to write a short one." So I'm going to try to compact a lot into a small bag.

My comment letter to you describes quality financial reporting as a paradigm, and I found it to be quite useful. It's based on four axioms. Let's pay attention to the beginning.

Incomplete information I believe creates uncertainty. Uncertainty creates risk. Risk creates demand for a higher rate of return. A high rate of return translates into a high cost of capital. A high cost of capital leads to low security prices. It also leads to friction in the capital markets.

The QFR paradigm then directs us to focus our attention on the initial problem, the incomplete information and the uncertainty that results from it. We've tried many ways to deal with that uncertainty. One of those is, of course, financial public reporting designed to reduce uncertainty about registrants.

Generally Accepted Accounting Principles are supposed to reduce uncertainty about those reports. Audits are supposed to reduce uncertainty about the financial statements. Independence rules are supposed to reduce uncertainty about the audits, and the SEC is supposed toreduce uncertainty about all of the above.

Therefore, I think we should resolve today's issues when that resolution occurs in a way that reduces uncertainty about the quality of the information. Everything else I believe should be secondary.

What, then, are the issues that we are discussing? The framing of those is crucial. However, as I consider the subject of this hearing, I find only two significant issues on the table, and one of those hasn't really been talked about much.

There are two more that are not on the table that I think should be. And finally, I see a fifth issue that no one has explicitly acknowledged.

The two issues on the table are the so-called modernizing of the investment rules and the prohibition of certain non-audit services. There are two issues that we should be talking about but we, obviously, will not in this venue.

First of all is the question of whether GAAP financial statements are worth auditing. And I believe this issue exists because many of the principles on which GAAP rely are very old, and they are all emerged from a political process.

And I'm not convinced that the financial statements do contain useful information. If they do not, then itdoesn't matter whether they're audited, and then it doesn't matter whether the auditor is indeed independent. But I don't think we're going to discuss that today.

Another issue that I think could be discussed but won't, in all of our focus in the controversy over non-audit fees, no one is asking the question whether audit fees might compromise independence. That's quite provocative, and I'll let that one be discussed elsewhere.

There is another issue that I'm calling the invisible issue. It's quite troubling, and it emerges not as I read the SEC rules proposal but as I read the press describing the rules proposal, and that is a debate as to who is empowered to decide when independence is impaired.

The Commission has had this power for decades and has used it to create and enforce rules. The Institute has also had this power. The firms have had this power, and now the ISB has been created but not given much authority.

And on that point, I would share an insight that I gained one day in a meeting when Clarence Sampson, was visiting -- being visited that day by the chief accountant of Israel.

And at one point, the visitor asked Clarence the question, "Do you have the authority to overturn the FASB?" And Clarence smiled and said with his characteristic directness, "I have the authority, but I don't have thepower," a remarkable statement, I thought.

And I believe that there is insight into the present controversy. You have the authority to prohibit ownership. You have the authority to prohibit non-audit services, but there is a debate going on by people who are not sure that you indeed have that power.

Where does the power reside? I've learned over the years that there's tremendous power in the market itself more than any of us could ever accumulate, and I give as an example the ownership limitation that has been proposed of a maximum of 5 percent.

If you were to decide that 5 percent was fair but the market believes that zero percent is right or 2 percent or anything less than 5 percent, there will be a penalty imposed on anyone who rises as high as 5 percent.

Your answer, basically, would be ignored, and the market would decide. I think that is also true with non-audit services.

If someone crosses the line and provides non-audit services that compromise independence, then a penalty will be extracted by the market.

All of this discussion leads me to a point that today's issue, as it's finally resolved, can be a landmark decision for the Commission but for a different reason.

What I have seen as I've looked at independencerules and been involved in their enforcement, that they have always come from a process that involves accountants talking to accountants, and should we be surprised that the outcome elevates accountants' interest above the public's interest.

And as a result of that elevation of accountants' interest above the public, I believe the uncertainty about the audits, uncertainty about the information being audited have caused capital costs to be even higher.

Therefore, I would encourage you to resolve these issues only after listening carefully to the opinions expressed by the investment community. You should not ignore the accountants, obviously, but now is the time to write rules to protect the public against accountants instead of the other way around.

With regard to the specific issues, I believe that everyone today is going to talk about non-audit services, so I'm not going to. I want to direct my attention more to the ownership, and my language is plain.

It simply says don't do it. This is a move -- this moves a step down a very steep and slippery slope. I do not see a redeeming value other than greater convenience for auditors in managing their resources.

There would be additional uncertainty created about the financial statements that will lead to higher capital costs. In effect, there will be a wealth transfer from thestockholders of the firm to the auditors.

In addition, there's an unusual, I believe, problem here with overlapping jurisdictions. Unless state regulations change, ownership will not be allowed even if you do allow it. You can be tougher than the states, but I do not see how you can become softer.

Like Mr. Cook, I find ownership to be totally incongruent with perceived independence. What I would ask you to do is encourage auditors to come up with their own solutions within the context of the existing rules, and I believe this can be done in fairly straightforward ways by hiring professional money managers.

This would be a voluntary approach, and I believe it would work better than any kind of regulatory approach. With respect to the non-audit services, all I will say is I believe you have the authority to limit them however you wish.

You can limit all activities of those who practice before you where those activities are pertinent to that practice, and I urge you to resolve the issue in a way that does not increase uncertainty.

Regardless of what you decide I believe there is a third point in your proposal that has not been adequately addressed, and that is the power of disclosure.

I encourage you to require the auditor and themanagement for each registrant to each file separate positive statements in which they affirm why they believe they are independent, and that disclosure should include the evidence that supports that conclusion.

In closing, I want to say that I believe you currently possess the authority and the power to forbid ownership and incompatible services. You also have the authority and the power to require managers and auditors to more fully inform the markets on these issues.

It's clear from the context that has brought us together today that you need to act on these issues in a way that protects and promotes the public's interest, and I think you have the obligation to produce these requirements despite being threatened by some constituents and harassed by some members of the Congress.

These issues are too important, as well as the capital markets, for those kind of games. The irony is that you're being harassed over trying to do something that is for the best of the auditors.

And like C.S. Lewis, I wish I'd had more time so I could finish in less time.

CHAIRMAN LEVITT: Thank you very much, Professor Miller. Our general counsel has a question, I'm told.

MR. BECKER: Professor Coffee, I'm just wondering if you would -- how you regard the change in the late '90s,in the mid-'90s to the RICO statute, the Racketeer Influenced and Corrupt Organizations Act, that eliminated securities fraud as a predicate offense for treble damages.

MR. COFFEE: I have conflicting reactions because I'm glad to have seen that change. RICO was being overused particularly in that context, but it is one more respect in which it's a fit indication that the legal liabilities facing the accountant for possibly shirking its duties as a monitor have radically been reduced, and that creates this problem about are they still the classic gatekeeper in terms of the existing economic incentives.

MR. BECKER: Could you just explain for the Commission what the change was?

MR. COFFEE: Essentially, any RICO complaint cannot assert violations of either the federal securities laws or conduct that could have been asserted to be a violation of the federal securities laws, so treble damages have been removed where, in the past, treble damages were often asserted in anti-fraud securities cases.

COMMISSIONER HUNT: I guess it's still morning, so good morning. Professor Antle, you talked about a study of the economies of scope. Do you think that study ought to be done before we act?

MR. ANTLE: Yes, I do, because we don't have any idea of the magnitudes of the benefits that we might bedestroying. It could be a fairly good case if the economies of scope turn out to be small, then you might well, on balance, decide that whatever perceived improvement in the financial reporting system you might get from banning certain types of non-audit services might be worth it.

On the other hand, if they're fairly large, then that's a different story. I did a little back-of-the-envelope calculation while I was sitting here by your own numbers that there are about $15 billion worth of non-audit services provided by the Big 5 in the United States in 1999, about 10 percent of that for audit clients, you said.

Some of my estimates were that about 20 percent of that number is, let's say, gross profit. So that's in the neighborhood of about 300 million a year just for the accounting firms.

If you double that just to naively assume the client gets equal benefit from the accounting firms, that's about a half a billion dollars a year in benefits that are produced by auditors providing non-audit services to their audit clients. Now, again, that's about as rough as you could get, but at least it's somewhere to start.

COMMISSIONER HUNT: Then you clearly have a different view than one of our earlier witnesses as to the appearance problem?

MR. ANTLE: I do, Commissioner Hunt. I think thereare two strands in my belief about this. One is that economic theory tells us that, yeah, perceptions are indeed important in determining equilibrium prices and in determining how markets function. There's no question about that. Prices are set by people's actions which are, in turn, tied to their beliefs.

Economic theory also would suggest to us, though, that having beliefs that are at variance with reality is a situation that shouldn't exist very long in a well-functioning economy. So that's what, sort of, ties people's perceptions back to reality.

So I guess I have a fundamental, sort of, efficient market's view of things deeply ingrained in my bones which suggests that if you have a perception that's out of line with reality, then it's the perception that ought to change and not reality. Another part of --

COMMISSIONER UNGER: Is that the way it usually goes? In my experience, I've found that like it or not perception is the ultimate reality.

MR. ANTLE: Well, I have some sympathy for that view as well. The closer you get to Freud the more you believe that. But there are, hopefully, are forces in the economy that drive things, sort of, toward reality, although that process is very sloppy.

What percentages you assign to one versus the otherare really -- I think you raise a good point.

But I was going to say that since I'm here testifying for myself -- I'm not representing anyone else --I have to say that one of the reactions that I have is that prohibiting certain types of services because people are concerned about this or that or there may be the appearance of a potential problem -- I mean, I actually went through the document and highlighted everywhere where a concern showed up with non-audit services, and it just strikes me in a very basic sense not right.

One of the things we do is we let people have the freedom to go about and integrate and do the things they want until they, sort of, prove that there's a -- until we find a problem.

COMMISSIONER UNGER: I take it it is your view that the Commission cannot, in this area, act prophylactically.

MR. ANTLE: Act prophylactically meaning that you think there might be a problem; therefore, you take some action in anticipation of that problem. I think that ought to be done with great consideration.

I don't want to say cannot because I haven't envisioned all possible circumstances, but non-audit services have been provided for a long time and have been provided in great magnitude.

CHAIRMAN LEVITT: Not in as great a magnitude as wesee today.

MR. ANTLE: No. They definitely have increased.

CHAIRMAN LEVITT: What gives rise to the perception, do you think, which has become so broad and so general? And it's very real. It's palpable. It's not something that's ephemeral. What do you think has given rise to that?

MR. ANTLE: Are these perceptions that you ask about, are they responses to questions, or are you talking about perceptions that are translated into actions in terms of people have shied away from buying securities?

CHAIRMAN LEVITT: No. I think the evidence of the perceptions are actions by many corporations and audit committees to make that separation to not use firms for providing consulting to their audit clients.

These are perceptions that are so broadly seen in the press. These are perceptions expressed by financial analysts. These are perceptions expressed in the political arena. Why? What gives rise to that, and how best to address that? If perception is the ultimate reality, you can't be blind to it.

MR. ANTLE: Well, I think it's very difficult for anyone, even myself, to have much of a real understanding of all of the incidents that auditors face. I know I learned a lot from Professor Coffee's talk and run-through of howauditor liability has changed over the years.

I think a lot of these perceptions come from piecemeal looks at the problem. I could present a situation to you in one way without reminding you that Ernst & Young just lost $324 million in the Cendent issue. You might say, "Wow, jeez, there's a problem."

I could present it to you in another way where I said, "You have to keep in mind that while they might

make --" by the way, profits on these jobs is the thing to look at, not revenues --

CHAIRMAN LEVITT: Are you saying that these perceptions are largely irrelevant, then?

MR. ANTLE: Yeah. I think the ones that we hear mostly my intuition is that they're largely irrelevant. People don't act on --

CHAIRMAN LEVITT: Forget about them? Dismiss them in terms of public policy?

MR. ANTLE: I think you have to ask seriously how well-grounded in fact they are. I'm not saying sweep them under the rug but how well grounded in fact are these alleged perception problems.

CHAIRMAN LEVITT: And their very existence is irrelevant, then?

MR. ANTLE: I don't think irrelevant in the sense that you would presume, as your questions have, that theremust be something underlying some of these. So you should definitely explore it.

But we know lots of cases where perceptions have been vastly wrong, the world is flat, that sort of thing.

COMMISSIONER UNGER: But underlying the discussion is the fact that the federal securities laws give accountants a franchise, because all of our statements, all the statements that must be filed with the Commission most of them have to have audited financial statements.

So you really need to keep that perspective. What you're saying makes perfect sense in the true business world --

MR. ANTLE: Right.

COMMISSIONER UNGER: -- but I think we have a slightly different focus because of that franchise.

MR. ANTLE: I agree with that entirely. The franchise that's given and that it's the Commission's responsibility to maintain and protect I think should be an important element in the consideration of these matters.

And that's why also I think that you're entirely right in delving into these matters and going into these matters, exploring them as deeply as possible and having whatever dialogue and study needs to be done to clarify them, because that franchise is a valuable thing that our government and my government has given these firms, and ithas responsibilities.

COMMISSIONER UNGER: Who performed these consulting services before the accounting firms? Is this a new demand for this type of service, and now it's being met by the firms, or is this a shift in business from some other part of the economy to the accounting firms?

MR. ANTLE: Well, there are probably people better qualified than I, but I think there's a lot of growth in services that they and others have innovated, which is why, in part of my remarks, I wanted to underscore the fact that I believe they've been the incubators of a lot of valuable services.

COMMISSIONER UNGER: Well, you've said they add value to the economy.

MR. ANTLE: Right.

COMMISSIONER UNGER: And so I'm assuming that they're new services that are being provided.

MR. ANTLE: Or at least they're taking maybe even existing services and pushing them into new market areas, and so on. Their economic success tells me that they've been successful in finding some way to get more profit out of that.

But again, this gets back to my call for study because the reality is we don't fully understand the dynamics of especially consulting relationships. We could understandthat an audit, on average, might last, you know, 14, 15, 20 years, but how do consulting relationships? What's the dynamics there?

So when we start talking about how an auditor might compromise an audit for consulting profit, well, is it a one-year consulting job? Is the dynamic such that one leads to another leads to another?

We don't know those kind of things, and those are fundamental questions about the economies of scope I think that we need to understand.

COMMISSIONER HUNT: Well, Professor Antle, I would just say because we're going to also have a dialogue, I think I have seen some cases where I do not understand the judgment call made by the accountant but for the importance of non-auditing service income. Now, that may be a perception that will prove to be wrong, but I don't think so.

MR. ANTLE: I think those need to be fully disclosed and discussed, and we need to really, you know, delve in. I think that as large as the public accounting profession is and as many partners as they have and as many situations as there are it would be kind of surprising if there weren't some somewhere, and I think they need --

COMMISSIONER HUNT: It doesn't happen with lawyers. MR. ANTLE: No. Of course not.

COMMISSIONER UNGER: Professor Coffee, can we talkabout the gatekeeper concept a little bit? Are you saying that the gatekeeper or the power of the gatekeeper influence has been diminished by what you've enumerated as the --

MR. COFFEE: Not the power of the gatekeeper but the gatekeeper's incentives have changed. It used to be that the benefits from an individual client were small, and the liabilities were great.

The liabilities have been reduced, and when you add non-audit services onto audit services, the benefits in the control of management have greatly increased, and management can use that discretionary power to ask the gatekeeper to --let's say to blink or to bend the rules in an area where the rules are often very subjective and very open-textured, which was Professor Miller's point, that the rules give you considerable latitude.

I'm not talking about engaging in open fraud. I'm talking about accepting a dubious interpretation that you wouldn't accept if it weren't for the fact that the rest of your firm is dependent upon this client, and you were seen as the one person who is, in effect, the executive in charge of cross-selling services.

And the gatekeeper, the audit engagement partner, is often in a position where he's got loyalties to the other members of his firm who have a tremendous investment in this client. Now, that gives you a variety of conflictingloyalties.

COMMISSIONER UNGER: What about the provision in the PSLRA that requires the auditors who actually report any problems to I think the audit committee --

MR. COFFEE: 10A you're talking about.

COMMISSIONER UNGER: -- and then the board --right. I was looking for it. I couldn't remember the number. Has that had any impact on maybe rebalancing the gatekeeper function?

MR. COFFEE: I think it's a good thing, but I think it has been relatively under-utilized. We've not seen a large number of filings come in, and that's because I think it's only in very limited circumstances when you're required to make a filing with the SEC.

So I'm in favor of the provision. I'm not sure that it has had a significant or measurable impact to this point.

COMMISSIONER UNGER: Are there instances when a client of a firm that performs audit and consulting services no longer has the audit -- terminates the audit relationship but maintains the consulting relationship?

MR. COFFEE: Well, I think it might work the reverse way. I could see under this rule that you might, on occasion, see an audit firm resign its audit role, which was only 10 percent of its revenues from the firm, to keep themuch more lucrative non-audit services.

I'm not sure there's a great harm in that. This is a market with a number of providers of auditing services, and if, in a hypothetical case, Arthur Andersen saw that its non-audit services were very valuable, resigned the audit role and PriceWaterhouse came in just to perform that service, I don't think there's a great harm.

There is the argument which has been presented that there are economies of scope. I'm a little dubious about that argument to the extent that we found that 75 percent of firms at present do not engage in this kind of cross-purchasing of both audit services and non-audit services.

To me, that's a kind of empirical evidence that there is no tremendous demand for this kind of dual services, although, if the Commission were to, in effect, not act and indicate that it was willing to tolerate this, I suspect that we would see that 75 percent figure decline relatively dramatically.

COMMISSIONER HUNT: But that doesn't take into account the cross-purchase of services that might be taken on. But of course, that probably creates less of a problem. If your auditing is done by one of the firms, and you're purchasing consulting services by another firm, then --

MR. COFFEE: That's permitted.

COMMISSIONER HUNT: -- the problem, hopefully, ismuch less, and even the appearance of a conflict doesn't exist then.

MR. COFFEE: I don't think there's any appearance of a conflict there, and I think that does permit the audit firm to market auditing services. All we're talking about is the cross-selling of these services.

COMMISSIONER UNGER: Of course. Of course.

MR. MILLER: Excuse me, Rick. I wanted to attack your envelope a little bit. What's missing is what has just been brought out, and that's if a firm can no longer provide these services there are at least four others who are ready to step in and do it. So it's not like the services would evaporate.

COMMISSIONER HUNT: Well, I think Professor, that's probably true, but the argument about one firm -- as you know, one of the arguments about one firm providing them is that we learned so much about GM, our audit client, when we do the consulting services, and we can do such a better audit of GM, as opposed to the fact if one of our rivals were doing consulting services, and we were only do what we had to do to do the audit.

MR. MILLER: I'd refer to you Mr. Cook's comments.

COMMISSIONER HUNT: I know. I know. It's not a comment that I necessarily believe, but it's certainly a view that's strongly held by some members of your profession, thatit really does enrich the audit the more knowledge the auditing/consulting firm has with respect to all the operations of the client.

Your views on ownership are that members of audit firms could reap the benefits of ownership in some of their clients through blind trusts --

MR. MILLER: My comment letter describes blind trusts. I believe also there is enough volume here that a firm could also create mutual funds that its employees could own.

COMMISSIONER HUNT: You mean one firm could create its own mutual fund?

MR. MILLER: With, of course, appropriate help from professional money managers.

COMMISSIONER HUNT: Sure.

MR. MILLER: And that fund would be fully diversified, totally liquid, even a family of funds with different asset allocations. But all of them would be stripped of any client firms. The consequence is, again, there would be on a voluntary basis compliance with independence.

COMMISSIONER HUNT: Would that be necessary if one of the partners invested in a blind trust in a recognized existing family of funds? The audit client couldn't possibly know if he was in a blind trust what he had, we would hope.

MR. MILLER: That's the idea. There's a real question whether a blind trust is feasible.

COMMISSIONER UNGER: Is truly blind or --

MR. MILLER: If it's truly blind. I think a superior one would be to know exactly what you do own and know that you don't own a client and be able to proclaim this to the world.

COMMISSIONER HUNT: In present circumstances, is it your view the partner in L.A. cannot own any interest in an audit client of the office in London?

MR. MILLER: I get e-mail every day from overseas, and I don't see that geographic distance means anything. Suppose they went to the same school at the same time. You've got a real problem. You can't just say geographic distance.

I'm troubled also by saying no involvement with the client because, as Mr. Cook has spoken and I believe this as well, a firm is a firm, and they're in constant communication with one another. I don't see how that could be drawn.

My point is I don't believe it's in the best interests of the firm to have that going on because it creates confusion and uncertainty, and that hurts the client. CHAIRMAN LEVITT: Our chief accountant has a question, Lynn Turner.

MR. TURNER: Professor Antle, one question for you. You talked about the need to have value-added services. An incubation of these, in fact, you said is they get big; it's not so important to have the firm's ability to do that, but it's important for them to be able to incubate services.

I share your concerns about value-added incubation and growing services, having been a member of a board of a technology incubator. But as I look through the specific prescribed services that we're talking about, the accounting firms didn't incubate legal services, and things like the actuarial services and the human resource functions, those are, basically, prescribed already by the AICPA's own rules.

And internal audit out-sourcing was incubated by business themselves, and they came up with the notion of internal audit, and in the area of system design and implementation it was some of the companies in America like IBM and other software companies that started out and incubated the notion of consulting and designing and implementing software systems.

On those specific services that the rule proposal talks about prescribing, maybe focusing on those that are not already prescribed by other rules, which ones of those is it your understanding that the accounting firms incubated themselves and came up with the idea that servicing grew?

MR. ANTLE: Well, I haven't gone through the list. That's my intuition about where the impact of this rule mightbe felt is in their incentives to innovate.

I haven't gone through the list. I'm sure that there are many, many services on the list that they offer that they did not invent, but I would be surprised if there weren't some services that they did or that at least they found new ways to market.

The real point is that there's some type of value added that these firm have -- some comparative advantage that these firms have in providing these services, and to the extent that we don't really understand what that comparative advantage is, where it lies, we don't really know what the effect of the rule is going to be.

I wasn't intending to say that every service they offer they developed themselves, although they might have pushed that into markets for clients that other people hadn't done. That's an innovation.

CHAIRMAN LEVITT: All of us and all the witnesses this morning and the commissioners have talked about the issue of public confidence, talked about trust, have talked about perceptions. That's clearly part of this equation.

I don't think there's any disagreement that the accountants of America have been given a franchise, and I don't think there's any question but that the Commission has a responsibility to act on behalf of the public interest.

I believe both the profession and the Commissioncannot do anything that is mindless of the public interest. And what is troubling to me is that if confidence and perception and trust is acknowledged to be so valuable a part of the process of our markets then how do we bring about a resolution of an issue as contentious as this in the absence of an agreement, in the absence of some creative way of working together to resolve the issue?

Because the very definition of the kind of polarization that we're talking about defies the resolution that we all seek. I'd be interested in hearing any response to that.

COMMISSIONER HUNT: I was going to ask Professor Coffee as a follow-up to that do you think this is an appropriate time for us to act?

MR. COFFEE: Yes, because I am doubtful about the claim that we should postpone everything for further studies. I have been coming to these hearings for about 25 years, and the first time I remember this issue being raised was back when the SEC was prodding the New York Stock Exchange to adopt a mandatory audit committee rule.

And the Commission was told that how dare you propose audit committee as being mandatory because there's no social science. There were no empirical studies. There still really are none, but I think there is wide consensus that the mandatory audit committee rule makes sense.

And a majority of outside directors, which has been encouraged by other means, also has made sense. It's only in the last two years that I think there is anything that even constitutes tolerable empirical studies suggesting that a majority of outside directors creates some economic value.

So it would be a long, long delay, and having been involved in many empirical studies, the first generation of these studies is always imperfect.

The study should be done. I'm certainly not opposed to the studies being done. I don't think they can be a precondition to the Commission acting. Right now you have the appropriate moment because the vast majority of firms aren't purchasing dual services. If you wait ten years, that will change, and testimony much harder to change an existing reality rather than an approaching change.

So I think this is the time for action, and I agree with the Chairman as saying I think if the Commission gave broad guidance that there has to be some limitation on the amount of non-advisory services that the industry can sell to its clients that are receiving auditing services.

Then, I think that kind of broad guidance might possibly be given to the ISB with an instruction to try to be more precise about drawing the line.

I think there are ways in which the industry is structured that there has to be a line drawn, a line thatsays there's a ceiling on the amount of non-audit services you can sell to an audit client could be quite sensible in helping to draw that line, and it might make this more of a cooperative enterprise.

COMMISSIONER HUNT: Suppose we got from all the firms data on their non-audit income and audit income from all of their clients and tried to map out where we thought there may have been some problems and where the income fell along a chart. Would that be a useful thing for the Commission to try to get publicized?

MR. COFFEE: I think everything is useful. My understanding is that from 75 percent we're not going to get data suggesting that they are purchasing such services. From 25 percent it would be interesting to look at.

I think the future, which really alarms me, is the prospect that a poin