UNITED STATES SECURITIES & EXCHANGE COMMISSION
HEARING ON AUDITOR INDEPENDENCE
Wednesday, July 26, 2000
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
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner
Presentation of John D. Hawke, Jr.
J. Michael Cook
John C. Coffee
Paul B.W. Miller
Ray J. Groves
John H. Biggs
J. Terry Strange
Joseph F. Berardino
Jack T. Ciesielski
William T. Allen
Manual H. Johnson
Robert E. Denham
John C. Bogle
Max H. Bazerman
Douglas R. Carmichael
Curtis C. Verschoor
Dan L. Goldwasser
Alfred M. King
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,
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.
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,
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.
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: 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.
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.
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 point could be reached at which the multiple could be 7, 8, 10 to 1 of non-audit versus audit services. And at that point, there's at least a danger that the audit function will become the loss leader by which a diversified firm markets a broad array of services.
COMMISSIONER UNGER: I just want to clarify. I guess what you're saying is, then, there is some threshold that you think the firms can accomplish the synergies of providing consulting and auditing without impeding the quality or integrity of the audit.
MR. COFFEE: I'm saying two things. There probably are some services which the existing rules already prohibit that simply shouldn't be performing by an auditor because they involve the auditor reviewing its own work product.
COMMISSIONER UNGER: Right.
MR. COFFEE: That's only a narrow category. There are other kind of services that don't involve this self-grading, but the danger there is that the revenues from non-audit services become so large and they give management such a club that the auditor, in effect, defers to management in a very subjective world. That's the danger I see.
And I think allowing some percentage of your audit services, maybe as much as 100 percent, an equal amount of non-audit and audit probably isn't going to corrupt the industry. I, at least, don't see any reason to see that.
You could debate what the level should be, but I don't believe the rule has to be completely Draconian and say absolutely no dollars from other sources.
COMMISSIONER UNGER: Thank you. I'm sorry. Who did I interrupt?
MR. MILLER: I interrupted you. I just wanted to respond to the Chairman's plea for consensus from all parties. I believe at the present time that there is a combination of public interest; that is, interest through the media and in the halls of Congress on both sides.
I also see a crisis in the profession itself with a need to monetize to provide for huge unrecognized liabilities. They need the money. So I would think there would be some economic incentives in place to cause the firms to spin off and completely separate out of the non-audit business.
CHAIRMAN LEVITT: Okay. Well, I think this has been an outstanding panel. I'd like to thank all of you. Our schedule calls for a break, but because we're a little bit behind schedule I'm going to continue right through with the next panel of John Biggs and Ray Groves if they are here. We are honored now to have two witnesses who have manifested not only leadership in their respective professions but extraordinary leadership in community endeavors and a sense of balance and perspective in terms of the public interest, and that's always a delight.
I absolutely welcome hearing from Ray J. Groves, a former chairman and CEO of Ernst & Young, a former member of the Board of Governors of the American Stock Exchange, a member of the board of the Metropolitan Opera, wonderful credentials; and John Biggs, chairman and president and CEO of TIAA/CREF, a member of the board of overseers of the FIBV and an individual who has numerous corporate and philanthropic contributions. Ray.
MR. GROVES: Thank you, Mr. Chairman. Like theother people presenting statements, mine are personal only, but they are based on experiences, as you've said, with one of the large Big 5 firms and now for the last several years as a member of the board of directors of a number of New York Stock Exchange companies, including serving on six audit committees, four as chairman.
I do share the Commission's belief that there is a need to modernize auditor independence requirements. Perhaps like others who have commented before and will comment later I would prefer to see as much private sector involvement as possible, but nevertheless it is time and there has to be some entity that does it, and I guess we're at the right one here.
To be specific on a number of the proposals, I agree with many of them. There are many I could agree with with some modification -- I would say modest. You might say more than modest -- and there's some that I don't agree with. I'll try to hit four or five from my statement and omit probably many of those that I do agree with.
In trying to set these four broad principles, I think that's a good endeavor, but I think there's a danger in doing that.
For example, in Principle No. 1, while I do agree that a conflicting interest with an audit client can impair independence, I just don't agree that every mutual interestwith an audit client can impair independence.
The meaning of the word "mutual" is just too broad to be used as a principle I think in this context, because I think acceptable mutual interests can occur in everyday matters, whether they be with legislation or industry associations or charity school boards, all kind you could have that.
I think back, for ten years, starting in '85 when I was chairman of the AICPA, I was involved in tort reform efforts that culminated not necessarily because of me in the Private Securities Litigation Reform Act of '95.
During that ten-year period, there were various coalitions formed, and some of those coalitions included audit clients of firms that were in the coalition. I don't believe that those caused an impairment of independence, and yet I think they were useful to do.
When you go to Principles 2 and 3, the auditor independence I agree is impaired if the auditor audits their own work or if they function as management or an employee.
But No. 4 on advocacy, I find myself in disagreement, at least in using it as a principle. Not to say that advocacy is right all the time, but it's not wrong all the time, at least throughout my 40-year career and I think for a long time before that it has been accepted practice for auditors to be advocates for their clients intax matters.
I just don't think a professional can provide tax services without being an advocate. Where would a company want to engage a professional to perform tax services who could not act in this capacity? And I don't think these CPA firms can attract people, top quality people, if there were that type of restriction.
And on the other side, serving as an independent director of SEC registrants, I believe auditor involvement in tax matters is generally a very good thing, but I would not feel very good if they couldn't be an advocate for the audit client in whatever they're doing. I would worry about how good a job they're doing.
Advocacy is also necessary in accounting matters. I've been asked in a number of occasions over my career here at the Commission by the staff as to whether I either advocated or supported a particular accounting procedure or principle or change in accounting, whatever it may be, and I hope most of the time I replied in the affirmative.
So it's a tough issue to deal with. I just think a different approach than what you have here is going to be necessary.
As to the financial relationships, I find myself joining a few of the predecessor people this morning. While I agree with most of what you said on financialrelationships, I would also prefer that you retain the current proscription of any direct investment in an audit client by all the partners, principals or shareholders in a firm.
I guess I grew up in an era where the firm and the partners were one in the same, and I think that it's appropriate to keep it that way.
Turning to non-audit services, I'd just like to say that I understand, including my colleague on my left, that people are very seriously and I think sincerely concerned about the potential for impairment when an audit firm performs a large amount of non-audit services.
I emphasize "large amount" because, in my personal experience, my anecdotal, times that I've seen this, or people expressed it to me it has almost always been because of size, as opposed to the type of service.
But I don't share that view that it necessarily impairs it, and I've never personally observed an impairment. I recognize also the difficulty in finding that, but nobody has ever been able to cite an example to me, but that doesn't mean they don't exist.
But turning to the specific ones that you mentioned, I certainly agree that whatever rules that you bring up on non-audit services that may impair independence I think they have to apply to everyone in the firm regardlessof what type service they provide.
In terms of financial information systems design implementation, which, of course, is the one that impacts, I think, your proposal the most, I could agree with this proposal provided there was a consensus on the two areas that you do say are acceptable, and that's dealing with the client's internal auditing, accounting and risk management control, and then, when the systems work is not significant to the company taken as a whole.
I think those are logical exceptions, but I would just want to make sure, as one would have to rule on these on an audit committee, that there was a definition that everybody felt comfortable what it means, that's all, just so we have some certainty so we're not always arguing about these, as to whether they fit that or not.
But the two -- I don't know if you call them exceptions or permitted services -- I think they would not impair independence, and I think they can be monitored by an audit committee.
CHAIRMAN LEVITT: Could you possibly help us with the language of this, give us your own thinking about this?
MR. GROVES: If you probably gave me through lunch, anyway, I probably could, but maybe not this morning. Yes, I think so, because I think what you're intending to do here makes sense. So I think you can come up with definitions.
I'll comment on internal out-sourcing because of the prior commentary. Again, I could agree with this proposal with one revision based on my own very personal experience.
I think limited amounts in specific areas of internal out-sourcing make a lot of sense, as opposed to complete out-sourcing, as long as the audit client maintains their own independent internal audit function with capable management and people within it.
Many companies, maybe not the real large ones, but many, many companies of decent size have trouble today maybe obtaining IS auditors for their internal audit department because of demand in the marketplace for people with that kind of talent today.
And also, if they happen to open up a subsidiary in, pick the country, France or Italy or in Asia, and that's the only one they have, and they haven't got time to hire internal auditors who can speak the foreign language, who can do the job.
For those specific tasks like that I think to supplement an existing viable internal audit staff with external audit assistance makes just a lot of sense.
And before complete out-sourcing became, sort of, one of the things that's done today these things were done, and I never heard a complaint ever about it. So I think ifyou go to denying complete out-sourcing, I think those things should be permitted.
Two more quick items. Contingent fees, I'd be okay on that because there's a pretty broad ban on that now, but you've got the value added in there, and I think apart from contingent fees I think professionals who do a good job like beating deadlines or finding matters that are really tough to find or preventing something in the work they're doing in auditing, I don't think there's anything wrong with being rewarded by additional fees for doing something like that.
And the last item would be on the proxy statement disclosure. Having lived through and participated in the formulation of the rule that existed 20 years ago, I think if you are going to proscribe certain non-audit services or say certain ones impair independence, then I don't see the need for disclosure of the ones that do not impair independence, because it seems to me you're saying that boards of directors and audit committees can't really follow your rules.
And I think we can if there is certainty in them. On the other hand, if you decide to go the other way and adopt Professor Coffee's idea of just having disclosure of fees and only have a limitation on number of fees, then disclosure would be completely appropriate, I think, as it is in the UK today where they don't proscribe any non-audit services, but they do require disclosure of in total the non-audit services.
And like, perhaps, the others I would just encourage you, as you're doing today, to get as much input as possible because depending on which direction you go the impact of some of these proposals could be fairly dramatic, and it takes a while to, kind of, gauge what that might be.
MR. BIGGS: Thank you. I'm pleased to be here to express the views of TIAA-CREF. I happen to be the current chairman and CEO, but my comments have been shared with my investment colleagues and also with our board of trustees and particularly the investment committees of the two who strongly endorse the policy that we've adopted at TIAA-CREF, which I'll describe, but also the concerns that we have about independence.
We manage slightly over $300 billion for our participants. We invest it all ourselves. We do not invest any with outside managers. We serve the educators in the country primarily in higher education.
In the TIAA life insurance component alone we have $1.5 billion in new fixed income investments made every month, and we do far more than that in common stock.
Essential to those investments made on a daily basis are the audit and financial statements of the borrower, the stock issuer, the entrepreneur, and our analystsobviously assume that these statements have been audited by an independent, disinterested and highly professional auditor from the outside.
And most of the time that assumption is correct, but recent exceptions, including fraudulent and deliberately misleading financial statements for public companies have caused us serious concerns along with other investors.
Could the auditors have been so totally deceived without some explanatory reason for what seems total negligence? Most of our largest losses due to fraudulent financial reporting have come in the public stock markets where the totals in our case come to hundreds of millions of dollars. And that's one company. When they're spread across many investment firms, the seriousness financially to us is obvious.
One of our most painful losses, however, may seem a relatively small amount, but it ended up in litigation that led us to some strong conclusions in this.
We made a private fixed income investment in a company that went bankrupt within weeks after our making a $12 million loan. Our due diligence after the cow left the barn uncovered a grossly fraudulent financial statement on which we relied because a Big 5 and Big 8 accounting firm had audited the statement.
A major asset was a building valued on a percentageof completion basis of 90 percent turned out to be a hole in the ground. The independent auditor had not bothered to look at the site.
Now, we sued and we lost further a lot of lawyers' fees, since we lost the case. The jury found the auditor had truly been negligent but did not have an intent to defraud us. Was the auditor just incompetent, or was he currying the favor of management?
We tried to develop the motivation in the lawsuit that there was strong motivation. In this particular case, there were no management consulting services to deepen that argument, but the basic problem of independence of the auditor in that case remains scarred in our minds since that very hostile litigation.
The old concept of independence no longer fits the current practices and culture. Prior to the buildup of the non-audit professional service in accounting firms the focus was on the one primary question -- did the audit professional have any direct financial interest in the company?
I think the profession and the SEC and the regulators developed excessively refined rules on what the members of the firms could or could not invest in. Ironically, this had the effect, by my experience in meetings with audit committees, that the auditor, when the independence issue was discussed, would go into excruciatingdetail to show the extraordinary comprehensive extent of the prohibitions.
Directors of the companies could then be lulled into sleep with the confidence that the auditor had true independence. I don't recall personally an audit committee meeting where the accountants themselves brought up the possible conflict from reliance on management resulting fees. Board members initiated those points.
I certainly endorse the relaxation and narrowing of the rules that the Commission has proposed. A genuine threat to independence, however, is the growth of the non-audit management services.
They're extremely profitable. They're growing very rapidly, as dramatically shown in your proposed regulation data. These services, in effect, have been owned by the audit professionals who could capture the profits from those additional services, but it's clear that that relationship, with its obvious inherent conflict, cannot endure.
Those who are owned; i.e., the management consultants, are reluctant to see their economic surplus taken by the audit partners. The Arthur Andersen breakup is a rather obvious illustration of that.
But there's an important exception. If those audit partners can justify substantial return from the consulting business due to their ability to cross-sell to their auditclients, and if that's their role, I think you can see the problem very easily of independence.
Most of the Big 5 firms are exploring ways to separate their management consulting and audit capabilities, but the frenzy of activity is not confined to the larger firms. Small accounting operations are also players as they sell out to major non-auditing companies, financial service companies that wish to benefit from the cross-selling of other financial services by their controlled auditing firms. American Express and H&R Block are the main examples of companies that followed this acquisition strategy and business model.
Simply apply the term "cross-selling" to the vital and independent role of the auditor, and it's easy to see how professionalism has been compromised. Assuring independence within the firms that offer consulting services I think is a Gordian knot that can be easily cut.
My own suggestion is to allow the firms to do what they want and let them pursue their self-interest as long as they abide by one simple rule: Independent public audit firms should not be the auditors of any company for which they simultaneous provide other services. It would be that simple, simpler even that the proposed Commission rule.
This is a broader rule than you propose since it would totally ban such activities rather than narrow thekinds of services to those that impose obvious and clear conflicts, which I think the Commission has identified.
As chairman of TIAA-CREF, I live in two of the classic roles for the accounting profession. One, TIAA-CREF is a user of financial statements as an investor, and second, we are a preparer of financial statements to report our results to our 2.2 million participants.
I want to comment on our experience and policy in the latter role as a preparer. For the last four years, TIAA-CREF has maintained a strict view of professional independence for our own audit firm.
Our rule is that when we need professional services and management consulting we hire someone other than our auditors to do the job, and we do employ a number of firms for professional services with a very heavy reliance on other accounting firms.
We bring in the consulting arm of a different accounting firm, perhaps someone totally unrelated to the accounting profession.
Our board audit committee has no question, then, on our accountant's independence. The committee members never wonder whether our auditors are receiving so much in consulting revenue that they dare not challenge management.
The arguments against our rule are familiar to all of you. They have been, I should say, vigorously articulatedby our own auditing firm. The drawbacks include distinct advantages of their own, however.
First, our accounting firm has not developed our general ledger software system for the company. If they had, our financial executives would have been quite relieved since the audit firm could hardly challenge the quality of that work. In fact, we've just completed that experience where we used a different firm to help us install a new general ledger system.
The CFO would have preferred probably to have the audit firm do it, but the CEO, the audit committee itself and the users of the financial statements would have lost an independent appraisal of that important piece of the company's management system.
The same analysis can apply to a host of other difficult financial management systems for which consulting help might be sought.
A major advantage of this rule is the simple certainty that our auditors express a clear-eyed independent view of our financial situation.
When a contentious issue on financial reporting arises which has occurred and the audit firm refuses to back down before management, which they did refuse to do in our case, company executives may regret not having a deeper economic relationship with the auditing firm. I've actuallyheard that expression.
On the other hand, when such a relationship does not exist, the CEO, the audit committee and the users enjoy confidence that they would not otherwise have.
Second point. If this were adopted by all companies, as proposed by the Commission in some form, the rule would bring the accounting profession to a considerably stronger position, in my opinion.
Accountants would continue their consulting practices as they wish while enjoying their substantial financial benefits, or they could spin them off and maintain an interest in the stock of the company that purchased it. But let the audit and consulting partners resolve how to split up the extra returns of the lucrative business without injecting a public interest issue in how they do that.
It seems to me that a powerful argument does exist for maintaining management consulting practices within the audit firm. The extraordinary complexion of our financial information systems requires knowledgeable people to audit them.
The auditors need firsthand experience in developing those systems in order to audit effectively modern high tech accounting systems, but I would encourage them simply to get that experience while serving non-audit clients. We trained a few people for one of the audit firmsin doing our work.
If CEOs and audit committees take their function seriously, with a few simple rules in independence, the rewards are subtle but real. When they have that quiet private meeting with the audit firm, they can get reliable answers to questions such as, "How are we doing? Has that new system really worked as planned?" and they and our investors can rest assured that external influence or self-interest haven't compromised the critical information for the company.
Our practice has been useful and has been strongly endorsed by our audit committee. We have eight independent experienced directors. It has also been strongly endorsed by our two investment committees, one for the stock side in CREF and the other in TIAA.
But it is, admittedly, a harsh rule for our accountants since there are few firms that follow our practice, but were there a uniform requirement, all the firms would have the opportunity to provide services to all the clients and could do so freely, and the incentive to general financial services firms to buy audit firms for their cross-selling capacities would be eliminated.
Accordingly, I'd urge the adoption of the simple general rule by the Commission, but if that may be too draconian, then at least adopt the narrower set ofprohibitions that you've described which would identify only those services on which there would be a clear conflict for the auditor to review its own firm's work.
CHAIRMAN LEVITT: Thank you very much. As I think about these issues and listen to the witnesses this morning, I think it becomes increasingly obvious that the Commission really doesn't have a choice in terms of doing nothing, as opposed to following this process.
This is an issue which has been with us for a long, long time, and doing nothing is certainly a powerful statement. And the nature of what we do becomes terribly important because some of these issues are going to just feed upon themselves, and through the years the profession has asked for clarity. They've asked for definitions.
And I think that even partisans of a view that may be different from the views that have been expressed by some of these suggestions are asking for definition and clarity.
With respect to the tax issue, which a number of commentators have spoken of, what do you think of the practice of sharing in the benefits of a particular tax device which may or may not be abusive? Do you find that troubling as a means of compensating the accountant?
MR. GROVES: I assume you're speaking to me and not my colleague.
CHAIRMAN LEVITT: Yes.
MR. GROVES: Yes, I do, particularly if it becomes a contingent fee as at least historically contingent fees were described; that is, where the bulk if not all the fee all depended on something that was going to happen in the future. My comment about value added I don't think really was a contingent fee type concern.
CHAIRMAN LEVITT: How much of that do you think there is, the contingent fee?
MR. GROVES: Well, I've been out of it for six years, Mr. Chairman. There was very, very little of that at the time, and I think the rules have become much more specific as to doing it for audit clients as that practice started to grow. I assume that there's not much of that at all.
But certainly, there are people who are looking for more than their standard billing rates for an idea that has got some real benefits to it. You're going to have some borderline issues, I suppose, between value added and contingent fees, but in my own personal experience value added was quite easy because it wasn't that big a percentage of any normal fee.
CHAIRMAN LEVITT: It seems to me that our economy and our society have so much to gain by some kind of resolution of this issue. I don't know how it will be resolved, but surely even those who oppose some of the ideasput forward here cannot say that this drum beat, this undercurrent, this continuing criticism is useful for the industry and that some kind of definition is called for.
Would you agree with that?
MR. GROVES: Yes. Yes, I would.
CHAIRMAN LEVITT: So that we cannot dismiss perception as being a terribly important consideration.
MR. GROVES: I wouldn't dismiss it. I assume that's why we're here.
CHAIRMAN LEVITT: That's right.
MR. GROVES: What that means is, obviously, everybody has a different view of perception. My colleague has a slightly different one than I do, but I think we both feel that something needs to be done.
CHAIRMAN LEVITT: Incidentally, I share your review that sometimes, in trying to formulate the broadest kind of exposure and the widest sorts of judgments with respect to an important and contentious public policy issue, language is broader than it will eventually be.
And that gives rise to concerns of its own, and I really would seek your help in trying to frame this language in a way that you think does not give rise to as many unintended consequences.
Do you believe, Ray, that the issue we are dealing with today is an extremely important public policy issue?
MR. GROVES: Yes, I do. I suspect you're in a better position in terms of the breadth of the exposure of the financial and securities markets to know how much it is, but it certainly is a public policy issue.
CHAIRMAN LEVITT: And not one that the Commission should turn away from?
MR. GROVES: No. I think it's clearly under your mandate. How you go about doing it, whether you have public hearings like you're having, whether you propose rules, where you seek other bodies like the ISB, how you do it I think is your judgment. But it's within your purview if not your responsibility.
CHAIRMAN LEVITT: The issue has been with us for so long, and the kind of attitudes and the public consideration of the issue has become so much broader than ever before that I'm not totally patient with the notion of study it longer and see if it will solve itself.
I think that would be an unfortunate outcome. I assume you agree with that.
MR. GROVES: Yes. Although, as I mentioned, let's say the backlog of the 25 years until it has been addressed in such a forum as this, what you have now before you has the potential for rather dramatic change, and so I think you do need to take the time to see what would be some of the manifestations of that change.
I don't think any of us in here can predict what all that would be, but those who are most affected would give you some idea.
CHAIRMAN LEVITT: I agree with that, and I think that how those changes are introduced -- again, I hope that there will be some narrowing of the interests on this in terms of approaching it in a way that is balanced and is sensitive. I fully agree with that. Colleagues?
COMMISSIONER UNGER: I have a question for each of you. Shall I start with Mr. Biggs, since you've been silent? You mentioned or you described some actions that you were familiar with with respect to fraud, and I think you're expressing a concern that a lack of independence could result in more fraud. I just wanted to, sort of, flush that out a little bit more.
MR. BIGGS: No. I was just arguing that in that particular case we believed that the auditor had great incentive to keep the audit client and was, in effect, trying to provide a service to that audit client and, perhaps, winking at something that was very serious.
I think in this case it was probably real incompetent because clearly, if the numbers had been right, he would have seen that the company was about to go broke.
But what induces the auditor to do that is all the powerful incentives to maintain the business relationship,and if you have just the audit relationship -- that's, obviously, quite valuable to the firm -- but if in addition there may be three, four, five times as much in fee income coming from the consulting and other services, then I think the motivation to try to accommodate management is overwhelming.
COMMISSIONER UNGER: When you mentioned that and when Professor Coffee mentioned the gatekeeper concept, I did think back to when I was an enforcement attorney and the fact that we actually get a number of cases, or did, from the accounting profession.
And in my mind I think I was wondering what would happen to those types of tips, if you will, if there was more of an incentive to maintain the business relationship and, perhaps, look the other way with respect to the audit. So I think that's probably what you're talking about.
MR. BIGGS: Yes.
COMMISSIONER UNGER: Then, Mr. Groves, with respect to the disclosure issue -- and I know you were picking up on Professor Coffee as well -- do you think one could adequately disclose away a conflict? What would that do to, sort of, diminish or change the conflict that could exist?
MR. GROVES: Well, my comment on disclosure was if you are going to provide or promulgate a list of specific non-audit services that would impair independence, thendisclosure of the ones that don't impair independence, I didn't see any reason for that.
COMMISSIONER UNGER: No. I agree with that.
MR. GROVES: But if you decided not to do that, if you went the other way and said, no, just on disclosure, then it would make sense to disclose them because there's a cause and effect or, you know, quid pro quo, so to speak, for that. Back when they were required about 20 years ago, at that time, it seemed to make sense. As it turned out, nobody at that time seemed to pay much attention to them, but at least the rationale was there, I thought, for it. Maybe I missed your question. I'm sorry if I did.
COMMISSIONER UNGER: No. No. I guess what I'm saying is maybe in a bigger context or a higher percentage than exists today in the reporting requirements, if we allowed for there to be a combination of consulting and auditing, could disclosure of that relationship cure a conflict?
MR. GROVES: Not if it were a conflict, no. Disclosure I don't think can cure a conflict. If it's a conflict, by the definition, it's hard to draw up, as the Chairman said, was one that caused something between auditor and their client, that just didn't make sense, that kind of conflict. I don't think disclosure alone can cure that.
COMMISSIONER UNGER: We allow disclosure to cureconflicts in the Investment Advisor and the Investment Company. That's why I was just wondering if you thought that would carry over into this aspect of the law.
MR. GROVES: I don't think so in the context in which you've been talking about the service area. You can go to maybe an easier one, financial independence. I mean, disclosing that the firm owned some part of the client I don't think disclosure could cure that conflict.
COMMISSIONER UNGER: Okay. Thank you.
COMMISSIONER CAREY: This may have been addressed by Commissioner Unger, but I do want to ask -- I didn't hear all of her questions -- Mr. Biggs, the instance you described in which the fully leased or 90 percent leased building turned out to be a hole in the ground does not seem to be a situation which would be addressed by the rules that have been proposed.
Is there something that you could suggest we do to, perhaps, capture that kind of activity, or do you have
MR. BIGGS: Well, I don't think you have to do anything. I think the auditors -- any auditor who looked at what had happened would have been appalled by the character of that audit. So I don't think it requires any action on it.
What I do suggest, though, is the independenceissue is an important one and I think was an explanatory reason for that audit failure.
COMMISSIONER CAREY: That was not an instance where audit and non-audit services were being provided --
MR. BIGGS: That's right.
COMMISSIONER CAREY: -- to the client, right?
MR. BIGGS: That's right. If they had, we would have won the case.
COMMISSIONER CAREY: Okay. Thank you.
CHAIRMAN LEVITT: What would each of you think about if the result of all this was a call for disclosure, specific disclosure? Do you think that that would be a satisfactory resolution of this issue, that this would put it to rest?
MR. GROVES: Certainly, on the latter, it's not going to put it to rest. I think we all agree with that. It may be satisfactory for a good many commentators.
CHAIRMAN LEVITT: If you read in the paper that that's the resolution, would you --
MR. GROVES: I'd be surprised first. And then second, at least on some of the boards that I serve on I would have continued dialogue with some of my audit committee fellow members because that would not satisfy them.
CHAIRMAN LEVITT: So you might be disappointed, then, at that outcome?
MR. GROVES: In addition to being surprised, yeah. To some degree, yeah. I would be.
MR. BIGGS: I'd certainly be disappointed by that. Obviously, it helps if there's disclosure. As I understand it, under the ISB rules, this has to be disclosed to the audit committee of a company, and I think that's helpful. At least it is clearly on the table before the audit committee, and the audit committee then has the duty of determining independence.
My own experience as an audit committee member when this issue has been discussed is there's a great deal of struggling with it with, in some cases, management wanting very much to keep the relationships that they had in spite of the fact that there might be what seemed to me inappropriate levels, three and four times as much in consulting fees as in audit fees.
In this particular case, finally the company just decided, "Well, we're going to change the policy and eliminate the question of using external auditor for doing additional services."
CHAIRMAN LEVITT: When you get locked into an issue like this with as broad public exposure as we're seeing, the economy's action undoubtedly will be followed by a series of events. If the Commission remains silent on this, undoubtedly, the result that both of you have talked about interms of accelerating the proliferation certainly would be an outcome.
And again, in a discussion which has the polarizing impact that this has it's often useful for commentators such as yourselves, representing in the one instance a measure of respect and a history in the industry and the other a user of considerable confidence, to the extent to which you can aid in the narrowing of these lines and come up with constructive applications to address some of what you perceive to be the looseness in terms of the Commission's actions, the release, that would be very constructive.
So what I'm saying is I thank you very much for being here and your interest which I hope is only the beginning part of a continuing process with both of you and others like you. Thank you.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Did you have something?
COMMISSIONER UNGER: No. I said thank you.
CHAIRMAN LEVITT: We're on schedule.
COMMISSIONER UNGER: Come back here.
CHAIRMAN LEVITT: We will convene again at 1:00 p.m. Thank you.
(Whereupon, at 12:00 p.m., a luncheon recess was taken.)
A F T E R N O O N S E S S I O N
CHAIRMAN LEVITT: Okay. I'm sorry that we are ten minutes off schedule, but we will catch up. I promise you that.
Our first afternoon panel consists of representatives of three of the major firms in the country; Terry Strange on behalf of KPMG, Joseph Berardino on behalf of Arthur Andersen -- and who is representing Deloitte?
MR. GARLAND: Bob Garland.
CHAIRMAN LEVITT: Robert Garland. Let me say at the outset that your firms are a distinguished group of professionals that I think care a great deal about the public interest, that have been actively involved in matters with the Commission through the years, have been supportive of the FIBV and the Principles of Independence that are very much a part of protecting that institution from the kinds of tensions that have surrounded it through the years.
The leadership of your firms has been active in a broad array of public interest issues, including certainly, in the case of Jim Copeland, the effort to establish an international accounting standard.
So we start with a premise of goodwill, and we'd like to build upon that in terms of proposals which I know you have problems with. But I promise you that the Commission will hear you carefully and respectfully. So whydon't we kickoff, Joe.
MR. GARLAND: If we may, Chairman Levitt.
CHAIRMAN LEVITT: Okay. He's yielding his time
to -- [laughter]
MR. GARLAND: I am Bob Garland. I'm the partner in charge of the audit practice for Deloitte & Touche in the United States.
If it pleases the Commission, what we would propose is that each of the three of us would take a few minutes to provide our thoughts which are clearly some parallel themes, but also we have some differences, and then when we finish making our remarks we'll get to questions and answers. That way the third person won't get squeezed.
But we'll, obviously, follow whatever protocol you would prefer. So if you're comfortable with that we'll proceed.
CHAIRMAN LEVITT: Sure. That's fine.
MR. GARLAND: Thank you. Thank you for the opportunity for all of us in the profession for this time to present our thoughts on what is, obviously, a very important matter for us.
I personally would commend the Commission for many of the activities they've undertaken over the last couple years, obviously don't agree with everything but really commend you for many of the activities have you undertaken,including this effort to modernize the independence in the area of financial and client relationships.
I've been with Deloitte & Touche for over 35 years, in fact my entire adult life. I've been an auditor all that time. I would tell you that I'm very proud to be an auditor, and I'm very proud to be a partner of Deloitte & Touche. I'm also proud to be part of this profession. I'm even proud when people refer to me as a bean counter. I've gotten used to that over the years.
But the reason I'm proud to be a partner at Deloitte & Touche and I'm very proud to be part of this profession, well, is that I believe our firm and our profession consistently strives to try to do the right thing, and as every adult in this room would know, that's not always easy.
There are many pressures on life that try to interfere with trying to do the right thing. These pressures are like gravity. They continuously are pulling at you trying to pull you down, and so we found in the profession we have to work very hard and we do work very hard to resist those pressures and, in fact, work with our clients and get the right answers. And I'm very proud of our record in that regard.
Over the years I've worked with my partners consistently to do the right thing. Now, don't get me wrong. We are human beings. We're not perfect. But I'm proud of my partners for their efforts in this regard and the way they work with our clients.
I will tell you that my partners and I and I believe the other firms as well in the profession take very much to heart and we take very seriously our responsibilities to the capital markets and the impact that they have on our society. This is very important to us, and I mean that very sincerely, and I mean that from my heart.
I believe that the profession along with investors and corporate management, standard-setters, regulators, investment bankers and the legal profession have really worked together and really deserve a lot of credit, and, in fact, they're the reason why we have the best capital markets in the world.
With that said, I think it's no secret that my firm and I believe that the appearance-based independent standard and the restrictions on scope of services that are being proposed are not in the public interest and should not be adopted by the Commission.
I agree with the findings of the Panel on Audit Effectiveness when they stated that the profession's audits are fundamentally sound but that we should continuously strive for improvement.
I believe that the SEC is well-intentioned in thisactivity, and my firm and I are in total agreement with your overall objectives of trying to continuously improve audit quality. We're in total agreement.
However, I believe that it is vital that as we proceed that we understand how these proposals will impact and how this rule would impact our ability to conduct audits. I think that's vital.
I personally believe, and I feel this very strongly, that this proposal will serve not to enhance audit quality but, in fact, over time will reduce it, and, therefore, I believe it's not in the public interest.
I really urge you to proceed with caution, to go thoughtfully and to slow down. Over the past 35 years I have been involved with hundreds of audits, and I've dealt with my partners on probably thousands of complex accounting and auditing matters.
I'm personally convinced it will be very, very difficult for us to conduct an audit of a large --particularly a large or highly complex public company without the skill sets and the competencies of my tax partners, my consulting partners, my actuarial partners and my valuation partners. I've seen us utilize these people on many, many different occasions.
As an example, we recently completed the audit of a very large complex public company where we had to reviewhundreds of thousands of transactions. We were looking for patterns of errors and fraud, and we found both.
The task was very complex, so complex that it ultimately exceeded the IT capabilities of our audit professionals. We had to bring in 16 of our IT consultants to work with our auditors to successfully accomplish the audit.
I've reflected on that specific engagement in relationship to the proposed rule, and I believe that if we did not have those competencies and if we, in fact, were pushed to dispose or divest of our consulting practice that we would not have those resources to bring to bear on the audit, and I think that would complicate our job.
While that situation was a very large client, I don't believe the situation was an isolated instance. The use of non-auditor resources in the audit is -- I think we're using it in many, many audits. I'd almost say virtually every audit, but that might be a bit overstatement -- and I would say that the trend is clearly increasing as our clients increase in complexity.
I believe, and only time will tell, if this rule is adopted as proposed, that the proposed rules will cause us to dispose of our consulting practices. That will be the practical consequence.
Now, I want to be careful to provide some balanceand not to overstate. I am not saying that an accounting firm that sheds its consulting competencies will not be able to perform an effective audit, but I am saying that losing internal access to a very unique set of competencies that we've built over the decades will provide, will create a significant obstacle or ability to accomplish high-quality audits.
I believe it will probably make audits more expensive, and I believe it will raise a whole set of new issues that we haven't previously confronted and that we don't really yet understand the implications of.
I believe and I hope that when we're done that the rule-making, whatever's accomplished will make it easier for us to accomplish high-quality audits and not make it more difficult. And I am concerned that the proposed rule may accomplish the latter.
Let me give you an example. If we have to go outside our firm to access these non-audit competencies, I believe we would have far less control over those individuals that have those competencies, and, as a result, we would have less control over the timeliness of their work, over the quality of their work.
I think we would also have a more difficult time evaluating the professional ethics and the independence rules that they apply. Right now, with those competencies underour roof, we have the ability to develop and train people over time that will set a mindset of professional ethics and standards that I believe is superior than if we were not a profession, and we were just an industry. So I worry about that.
I believe that before we make the dramatic changes that this rule would propose that all stakeholders in the financial reporting process should ask a couple of questions. I think we all together should ask a couple of questions.
The first is why should we enter these risky and unchartered waters? And there would be good answers to that the second question is what problems are we trying to solve?
I believe that there is no evidence that a broad scope of services has an adverse effect on audit quality. We've been studying this issue as a profession -- I think the SEC has looked at this -- for over 40 years now, and no one, to my knowledge, has ever produced any evidence suggesting or proving that that's the case.
My own personal experience over the last three decades in fact has caused me to conclude just the opposite. I believe and I really believe that a broad scope of services enhances audit quality, and I've had a number of personal instances that caused me to come to that conclusion.
As you're aware, the Panel on Audit Effectiveness recently studied this and other issues with respect to theaudit profession, and like everyone else who has studied this profession over the decades, again the panel was unable to identify any instances where the provision of non-audit services had a negative effect on audit quality.
And as I think you're also aware, they found exactly the opposite, that in a quarter of the engagements they looked at their conclusion was that it enhanced audit quality, had a positive impact.
I think we should not tread over that independent conclusion lightly. I'd say given what is at stake and the fact that there is no problem, at least in my mind, it would be very dangerous for us to take on the considerable risks that I believe the proposed rule would present.
To me, it would be like doing radical surgery on a healthy patient. I understand that there is a perception of independence issue that's caused by a broad scope of services, and concerns have been raised.
Unfortunately, I believe the SEC is responsible, partially responsible, at least, for raising this perception and these concerns. However, I personally question if the perception issue really is a widespread issue with investors. I see no evidence of that. I see no evidence of a confidence crisis in the capital markets.
However, even if there is a widespread and I would call it misperception about a broad scope of services and itsimpact on audit quality, I personally believe that the best way to deal with misperceptions is with facts.
I'll give an analogy. Many hundreds of years ago common sense or the general perception was that the world was flat. At that time, we did not go out and build fences around the edge of the world.
Rather, what we did was to study the issue, and we gathered facts, and when we had the facts, we presented the facts to the people. Once the people had the facts the perceptions changed.
My hope is that as you go through your deliberative process and as you gather the facts that you will come to agree with me that, in fact, a broad scope of services is a positive thing and has a positive impact on audit quality and is not a negative one and that you will -- once you understand these facts and assuming you agree with them that you will communicate these facts to the public-at-large. And I believe such a communication would have a very positive impact on perception.
I guess the main question to be addressed here is how do we resolve the issues in front of us? How do we resolve the debate? And there clearly is a debate at this point.
I think, as the Panel on Audit Effectiveness has so perceptively noted, the U.S. has developed the best capitalmarkets in the world as a result of a very effective partnership between the standard-setters, the regulators and the profession, and I believe we must make every effort to make that partnership continue to work.
I think the partnership, as the POB noted, is under unusual stress. I also believe that a solution that is mandated by the SEC and that is forced upon the profession would be premature, will not be the answer and, in fact, will undermine our partnership.
I believe due process in the private sector with appropriate and substantive regulatory oversight is a far superior solution, and I suggest that what we do is sit down together, the SEC, the accounting profession, the POB, and we thoughtfully deliberate the recommendations of the Panel on Audit Effectiveness, as was done with the blue ribbon committees' recommendations.
I also suggest, as did the Panel on Audit Effectiveness, that is the ISB be allowed to do its job in the area of independence and scope of services free from undue pressure from either the SEC or the profession.
Personally, as I have watched the ISB be formed and develop its findings, I have personally gained confidence in their work. And I believe that if we give them time and allow them to work through these very complex issues that they will continue to develop standards that will, in fact,enhance the effectiveness of audits.
I think they will accomplish the changes that are needed that will allow us to continuously improve audit quality, and I know that's the goal that we all have in common.
MR. STRANGE: Good afternoon. My name is Terry Strange. I'm a vice chairman in the firm and am the global managing partner for audit for KPMG.
First of all, on behalf of KPMG, thank you for the opportunity to testify this afternoon. We are totally supportive of the Commission's desire to modernize the independence rules; however, we are troubled by two aspects of the current proposals.
First, we think the bundling of the much needed revisions on existing rules on investments and family relationships with a restriction on scope of services is inappropriate.
Second, we perceive the process to be somewhat rushed with regard to that part of the proposals.
The scope of service aspect of the proposal we believe is very complex and could have very profound and far-reaching consequences for the accounting profession and the financial reporting system.
We encourage the Commission to separate the twoaspects of the proposed rules and to extend the analysis and comment period for the scope of services component.
The remainder of my comments today will address our broader concerns with regard to restrictions on non-audit services. We will be prepared to provide more detailed comments on all aspects of the proposal at the next set of hearings.
The basis in the proposal for the restriction on non-audit services, in our view, lacks factual justification. Accounting firms have provided non-audit services for all of the 100-year history of the profession. These services, by and large, have grown as logical extensions of the work that we do in performing audits.
Virtually all of the research that has considered the implication of non-audit services has recognized that such services enhance auditor knowledge and thereby improve the quality of audits. No research that we are aware of has concluded the independence of the auditor is, in fact, impaired when there's the presence of non-audit services.
The most recent research was conducted by the O'Malley panel, a panel formed at the request of the SEC, which concluded it is not aware of any instances of non-audit services having caused or contributed to an audit failure or the actual loss of independence.
Instead of empirical evidence, the proposal isbased on investors' supposed perception that a broad scope of practice impairs auditor independence, but even there the proposal does not cite any evidence of a current problem.
The staff suggests that taken together various studies suggest that important constituencies see a connection between the business scope of account firms and auditor independence. We don't believe the reasoning in the proposal by itself is sufficient to justify a government imposition of a restrictive and what we believe could be enormously costly rule.
The lack of empirical evidence we believe also raises a question as to the timing of the rule-making, considering the announced restructurings of certain firms. A number of the large accounting firms, ourselves included, are in various stages of restructuring.
In our view, the restructurings that are underway are driven by market forces, not regulatory considerations. We believe the Commission and the investors would be better served by evaluating the results of the current market restructurings, market-forced restructurings, and the ability of the firms to effectively fulfill their role in the capital markets before forcing regulatory restrictions that could have unintended consequences.
We have spent significant time and capital over the last several years attempting to prepare our firm to functionin the information age. We do not have a crystal ball and cannot predict with great certainty, but we are very confident that the way audits are conducted today will be very different than the way they are conducted in the future. We believe and we are structuring our business model to put us in a position whereby we will be much more focused on the effective functioning of systems and business processes that we have in the past.
We think it is highly likely we will be reporting on those systems in the future. We think we will be dealing with information outside the current measurement and reporting model, and we believe we will be providing assurances that the quality of information systems is sufficient to produce reliable information on a real time basis.
The range of skills needed to operate in that kind of environment will be broader than the traditional skills housed in the audit functions. We are concerned that restrictions on non-audit services will limit our ability to attract and build the skill sets that will be required to be effective in the information age and ultimately protect the investor.
Therefore, we believe that the proposed regulatory limitation on non-audit services could undermine the accounting profession's ability to adapt to the 21st Century. While some may say that the proposal is carefully limited, that accounting firms can still provide non-audit services to non-audit clients, that assertion ignores the incentives that will be inherent in the proposed rule.
Accounting firms, we believe, will be driven by market forces to split their audit and non-audit businesses so that each aspect of the business can compete for 100 percent of the market. We believe that is simple economics.
The proposal, in our judgment, inappropriately presumes that audit committees lack the judgment and ability to address independence issues. We applaud the SEC and the ISB for the recent measures it promoted to increase the involvement of audit committees in evaluating and addressing any independence issues.
Audit committees have the business acumen to address independence issues on a case-by-case basis, thereby preserving a corporation's ability to select its auditor for non-audit services if that is the best choice for the company and the investor in the circumstances.
We believe that the proposed rule is an inflexible regulatory ban again that could have unforeseen consequences for investors such as increased costs. We believe the Commission should allow time for the recent audit committee initiatives to take effect.
Ultimately, we think that the Commission mustcarefully analyze the cost of the proposed regulatory ban not only to the accounting profession but ultimately to investors and companies that purchase both audit and non-audit services from accounting firms.
In conclusion, we are recommending that the Commission bifurcate the rule-making between the modernization of existing rules on investments and family relationships and the restrictions on scope of services.
We recommend that the proposed time line for the scope of service proposals be extended and an undertaking be initiated to substantiate the need for rule-making and ultimately the cost benefit of that proposal.
Thank you very much.
MR. BERARDINO: Good afternoon. I'm Joe Berardino. I'm the managing partner for North America Assurance and Business Advisory Practice. I've submitted separately written testimony, but frankly, after reviewing my esteemed competitors' comments, realized there would be a lot of redundancy by the time you got to me.
So what I've done is taken a slightly different tact just highlighting a couple of those items which, hopefully, will be helpful.
The first thing I want to take on is an issue that I heard earlier this morning, this whole issue of the relationship between the SEC and the profession and how it'snot as cooperative, perhaps, as we'd all like it to be.
Let me state outright I do believe, we all believe we have a mutuality of interest, and the that is to protect the public investor. We'll never forget that.
We also feel that over the last two years the SEC's initiatives have been very, very helpful to us in helping us perform our job. We have a very hard job, and you've done a number of things that have helped us do our job, and they've all been highlighted by my colleagues -- the ISB creation, blue ribbon panel on audit committees, Panel on Audit Effectiveness, serving up the whole issue of improving worldwide auditing standards, a number of the Staff's Accounting Bulletins, et cetera.
You've been helpful. We appreciate it, and we'd like to go forward in find more ways we could all be helping each other with this mutual interest.
We've also been extremely supportive both in public and privately with our clients, in the board room and behind closed doors with our clients trying to explain to them how they needed to raise their game in the public interest.
As for today's conversations, as stated before, the modernization of financial interest and family relationship rules are long overdue. They are also helpful, and we feel we can work very easily with the SEC on putting this on a fast track towards resolution.
However, no surprise maybe at this point, the proposal on scope of services is not helpful. In our opinion, we do think it will harm audit quality. We think these proposals, intended or otherwise, will lead us down the path to become statutory audit firms without the deep competencies we need in an extremely complex and quickly changing technological environment.
Why do we say this? I mean, that sounds like a pretty strong statement. Why do we say this? Let me try to get very practical. If you sat in our board room and audited our company as the Panel on Audit Effectiveness did, but if you sat through our deliberations and asked us or biggest problem, or number one problem is talent.
We have all sorts of institutional processes, et cetera, but, at the end of the day, we're a people business, tens of thousands of people around the world. And the question is in the United States in this full employment economy that we live in it's very hard to find people.
I've been around 28 years and remember the days where there was a deep pool for us to fish in, lots of accounting majors primarily those with the skills we were looking for. We could pick and choose who we wanted to keep and, in time, we had the choice in terms of who stayed and progressed and who didn't.
That's changing. Our young people have many moreoptions, and our firms are growing. And I'm talking about our auditing firms are growing very substantially, and our appetite for people, not just accountants, but people who want to be technology auditors, derivative auditors, et cetera, our appetite is insatiable, and the market is very, very, very competitive.
So help me. Give me the words when I sit down with that hot young student, might have technology skills, and I say, "Come join our firm, and you, too, can be a technology auditor. But you might not able to do the consulting you'd like to do on 20 to 40 percent of the market, but you can do all these other things, and I think we can say some very positive things."
And I walk out and one of my competitors outside of the public accounting profession comes in looking at that same competence and says, "You can be all you can be. There are no restrictions. You can take those same skills and have a much broader fish pond to fish in."
This is why we are concerned, and maybe you can help us. Maybe we don't have the right words, but we are seeing this every day today, and we only see this war for talent becoming more and more competitive and these proposed rules making it an extremely difficult conversation.
Further, on the issue of audit quality, I think we'd all agree that the more the auditors know about theirclient the better the audit is. We've cited the positive correlation between doing non-audit services and audit quality.
People have said these rules are common sense, and I'd say let me talk to you about common sense. If you or I were a CEO and wanted to perpetrate a fraud or cook the books, I think we'd want to keep the auditors in the dark. I don't think we'd be hiring them to help us implement our systems. I don't think we'd be helping them to look at our complex transactions.
We'd have them do as little as possible, and then once they got smart four or five years later, I'd find another accounting firm under the guise of independence and rotation of auditors.
So we think on the face of it common sense would indicate deep competencies, and be all you can be. Therefore, we feel these proposals are dramatic and would harm our audit quality.
So where does this leave us in terms of trying to go forward? First of all, we would disagree with the notion that we do not want change, that resisting this aspect is resisting change.
We think we've amply demonstrated through some of the initiatives and more that I mentioned earlier that we are very, very receptive to change. We believe we have tochange. The market is demanding it, and the public demands it, and I think we've made very positive steps forward.
We agree with the two firms that went before me that these proposals -- excuse me. The changes that have already been implemented need a chance to work. As each of the firms go forward with what are developing to be very different business models, the marketplace will tell us who's right and who's wrong.
We think this is a better place to be than through regulation dictating a business model that we all need to follow.
We're very concerned with the fast-tracking on these rules on scope of practice. We find ourselves in sort of a he said/she said mode where facts might confuse our conversations, and, frankly, we need more than 75 days collectively to come up with facts to make sure whatever we come up with is going to have the intended impact.
We're also greatly concerned by the discussion of appearance of independence. Sure, we agree that we need to appear independent, but who should be the judge of that? Should it be the firms? Should it be the individuals? Should it be the SEC? Should it be the shareholders?
We believe the shareholders are the people who need to be protected. We also believe they're represented. They're represented on audit committees. Audit committeesare able and do see every assignment we do for that company, the size of the fees, the nature of the work.
And we feel the work the SEC has done to raise the image of these audit committees is extremely positive and is an excellent place to look for solution to this "appearance problem."
I've been entrusted with a leadership position in my firm, and my partners remind me when we come up with new ideas there's a big difference between a vision and a hallucination, and it's management's job to know where that line is.
Likewise, we're concerned about this appearance issue. How can future generations that do not sit in this room or do not sit in on the deliberations as to this appearance standard, how will they be interpreted in the future? We're real nervous that that will be misinterpreted in ways never imagined and is a great area of concern for us. So we continue to have a mutual interest in positive change in the public interest. We remain far apart on some of these fundamental questions. We'd like to see a regulatory process that is more fact based than exists today. We're more than happy to do our share to provide those facts in due course.
CHAIRMAN LEVITT: Joe, let me follow-up on your very comprehensive and pointed testimony and ask you a fewbrief questions.
Do you think that there has been and continues to be, for whatever reason, whoever caused it, an appearance problem, or do you think that's way overstated, and it simply doesn't exist? What's your personal judgment?
MR. BERARDINO: My personal judgment is the more we talk about it --
CHAIRMAN LEVITT: For right now. Let's say we don't talk anymore, but does it exist today, in your judgment?
MR. BERARDINO: No.
CHAIRMAN LEVITT: It doesn't exist?
MR. BERARDINO: No.
CHAIRMAN LEVITT: And if the Commission decided that because of its fairly comprehensive schedule of issues it was going to stand back from this and just drop it totally, would that, in your judgment, make the appearance issue more real or less real?
MR. BERARDINO: I think it depends on how that was done. I think, in the context of some of my earlier comments I think we can declare victory, we collectively, with the proposals put forward for audit committees.
Audit committees stand in the shareholders' shoes. It's been very clear through the ISB and comments that the Commission has made that this is an issue all auditcommittees ought to look at in detail.
CHAIRMAN LEVITT: So that if the Commission stopped there and said, "We've looked at this. Those that have said that there is an appearance problem for 15 or 20 years have probably overstated the case, and we feel that the recommendation to allow audit committees to inquire into this area would provide the kind of prophylactic cure to an issue that really doesn't exist at this time"?
MR. BERARDINO: I'd say the question has existed for years. Some companies have taken positions for years that their auditors should not do non-audit services. That's their prerogative.
CHAIRMAN LEVITT: But don't you think when a company of the caliber of Pfizer, with the kinds of members of the board and the audit committee that's represented by Pfizer takes the position, as many other companies, fine companies in America, have that consulting services should not be offered to them by their auditor, doesn't that say something about their perception, at least?
MR. BERARDINO: They're entitled to their view --
CHAIRMAN LEVITT: Clearly, they have a perception.
MR. BERARDINO: Yes.
CHAIRMAN LEVITT: And clearly, there are many companies in America that have a perception.
MR. BERARDINO: And there are many others that havedifferent perceptions and see value in their auditors knowing more about their companies and being more insightful.
CHAIRMAN LEVITT: And you believe, though, that the Commission just suddenly walking away from this issue wouldn't escalate the kind of perception that doesn't exist today?
I guess my only question to you, really, is this: None of this happens in a vacuum. All of it happens because of events that none of us have much control over, and if there is an audit failure sometime in the future after the Commission has walked away from an issue that has been so broadly publicized not just by this commission but for years and years and by audit committees and companies, I think that's when the chickens come home to roost, and that's what I'm concerned about.
Let me ask you this question: Supposing the Commission does walk away from the issue. Is it likely, in your judgment, that that percentage of firms' revenues coming from non-audit service would continue to escalate?
MR. BERARDINO: You might be surprised, many might be surprised that if you look at the growth in our various practices, the practice I run is growing faster than our consulting practice. So it's not a given that these --
CHAIRMAN LEVITT: Well, what do you think? I'd be interested in what all of you feel. If the Commission takesno action on this issue today, do you think that non-audit services, as a percentage of a firm's overall business will increase?
MR. GARLAND: Chairman Levitt, could I go back to your first part of your question, and that is, is there a perception issue?
My own personal opinion would be a bit different than Joe's in that I think in certain areas with certain individuals there is a perception issue.
Clearly, there's a perception issue with the Commission, with the staff, or we wouldn't be dealing with this, and there probably are individuals out there that have concerns and have a perception issue.
I think the more important question is, however, do investors have a perception issue, and I've not seen any broad scale evidence that says that they have a perception issue, that they've lost confidence in the audit profession, in the management, in the capital markets.
Just the opposite. I'm concerned right now that they're over-confident.
CHAIRMAN LEVITT: Can you, kind of, address the question that I -- I will get back to the perception issue. The question is do you think that the volume of non-audit services is likely to increase if nothing comes of these discussions in this proposal?
MR. STRANGE: Let me take a crack at that one, Chairman Levitt.
CHAIRMAN LEVITT: Well, I'd like each of you to give me your view. I mean, there's no absolutes there. What do you think?
MR. GARLAND: I can't predict what will happen, but I can tell you --
CHAIRMAN LEVITT: Well, what do you think is likely to happen?
MR. GARLAND: What I was going to say is I can tell you that last year, and we're projecting continuing to this year, that our audit practice is growing faster than our consulting practice, which is the opposite of what we'd experienced for about a four- or five-year period?
CHAIRMAN LEVITT: What do you think is likely to happen? Do you have any judgment? If you don't, you don't.
MR. GARLAND: My judgment is for the next couple of years that the audit practices will probably grow faster or certainly as fast, perhaps even faster than the consulting practice. That's my best judgment. I don't know what will happen beyond that.
CHAIRMAN LEVITT: And do you all share that view, that it's likely that the audit practice will grow faster than the non-audit?
MR. STRANGE: I'd like to put a slight twist onthat answer. I believe what we've seen in the last half decade, maybe whole decade, is tremendous growth in the information systems integration business, which sometimes the word "consulting business" just is synonymous with that.
Consultative services in our firms are actually broader than just systems integration, but that has been the thing that has grown so fast that it has fueled the size of these consulting practices.
I would tell you that based on what has happened in the last couple years in the assurance business and what we see over the next few years the growth in that business will be very strong, probably at least equivalent to the consulting businesses.
CHAIRMAN LEVITT: Joe, what do you think?
MR. STRANGE: Let me add one more thing. Part of the question is what do you define as consulting. Let's put systems integration aside for just a moment. Let's talk about a piece of the business that, in our firm, we call it information risk management. Each of the firms has this and names it slightly differently.
But this is the group that deals with security controls around systems and information technology. Now, they cross over both sides of the street. They do work that is consultative in nature, as our clients try to determine what they need to have secure systems, particularly in thesemore complex environments, but they are very, very important to the audit process.
In fact, if we did not have them, we could not complete an audit of a complex and sophisticated company. So I'm not sure if you'd characterize that as a consulting business of a pure part of the assurance business, but it is probably the fastest growing piece of our business, and that's just one example. It's just not a pure question --
CHAIRMAN LEVITT: I think that's valid. Joe?
MR. BERARDINO: My goal is to go fast in our consulting practice. I don't know if we'll achieve that or not, but I'm very optimistic we can continue to grow.
CHAIRMAN LEVITT: Okay. Judging by what each of you has said it suggests audits without consulting somehow or other are less good audits, if consulting is so essential to the audit function. I don't understand that.
MR. GARLAND: I don't think that's quite what we said, but I'd also, before we finish, like to go back to your issue about the Commission walking away, because I think that's a fair question and one we really haven't had a chance to respond to.
I don't think we're saying -- well, I'm not saying that any audit that doesn't involve non-audit competencies, which is broader, in my mind, than just consulting, is not an effective audit.
What I do believe, however, there are many, many situations, especially in very fast growing and very large coming that are quite complex where you cannot do an audit with just auditors.
And by the way, the profession, for 30 or 40 years, has not been able to do audits with just auditors. For example, tax competencies are absolutely vital given the complexity of the tax regulations, but that goes on to the IT area, the actuarial area and others.
So I would not suggest, have not suggested that an audit done without the use of other competencies is inadequate, but I would suggest that having those competencies available for the many situations where you need them is vital.
CHAIRMAN LEVITT: You've suggested that the proposed prohibitions, only two of which are new, and those are not the ones you mentioned as necessary to enhance the audit, would force you to sell your whole consulting practice. Why is that?
MR. GARLAND: Well, first of all, I don't believe that the -- I believe the proposed prohibition would probably adversely affect our ability to do 50, maybe 60 percent of our current business.
So I don't agree with your statement that all we're trying to do is codify each -- I don't agree with that atall, but to go to the point of your question, why do I believe that these rules, if adopted as proposed, would cause us to sell or dispose of our consulting practices?
There's no way the consultants and these people with the non-audit services -- first of all, living in the audit world is very complex. It's very different because there's independence rules. There's a lot of restraints that, if you were in a separate business, you wouldn't have those same considerations.
Our consultants have, over the decades, been willing to deal with those complexities and restraints and reliances and joint ventures, and things such as that because of the benefits they get out of the association with us.
If we eliminate those benefits so all they are dealing with -- which I believe this rule will do -- so all they are left with are the detriments, the complexities and the limitations and the restrictions, they're gone.
CHAIRMAN LEVITT: I've one other question for you, Mr. Garland. In your testimony you say, "The lack of any empirical evidence of a problem cannot be justified on the ground that it is too hard to find."
You go on to say that the Commission looked for evidence of impairments in audit subject clients investors --impairments in audit quality or auditor independence attributable to the scope of services provided to an auditclient but found none."
"The Commission has access to all of the data necessary to undertake that statistical study. The lack of evidence of a problem is significant, but it cannot be dismissed as evidence that could never be objectively determined."
MR. GARLAND: Chairman, that's not my statement that you're reading from.
CHAIRMAN LEVITT: Let's see, am I reading -- Well, I guess I have a copy of a document that says, "Intended Statement." At one point, did you --
MR. GARLAND: No. I've modified my statement somewhat. The words you've used are not the words I would have used. It's not the way I talk. I'm sorry. I'd have to look at it. I'm confused right at the moment, as I'm sure you are.
CHAIRMAN LEVITT: Okay. I'll show that to you.
MR. GARLAND: Okay.
CHAIRMAN LEVITT: Terry, you point out the potential liability as a deterrent to an auditor making compromises on the audit. Professor Coffee this morning stated that this disincentive has greatly diminished recently and that the economic incentives in providing consulting services has expanded.
How do you explain the apparent disconnect betweenyour view and his?
MR. STRANGE: I am not acquainted with Professor Coffee, and I'm not sure which firm he's currently working for, but if he's not in the profession, I'm not sure he has a clear view as to the way it works.
If you are in a compromised position in our organization, and I think the same is true of the other major firms, where you did not discharge your professional responsibilities in the proper manner, your career is over, and it doesn't matter -- that is the first gate, technical competency and the way you perform on engagements.
It doesn't matter what you might have sold, what new client you brought in. If you don't discharge the professional responsibilities first, you have no future with our firm. We have a strong and long record of that.
With regard to compensation and more of it being determined by whether or not -- and I presume he's referring to what he would call cross-selling, if an auditor sells tax or consulting work. That is a big piece of income.
That is not the case in our organization. There are incentives. If you are the kind of business person that can introduce solutions to your client's problems and convince the client that we have the right solution, but that's makes up a very, very small percentage of the total compensation of our audit partners.
In fact, on the average, it would be less than 2 or 3 percent, and, on the high side, it would no more than 4 or 5 percent.
CHAIRMAN LEVITT: I appreciate that point. Again getting back, Joe, to your point about recruitment, these young men that you're talking to that you're trying to --
MR. BERARDINO: And women.
CHAIRMAN LEVITT: And women.
MR. BERARDINO: I was on that one. I've got two daughters.
CHAIRMAN LEVITT: These young people you're talking to, you can offer them the right to consult on non-audit clients. Why isn't that an attractive inducement? Why must they have the special right of consulting only on an audit client?
MR. BERARDINO: They don't have to. All I'm suggesting is put yourself in their shoes, and they're given a choice. I've got an uphill battle. I'm not saying I can't win it, but I'm saying I've got an uphill battle.
One way to deal with it, you might say, I just pay them more money, and I'd say that's a possible solution. It also has dramatic impacts to our clients, because we're going to ask our clients to pay for that.
CHAIRMAN LEVITT: Do you agree with the O'Malley report's finding that the firm's management consultingpractices have expanded far beyond those skills required for audit support and the traditional areas related to financial planning and controls? I'd like to ask each of you that question.
MR. BERARDINO: I'm back to Terry's point on let's define "consulting." It is a huge market, and those who don't have jobs are called consultants. So it's kind of hard to figure out where that line starts and ends.
It is a natural course of events for an individual, as they develop a competency, to go deeper and to go broader, and I will not sit here and suggest that our competencies are limited in our consulting practice to audit support or financial systems. So they have expanded.
CHAIRMAN LEVITT: Do you think they've overstated the case, the O'Malley panel?
MR. BERARDINO: I think our firm is in a slightly different position than other firms, since we have, essentially, tried to replace Andersen Consulting.
The reason we've tried to replace Andersen Consulting is when they turned their back on our audit clients we needed to develop those competencies to be relevant to our audit clients.
CHAIRMAN LEVITT: But do you think they're wrong in what they've said, or do you --
MR. BERARDINO: All I can refer to is my reality,and in my firm I don't think that's true. At other firms it might be.
CHAIRMAN LEVITT: Okay. Well, each of you have commented on the O'Malley panel. I'm interested to know whether you feel this statement is correct or incorrect. Terry?
MR. STRANGE: I don't think that statement characterizes what commonly would be referred to as consulting in our firm. Our systems integration business is all about putting in big systems, creating the control environment necessary to cause the business to function, provide accurate reports, et cetera.
The size of it has probably grown beyond what we might have imagined 20 years ago when we started it driven by what's happened in information technology, but the scope of it, at least in our particular set of circumstances, is not much beyond where it was originally.
CHAIRMAN LEVITT: Mr. Garland, how do you react to the O'Malley panel statement?
MR. GARLAND: I'm sorry, Chairman. I was trying to clear up this earlier confusion, if you'd allow me to go back very quickly. You have a document that I think was received from our firm. It was a preliminary document that had been submitted sometime before I actually had a chance to sit down and draft my comments in my own words.
So I think you were reading something very preliminary that I changed, so just to clarify the confusion. CHAIRMAN LEVITT: So that's not relevant; it's not valid; it's not correct?
MR. GARLAND: Before I answered that, I'd want to study it more carefully.
CHAIRMAN LEVITT: Okay. We could talk about that later. The question is whether you agree with the O'Malley panel's observation that management consulting practices have expanded far beyond those skills required for audit support.
MR. GARLAND: Very clearly, our management consulting practice has expanded very clearly over the last several --
CHAIRMAN LEVITT: But are you comfortable with the O'Malley panel's characterization?
MR. GARLAND: I'm not uncomfortable with it.
CHAIRMAN LEVITT: You're not uncomfortable with it. Okay. Colleagues?
COMMISSIONER CAREY: Mr. Strange, I do have a question for you because I read your prepared statement, assuming that I've got the accurate one.
MR. STRANGE: We'll see.
COMMISSIONER CAREY: And in your remarks you cite a sentence from the O'Malley report that says, "It is not aware of any instances of non-audit services having caused orcontributed to an audit failure or the actual loss of auditor independence."
Your statement goes on to say that we should "stop and consider those words." Do you think we should stop and consider the very next sentence in the report?
MR. STRANGE: Are you going to read that to me?
COMMISSIONER CAREY: I will. I'll read the rest of that aloud which I believe clarifies the previous sentence. It says, "However, as the POB noted in its study on scope of services, specific evidence of loss of independence from management advisory services, a so-called smoking gun, is not likely to be available even if there is such a loss, and many have expressed concerns that these services and pressures to sell these services may cause an auditor to consciously or unconsciously subordinate his or her judgment to a client's desires."
MR. STRANGE: "May possibly" I think were the word that were in that sentence.
COMMISSIONER CAREY: Yes. The words probably were in that sentence.
MR. STRANGE: The point you're making, I think, is that we can't prove -- we can't find tangible evidence that the auditor rolled over, if you will, because of the presence of non-audit services, but it could have happened. But since we can't prove that it did, we're left to presume that itcould.
That same convoluted reasoning for a profession with a 100-year history and the notion of scienter -- and I'm no lawyer, but the notion of having knowledge --
COMMISSIONER CAREY: Actually, I'm one of the few up here who's not a lawyer either.
MR. STRANGE: Okay. Well, maybe we can have a reasonable conversation. Maybe not.
MR. STRANGE: I was just pointing out my inferiority, actually. Where was I? My point is that establishment of state of mind or whether or not someone did something with knowledge I thought was a point of evidence that was used in proceedings.
And why we would ignore it in this case, where we can't prove that they behaved in this particular way because of the knowledge of non-audit services, it's okay to presume that they might have?
Again, there have been studies over the years, a fair amount of research, different commissions that have not been able to come up with an instance, and I've been in this business for 32 years.
And I've been in and out of a lot of different roles in the firm. I've been involved in a lot of difficult situations where maybe I didn't think we should have donewhat we should have done, but it was never influenced by something outside of the audit process.
There are things that might influence inside the audit process, but never have I encountered that. That's why I have a great deal of difficulty putting stock in that statement.
COMMISSIONER CAREY: But would you say it's a more accurate representation of the panel's conclusion to cite both sentences?
MR. STRANGE: That is what they said, yes.
COMMISSIONER CAREY: Okay. Thank you.
MR. STRANGE: You're sure you're not a lawyer?
COMMISSIONER CAREY: I'm sure.
COMMISSIONER HUNT: We're working on him.
COMMISSIONER CAREY: I take tutorials from Dean Hunt.
COMMISSIONER HUNT: Each of you gentleman I think have made the point that you know of no instances in which the rendition of non-audit services to an audit client has impaired the quality of the audit.
As I think I said this morning, I think I have some cases like that, but I'm not an accountant, thank god, so maybe what I saw was different.
Would each of you be willing to provide the Commission with information on the amount of your firm'srevenues and gross profits from providing your SEC audit clients for non-audit services prohibited by the rule proposal but not currently prohibited?
Because you all have made the point strongly that there is no evidence to show that impairment, we would like to see that revenue data to see whether there are instances where we think perhaps there has been some impairment of auditing judgement because of the size of non-audit fees.
MR. STRANGE: The question I would ask is would seeing a list of fees by, say, audit tax and consulting for each public company that we audit, how would that imply whether or not there had been an impairment of independence by the presence? I'm not sure.
COMMISSIONER HUNT: I'm not so sure that at the present time -- you said there are no instances that you were aware of, but if we had a running count of that kind of stuff on an annual basis and we saw what we thought was an impaired audit, the correlation between the impaired audit and the difference between the auditing fees and consulting fees might appear to be very relevant.
MR. STRANGE: I see. If there's a problem, and then you look back and you see the presence, then the question could be asked. I see your point.
If you're asking me if we would be willing to provide such information, I haven't really given that anythought, and it's not my ultimate decision.
COMMISSIONER HUNT: Okay.
MR. STRANGE: But I certainly wouldn't tell you no at this point in time. In fact, I suspect you could certainly get that information, if you wanted.
COMMISSIONER HUNT: In some contexts, we could get it, but you don't want to be in that context.
MR. GARLAND: You're right. We don't.
MR. BERARDINO: I'd just pile on a little bit, and maybe I'll be a little aggressive. We don't own our clients. We can't make them hire us to do things, and audit committees for all our public clients see all that stuff.
So I'd say transparency is a friend. There is no coercion going on here. It's all a matter of the marketplace working, and, frankly, with different people having a different perception on how the marketplace ought to work.
So I'd be comfortable having you look at anything you think you need to look at to get comfortable but remind you that every company that you'll see that data for those boards have already been through that information.
COMMISSIONER HUNT: I understand that. I understand that very much and appreciate that. I still think this agency, as an institution, might be very interested in seeing that information.
COMMISSIONER CAREY: Could I ask another question,Mr. Chairman? I'd like to again address this to Mr. Strange, because he brought up what I have long thought was a very interesting topic, which is that the divergence between the consulting arm and the auditing arm of Big 5 firms is driven more by market forces than regulatory concerns.
Given that, why is there, on the part of the three of you here today, resistance to something that is, perhaps, evolving quite naturally?
MR. STRANGE: Let me address this first, since we are the firm that has restructured --
COMMISSIONER CAREY: Yes.
MR. STRANGE: First of all, what we are separating is not everything on this list of what you would call non-audit services. It is our systems integration business, and it has evolved to where it has evolved. Because of the needs for capital it needs a different business model. It competes for a different type of professional with a different set of competitors. It needs to make acquisitions to be big enough to compete, a whole different set of marketplace dynamics that affect that business.
It's not something that we necessarily intended 20 years ago when we started it but what it has evolved to, and we are reacting to that and have been reacting to it long before this rule-making started. We actually began to talk to Chairman Levitt and the chief accountant some two yearsago about this subject. But it was purely driven by market forces.
You may say that some of the other services we continue to house in the firm that are non-audit services might evolve to the same point. I don't think it's likely because of the magnitude of these services and the nature of them.
Information technology drove what has happened to our systems integration business. Who would have foreseen what has happened in the last decade 20 years ago? My concern -- and maybe I haven't articulated it as well as I wanted to.
But my concern about the type of ban on non-audit services really runs to our ability to build the kind of skill sets inside the firm to discharge the audits of the future, and the audits of the future are not that far away from us. And I think we have great difficulty doing that under this rule-making proposal.
Now, I'm not smart enough to predict 10 or 15 years whether some of those kinds of services like this information risk management business that I spoke of a minute ago that I think will be likely 40, 45 percent of our audit effort in another half decade, if something happens in the far future that causes that to need a separate business.
But certainly, in the near term, trying to deliverunder our responsibility in the capital market system, that is something that has to be part of the audit delivery.
COMMISSIONER HUNT: If we came up with a rule that said none of the firms could provide any of the prohibited services to their audit clients, but, of course, you could provide those services to your non-audit clients, and every firm would be, obviously, in the same boat or box, would you think that was a workable rule?
MR. GARLAND: This is Bob Garland. I would not.
COMMISSIONER HUNT: Why is that?
MR. GARLAND: Because I don't think there's any economic or business reasons for consultants to continue to be in the same organization with the auditors.
COMMISSIONER HUNT: So you would think that that would lead to, because you were not providing, sort of, integrated services to your audit client, it would lead to a automatic disassembling of the firm?
MR. GARLAND: I'm personally convinced of that. Yes, sir.
COMMISSIONER HUNT: Mr. Garland, I don't know that you responded to my question about the information that the agency might want to see from your firm.
MR. GARLAND: I didn't. I don't know the answer. I'd want to go back and talk with our CEO and managing partner.
COMMISSIONER HUNT: Okay. That's fine. I must say that there was some talk earlier on about declaring victory and walking away. I hope that wasn't an analogy to what one of the congressmen said about Vietnam, declared victory and just walk away.
Well, I thank you all for being here. We have found your testimony relevant and valuable, and I'll turn it over to Commissioner Unger.
COMMISSIONER UNGER: You sound like you were going to let them get up. I have some practical questions for you because I feel a little in the dark about how your business works. You said we could use some more facts, and if you're willing to give them, I'd love to hear them.
How exactly does it work when you say you have this consulting business and this auditing business, yet you have these consultants providing services in the course of performing the audit?
Are they consultants or auditors, or how exactly does it work in terms of building the team for the audit?
MR. BERARDINO: Typically, the team is put together from within the practices each of us run. From time to time, and as Bob suggested, increasingly more often people who are housed in different portions of our practice called broadly our consulting practices, are asked to come and help out.
In all of our firms we build our competencies alsoalong industry lines, so we have teams of people who are industry experts. They could be tax experts. They could be systems experts. They could be auditors. We're constantly sharing information on the latest software packages, the risks of installing them, the risks to the business in using them, et cetera.
So on the one hand, we build competencies in different houses, if you will. When we hit the marketplace, we look back at all those competencies and we say, "What do we need on this assignment?"
Typically, it comes within the assurance practice, but increasingly it's coming from different houses in our practice, and that's what we're afraid of is that we'll call, and there won't be anyone to answer the phone. That's why we're here saying we need these guys.
COMMISSIONER UNGER: The talent that you're drawing on that you're concerned about leaving the firm would be considered part of your consulting group and not your auditing group?
MR. BERARDINO: Both. Because if you look at --and I think Terry had a comment on this. If you look at what we call assurance and business advisory, four years ago 1 percent of our people in the United States were technology auditors. Today that's 6 percent.
So they're now licensed to sign off on the opinion. They're extremely valuable on the audit of financial statements. That number has got to get to 20 percent in the next three or four years for us to be relevant, and those are people we are going to have great difficulty attracting with these rules.
COMMISSIONER UNGER: So are the same people who are being called upon to enhance your audit the ones that would be called upon to perform consulting services?
MR. BERARDINO: In some cases, that's true. Let me give you -- maybe it would help if I give you sort of a slice of life example.
We're in doing an audit, and we find a problem in the disbursements area. Controls aren't what they should be. The system's broken. The security codes are not appropriate. We have an obligation to, first of all, identify that and bring it to our client's attention.
And let's say we have our technology auditor who finds that problem. That's very valuable to our clients because they want to improve that system. They might then say, "If you're so smart that you found this problem, help me fix it."
COMMISSIONER UNGER: Right.
MR. BERARDINO: That's how all these practices started. It wasn't because our predecessors were geniuses and said we need more revenue. It's because our client said,"Fix that problem." And we think that's in the public interest.
COMMISSIONER UNGER: Right.
MR. BERARDINO: And we think those problems are going to continue, with the vast and quick change in technology.
COMMISSIONER UNGER: So if you don't have, though, the same individuals providing the auditing services that are providing consulting services, then our proposed rule doesn't really impact that part of the business, correct?
MR. BERARDINO: It impacts our ability to get people to show up for work.
COMMISSIONER UNGER: Who are your competitors for this talent?
MR. BERARDINO: Other consultancies, private industry.
COMMISSIONER UNGER: So people, even though they're not currently performing both functions, don't want to be told that they can't? Is that what you're saying?
MR. BERARDINO: Yeah.
MR. GARLAND: At Deloitte & Touche, we have a large Audit group, Tax group. We have a Consulting group which has a large IT component to it and other components as well. We have an Actuarial group. We have a Valuation group. We have different groups.
And many of the people in these other groups, not all, but many of them will consult with clients on consulting types of engagements, but the auditors will also draw them into the audit because of their specialized skill sets and talents.
Our clients are in a tremendously competitive environment. They're moving very rapidly. They're trying to improve themselves, stay up with the competition, and they're constantly involving and changing at a very fast pace.
The technologies of a year ago, in some cases even a few months ago, are no longer the technologies of today. We need to have people that can keep up with those very rapid developments.
I believe if our consultants, for example, only did audit work, and they believe this as well, they would not be at the leading edge. They would not be keeping up.
And then, when they're coming in to help us trying to figure out where these systems stable, are they secure, are they state-of-the-art, those kinds of questions, they would have a very difficult time if they're not doing both over the course of a period of time, let's say a year. Also, they would be much less interested in staying with us, I believe.
COMMISSIONER UNGER: When the consultants are brought in on an auditing engagement, are they billed to theclient as consultants or as part of the audit, or are they separated out?
Because the next question I'm going to ask you is what percentage of your revenues are from auditing and what are from consulting?
MR. GARLAND: When they're brought in -- and I'll just speak for Deloitte & Touche. I'll make a general statement. There may be some exceptions. But when they're brought in as part of the audit, they are typically billed to the audit account and charged to the client that way.
Now, if, for example, they find some systems problems, flaws and the client asked them to give them advice on how they might fix that, that same professional might switch over and stop charging to the audit process and start charging to a consulting process.
And as far as the percentage of our revenues that are, I'll call it, non-audit, I think the comments -- I was here earlier today -- that I had heard I believe made by Chairman Levitt that approximately 30 plus percent of our consolidated revenue are audit related, that would be fairly accurate for our firm.
COMMISSIONER UNGER: Terry and Joe?
MR. STRANGE: I'm pretty much on the same page as Bob. The way I would characterize it is we've got a history in the profession of hiring accounting majors, people whoknow about accounting measurement who come in to these firms and learn how to audit. And that worked well in prior environments.
And what we've been trying to -- the point we've been trying to make here is that the environment we find ourselves in today and what we clearly see in the future is that's not enough, just people that know about accounting measurement. You have to have other disciplines.
Now, there's not a history of those other disciplines being auditors, and we believe that the ability to hold those people in the firm and bring them to bear in the audit process is inhibited if you tell them, "All you can do is critique. You can never be part of a solution," because they will see that as an impediment to a broader career path.
CHAIRMAN LEVITT: Is it fair to characterize an audit as a critique? Again, from my experience on audit committees, I've found that an audit is a very constructive process in and of itself.
MR. STRANGE: It is, Chairman Levitt. And it really goes to what you intend with these rules when you talk about prohibition of -- you don't use the word "consulting." You say "non-audit services."
What I'm suggesting is an environment where, in the process of the audit, we are a lot more engaged in thesystems and processes and that we've got to go farther than just writing a letter and saying, "Oh, by the way, you should try to fix this."
We've got to be engaged in helping build these systems and monitor them so that we know that they are functioning, and it takes these kinds of skill sets. And if we tell our people that all you can be engaged in is the oversight role -- you can't be engaged in the crafting of the solution and the implementation of the solution -- I think it's going to be very difficult to hold them.
CHAIRMAN LEVITT: Some of the solutions, not all of the solutions. Just some of them. This is not intended to be --
MR. STRANGE: I'm talking mostly about systems at the moment, systems and controls and systems.
CHAIRMAN LEVITT: Do you care more about that than you do the prohibition on out-sourcing, for instance?
MR. STRANGE: I've got to tell you I was very baffled by the -- because I have a different view of the world, I guess -- by the prohibition on internal audit out-sourcing.
I see it as a continuum of auditing, and I see this out-sourcing phenomenon as having the potential to put the external auditor in a better position than they've ever been in in terms of knowledge about the enterprise. I never sawit as standing in management's shoes as part of making management decisions.
I saw it as an extension of the role deeper into the enterprise. I really would like to have a theoretical conversation with someone about that one because I am totally on the other side of the fence. I think it's a bad answer for the business community because I think ultimately you get a better total risk management product for the price than you do with two separate firms.
And I don't see that anything is necessarily gained in objectivity. I think you lose a tremendous amount in terms of understanding and knowledge of the business at hand.
MR. BERARDINO: Let's talk about the market force.
COMMISSIONER HUNT: Gentlemen --
COMMISSIONER UNGER: I think there's one last answer pending.
COMMISSIONER HUNT: Oh, okay. Go ahead.
MR. BERARDINO: I agree with the earlier comments, and as to the percentage of our firm that is within Assurance, it's about half.
COMMISSIONER UNGER: Okay. Thank you.
COMMISSIONER HUNT: Gentlemen, do you think the proposed rules are workable if they are modified and narrowed in some way?
MR. BERARDINO: I'd love to say yes to thatquestion, but the devil is in the details.
COMMISSIONER HUNT: Well, we'd, obviously, be willing to seriously consider any suggestions you or your colleagues have had.
MR. BERARDINO: I think, Commissioner Hunt, we would welcome, as a profession, the opportunity to sit down with the staff of the Commission, whoever you designate, and try to work out what would be a workable set of rules.
I think that's a far preferable answer than mandate a set of rules that we are very uncomfortable with and don't think are workable.
CHAIRMAN LEVITT: The intent of the release was to serve as a broad array of ideas and concepts and questions. But as I said before, nothing happens in a vacuum, and the tension between the profession and the Commission goes back long before this group here got into the issue.
And I think that's an unfortunate byproduct of all of this, but I would say to you that I think your testimony today has been very helpful.
You've been very candid and forthcoming, and I really would welcome the opportunity of having you come forward and saying, "Look, this is too broad. We should focus on that."
I think to dismiss it as all wrong or for us to say it's all right would be a dreadful missed opportunity. Itisn't all wrong, and it certainly isn't all right. So I would welcome that kind of working session to see if -- we're not going to reach total agreement. We can do better than we are now, and that's what I would look forward to.
So I want to thank all of you for being here. I'm sorry it has taken as long as it has. It has put us a little bit behind schedule, but I hope that you found that the spirit of our questions and the nature of our questions really indicates a desire to get at answers rather than to make pronouncements.
COMMISSIONER CAREY: I'd like to thank all the panelists for your thoughtful and candid responses and tell you that I found it quite helpful.
COMMISSIONER UNGER: Thank you.
MR. GARLAND: Chairman Levitt, I will also get you a copy of my actual remarks. Sorry about that.
CHAIRMAN LEVITT: Okay. Jack --
MR. CIESIELSKI: Ciesielski.
CHAIRMAN LEVITT: How are you?
COMMISSIONER CAREY: Fine, thanks.
CHAIRMAN LEVITT: I'm sorry we've delayed you a half hour. All of us have read a good deal of what you write about, and we know your opinions are strongly held and usually strongly stated. Please.
MR. CIESIELSKI: Thank you. First of all, I'd liketo thank the Commission for the honor of being here today to express some of those opinions.
As part of my opening remarks, I'd like to present a little background information about myself and my firm, because I understand that a little firm in Baltimore called R.G. Associates is not as widely known as any of the Big 5. So let me describe a little bit about my background in order to provide some context for my comments.
I spent nearly seven years as an analyst with a major mutual fund group in Baltimore starting in 1985. I'm now an accounting analyst who writes about accounting issues in a research service entitled The Analyst's Accounting Observer.
I work with many buy-side and sell-side analysts. I provide assistance to individual analysts of both stripes when it comes to understanding either general or company specific accounting issues.
One impression has struck me over the last 15 years I've been in the investment business. Users often have little knowledge or understanding of the auditor's mission or responsibilities. That may largely be due to an accounting profession that increasingly seeks to distance itself from the public image as auditor in favor of one that positions accountants in the public's collective mind as business enhancing consultants.
For evidence of this, one only has to look as far as the Wall Street Journal. Ads for the Big 5 accounting firms are in the public image campaign of the AICPA. Let me state up front that I don't believe there's anything innately wrong with accounting firms offering consulting service, but I believe that this kind of activity only increases the confusion of the user community regarding the role of the auditor in the capital markets.
I detect frequent cynicism on the part of users regarding auditor independence. When the really spectacular accounting disasters occur, that cynicism is only magnified.
I believe the single most important challenge facing the auditing profession today is the issue of auditor independence and the appearance of independence. Enhance the independence of the auditor, and many of the other issues that concern investors will be remedied as well.
I believe that the truly independent auditors freed from worries about other services provided by his or her firm would bring about more improvement in the audit process than, say, any number of new rules about revenue recognition.
I think the single best way to improve auditor independence and the appearance of auditor independence is to call for an exclusionary ban on non-audit services to audit clients.
I'm concerned that the auditing side of accountingfirms may wind up being a mere sideline to consulting activities if trends continue and that the appearance of independence will be tainted.
If such a ban were enacted, I believe that the auditing profession would enormously improve its independence both in appearance and in fact. In providing advisory and auditing services, a firm is effectively serving two clients that are different.
Liberated from serving two potentially conflicting masters, auditors would enjoy greater independence in appearance. No longer might it look like they were auditing their own work or advice.
I've heard one argument proposed that the existence of consulting relationships with audit clients actually enhances audit reliability. That argument invites one to believe, then, that the auditor is relying on the work of the consulting side of the business or is auditing its firm's own work.
Such an argument does not support the existence of independence in such situations either in appearance or in fact. I believe that the auditing function is enhanced when it stands alone from the consulting practice where there is no opportunity for it to be used as a loss leader to gain entry into more lucrative consulting opportunities for clients.
Cutting audit services free from consulting services might permit a stable pricing structure to emerge in the whole auditing business, one that would allow firms to hire talented professionals and give them the necessary resources to perform more thorough audits.
I believe that the accounting firms have difficulty in attracting professionals to be auditors at a time when staggering financial rewards are available in other fields such as finance or technology.
I have heard the argument that the existence of consulting practices in accounting firms assures that the best and brightest talent can be recruited. That may be so, but such talent is attracted to the consulting side and not the auditing practice.
Perhaps such recruits might be required to spend a minimum number of years on the audit side before graduating to the consulting practice as a stepping stone or a learning curve. That doesn't encourage one to believe that the auditing side is the real attraction or that their best efforts are being directed at their short auditing careers.
I think the real problem in attracting talent in the auditing profession is the share ownership restriction placed on auditors. The Commission's independence proposal is a move in the right direction toward making accounting firms more competitive in the labor markets.
Entrants to the audit profession shouldn't have to presume that they must take a vow of poverty during a bull market to comply with independence rules. The relaxation of share ownership constraints that are proposed in this document should allay most of the fears of future auditors.
I'm in favor of the Commission's proposal for proxy disclosure of the amount of non-audit services provided by auditors to their clients. As I've said before, I believe the existence of such relationships damages the appearance of independence.
It would help investors channel their skepticism more constructively if they had hard facts about the dollars involved in such relationships. I find it ironic that such a disclosure existed when the non-audit services provided by auditors was insignificant compared to the audit services.
Since the roles have reversed at many firms over the last decade, the information is unavailable. If there is truly a benefit to the audit process to having a consulting practice work with the client, then firms should not object to the disclosure of such information in the proxy or other parts of the financial reporting package.
Let me conclude my remarks with the following observation. In providing consulting services, the accountant is acting as an advocate for the client counter to the principles of independence. Take note that much of thegrowth and consulting services has occurred during a period of terrific economic prosperity, a condition that's certainly never guaranteed to be permanent.
If we're asking hard questions about independence and the appearance of independence now, won't our concerns be magnified during times of economic distress? It's not hard to imagine an economic environment where firms may be more prone to pushing the envelope of reliable accounting and reporting, and that's when you would want an auditing profession possessing unquestionable independence.
If we have qualms about that independence now, it will be worse in an economic downturn, and that's when investor confidence may be tested on issues other than auditor independence.
I support nothing less than an outright ban on non-audit services for audit clients. According to the findings of the O'Malley panel, that's a situation that already exists for a majority of publicly-held firms.
And that's not to say that firms shouldn't have consulting practices but just that their consulting practices should be independent of their audit clients. Rather than trying to embroider a set of rules that permit the erosion of the appearance of independence, I would prefer that the Commission start with a clean sheet of paper.
As long as we construct exceptions for non-auditservices provided to audit clients, the appearance of independence will be impaired. That concludes my opening remarks. I'll be glad to take your questions.
COMMISSIONER UNGER: The issue of disclosure came up this morning, and what impact, if any, disclosure could have on, sort of, remedying the appearance issue?
In other words, if accountants were required to disclose the amount of revenues they obtained from consulting, as opposed to auditing, could that help address the appearance issue?
MR. CIESIELSKI: I think it would help address the issue but maybe not the appearance issue. Certainly, if you have minimal or no consulting fees from an audit client, if you wind up seeing 100 percent of the audit fees coming --excuse me, 100 percent of the fees coming from the audit side and none from the consulting, there's no appearance of --there's no questioning of the appearance of independence.
COMMISSIONER UNGER: Right. And no need for a cure.
MR. CIESIELSKI: Right. No need for a cure. I think having that information publicly disclosed would improve the audit process even if they continue to do consulting engagements, because I don't think you would want to risk having an audit blow up and then having it show up in the proxy later that 75 percent of your total fees from thataudit client were really for consulting engagements.
I think then you would really have -- then you'd certainly have evidence that there might have been impairment. You would certainly have the question much more poignantly stated.
And I think having that information in there would be a good, I guess, sword of Damocles over the auditor to perform well on the audit side so as to not be in that tricky situation.
COMMISSIONER UNGER: I don't know if you're the right person to ask this question, but I know that you analysts have a lot of background, economic information, et cetera.
MR. CIESIELSKI: I have an accounting background.
COMMISSIONER UNGER: You don't have an accounting background?
MR. CIESIELSKI: I do. Go ahead.
COMMISSIONER UNGER: We have to clarify that with every witness today, apparently. How important is the audit function of a firm to the consulting service? I was glad at the last panel to clarify, sort of, how the consulting practice grew out of the auditing service, but were you to take away that auditing component and have just consulting, really, how successful, how much would that change the dynamics of the marketplace?
MR. CIESIELSKI: Good question. Being on the outside of the auditing firm, I can only surmise. I'd qualify my answer with that statement first.
If you're barred from doing consulting work for your audit clients, it seems to me that still leaves an awful lot of potential clients out there to go get for your consultants.
And I don't see why you couldn't haul in 16 or 18 or whatever the job takes of consultants who are not working on the consulting engagement for your audit client to work on your audit.
I don't see why you would have to have the firm split up or be torn asunder just because you couldn't offer some services to your audit clients. You can still develop knowledge and technical ability by servicing all the other publicly-held companies that aren't your clients.
COMMISSIONER UNGER: So when an audit came to the point of saying, well, here is a problem we need to fix, it shouldn't necessarily be an issue of finding someone who wasn't working on that audit to fix the problem, if that's the synergy that the firms are now facing. But I don't know prospectively what types of synergies there would be between the auditing and consulting service that our proposal would prevent.
MR. CIESIELSKI: Again, I'm from the outside, but Idon't feel what's being proposed is a big impediment. I think you can still develop proficiencies outside of developing them in consulting relationships with your audit clients, and you can transfer those proficiencies to audits when need be.
Auditors have always had to call in specialists when matters are outside their understanding. So if you've got this healthy IT consulting side that just doesn't work on any audit engagements, I don't see why you couldn't pull them in to help work on the audit if they're working on audit type work, not advocacy type consulting arrangements for your audit client.
COMMISSIONER UNGER: Are you familiar with the revenues of the accounting firms? Because I guess I should have asked which I didn't, if you're still here, is what percentage of the consulting revenues come from non-audit clients.
MR. CIESIELSKI: I don't have access to that kind of information.
COMMISSIONER UNGER: Thank you.
COMMISSIONER CAREY: Jack, of the really spectacular accounting disasters we've witnessed, is there any one or more that you think can be directly traced to a lack of auditor independence?
MR. CIESIELSKI: Good question. It's hard toanswer that objectively because we don't know how much non-audit services mattered to the auditing firm in any of those instances. I would say that in some of them I've seen the audit committee didn't seem to have an extremely strong background in finance and accounting matters.
But in the extreme examples we've seen since 1998, outside of what has been written in books I can't see anything in the publicly-available information that would lead you to believe that there is an impairment of independence because of consulting.
There should be some more information, perhaps, like I said, in the proxy that gives you some reason to be concerned when you see it arise.
And as I said, I think that would be a very good impetus to the auditing firm to make sure that the job is done right so that they're not in the embarrassing situation of having to answer a question like that, that the information in the proxy would spell out.
COMMISSIONER CAREY: Thank you.
COMMISSIONER HUNT: Sir, one of the arguments that you made -- hold the view of the panel, I guess, that preceded you, which is a little opposed to your view, is that many of the clients, essentially, want one-stop shopping, that they want to be able to go to one large firm and get consulting advisory services as well as their auditingservices and, arguably, in the future, their legal services as well.
Do you think that that desire for that one-stop shopping really should -- is a realistic one that we should pay attention to?
MR. CIESIELSKI: I would say that 75 percent of the publicly-held firms don't desire one-stop shopping, and of the other 25 percent some may request one-stop shopping, and some are sold one-stop shopping.
COMMISSIONER CAREY: Some, in fact, have a policy that's two-stop shopping.
MR. CIESIELSKI: Right.
COMMISSIONER CAREY: Aren't there many publicly-held firms that, as a matter of policy --
MR. CIESIELSKI: That believe in a separation of --
COMMISSIONER CAREY: -- separate the audit and non-audit?
MR. CIESIELSKI: -- church and state. I believe there are those firms, but I don't have numbers.
COMMISSIONER CAREY: Let's not raise the level of debate quite that high.
COMMISSIONER HUNT: Do you think there is possibly a threshold level of consultants' fees beyond which we should -- vis-a-vis auditing fees beyond which we should say you can't go?
MR. CIESIELSKI: No. I don't think you can get a certain dollar level or a certain percentage fee level because any time you draw a bright line like that there's always, you know, somebody that will run right up the line and not trip over it. Inflation changes things like that.
I think you really have to go back to the nature of the services performed. In the proposal, there was the alternative proposal of non-audit services being barred for audit clients except for those that are a natural outgrowth of the audit process such as business risk, assurance services, and the like.
And the way I read that -- I could have read it wrong -- it's an outgrowth of what you note in the management letter that you're supposed to provide management about the state of internal controls.
I wouldn't find that to be an unreasonable kind of service. You're not taking an advocacy position. You're not going to wind up auditing your own work. I think it's much more important to stratify the issue by the kind of services that we're talking about rather than dollar amounts.
COMMISSIONER HUNT: Thank you.
CHAIRMAN LEVITT: Thank you very much. We appreciate your testimony and your interest and your commitment.
MR. CIESIELSKI: Your welcome.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: The next panel consists of the chairman and members of the Independence Standards Board: William T. Allen, who has taken on this thankless assignment; John C. Bogle, a very symbol of independence personally, founder of Vanguard fund; Robert E. Denham and Manuel Johnson, former vice Chairman of the Federal Reserve Board.
First, I want to thank all of you for doing the Lord's work, being as thoughtful and as committed and concerned and sensitive as you have been. Surely, you recognize full well the difficult task confronting the Commission, and we very much appreciate your perspective. Chairman Allen.
MR. ALLEN: Thank you, Mr. Chairman. If it pleases you, we will proceed in the following way. I'll take 10 or 12 minutes, and each of my colleagues will take two or three minutes for an introductory statement and then be available for any questions you might have.
I'm here today, as Chairman Levitt said, in my role as Chairman of the Independence Standards Board, but I don't speak for the board this afternoon. Each of us brings our own views to the questions that you have before you.
My background is as a judge and currently as a professor of law and business at New York University. I was asked to serve as chairman of the Independence StandardsBoard in 1997, and I thought it was an opportunity for some public service, and I agreed to serve, and I'm happy that I did.
We public members of the Independence Standards Board are, unlike any other witnesses you've heard today, really non-expert in the accounting profession except insofar as we have some business experience or, in my case, legal experience with the world of auditing and have learned over the course of the three-year term of the Independence Standards Board.
So we're available to help answer any questions you have, thinking that we have been addressing these questions for a little longer, perhaps, than you've been thinking --not you, Chairman Levitt. I know you've been thinking about the independence issue for a very long time.
One thing we agree, the members of our group all agree, the clear importance of auditor independence in fact and in appearance as a vital precondition to the workings of efficient capital markets in the United States. There's universal agreement on this.
We also agree, I think, on the evolution of the auditing profession into multi-service professional firms has given rise to reasonable concerns that the integrity of financial data is being or may be adversely affected or at least that markets may become suspicious of that fact andimpose an additional risk premium.
The ISB has commissioned studies on the perceptions of the investing public realizing the quality of financial reporting and the issues of auditor independence.
The most recent report of findings was delivered to the board last week by the research firm Earnscliffe Research & Communications stated very briefly the results of that study were rather similar to an earlier study done by the same firm.
And the conclusion was that there's a high degree of trust in the integrity of financial statements and in the auditing process, but nevertheless there is important concern about the existence of non-auditing services being a significant part of the business of many accounting firms.
Now, that's not a very satisfying report in the sense if anyone wants a clear answer, but I think it confirms the other reports that we have commissioned, that there's high degree of confidence in the integrity of existing financial statements, but there is a level of concern.
Let me step back, if I may, and talk about the Independence Standards Board. We have made annual reports each year we have existed and sent them to the members of the Securities & Exchange Commission.
But this is the first time that we've appeared before you, and so I briefly would like to go over theindependence related matters that have occupied our time.
The board was established in 1997 and was authorized in very early 1998 by the issuance of an FRR from the SEC to create standards, principle-based standards, to determine the independence of auditors of public companies.
We set about early on to create a conceptual framework for doing that job. We appointed a task force of the board, a task force of public citizens both from the academy and from the profession and from the investment community, and we have academic consultants.
That task force and the consultants have been producing working on a conceptual framework, which is a rather advanced state but still a work-in-progress.
And we, in addition to the conceptual framework, began before the conceptual framework was completed in an imperfect process but one we felt some anxiousness to begin to advance the ball on substantive standard creation, the first standard that we took up for studying involved corporate governance.
And our thought was to try and encourage in some way the involvement of audit committees in the maintenance and monitoring of the auditor company relationship, and we went through a long public process with public hearings and notice, et cetera, and adopted Independence Standards Board Standard No. 1 which requires conversations between theauditor and the audit committee of the board with respect to all relationships that a reasonable person might believe would bear upon the independence of auditors.
The second standard that we took up addressed the auditing of mutual funds and affiliated entities, and that was passed in December of 1999.
The third standard that we created was designed to modernize independence rules with respect to employment of former audit firm partners or employees with audit clients. The next matter that we have has not been adopted as a standard yet.
It's at the ED exposure draft stage, and it's ready to roll, but we have suspended consideration of it while the Commission considers the present matter before it. But that is the project on financial interest on audit firm personnel, question of ownership of stock, et cetera, and a related project on family relations -- can my son-in-law work for the audit company client?
We have other projects that are at a similar state of advancement, one on valuations and appraisal services, and finally, we have a project on future firm structures, which is a complex matter that's also dealt with to some extent in your proposed rule-making.
Many of these have been reflected in your rule-making but in ways that are, in some respects, a bitdifferent. In all, the Independence Standards Board I think has worked well.
It's an unusual structure. It's four members of the profession and four lay people or non-accountants of some experience. We have not had an occasion of a split vote. We have worked, as I say, well together, and my colleagues can share their insights on that topic.
And we have also -- I don't think it's breaching any trust -- to say informally we have discussed whether or not it would be desirable to increase the public membership of the board to a majority.
I don't think it would be change the outcome of our deliberations, but I recommended that we consider doing that on the notion that it might help the perception of the world, thinking that perhaps we were compromising to get standards done.
And I think we have reached an agreement about that, but it's not -- I'm not sure all members of the board
-- I haven't talked to all members of the board yet, but generally that's where we stand.
Now let me turn to my substantive testimony, if I may. I've got four points that I want to make with respect to the proposal. First, part of it I warmly embrace and endorse. Secondly, another part of it I'm, sort of, agnostic on at the moment.
Simply because of any judicial training I feel as though I haven't been led by the evidence to anyplace at the moment. Third, I want to make a suggestion for modification, and fourth, I want to express a little concern about the future interaction between the ISB and the rule-making process.
First, with respect to the warm embracing and supporting and all that, I very much am in favor of the disclosure item. I think it's consistent with the underlying philosophy of the securities regulation in the United States since 1933.
It's a conservative step. It has consequences for the accounting profession. I mean, I think they tend to resist it when I've talked about it. They tend to resist it because there's nothing particularly in it for their clients. The clients don't want to disclose what they're doing with their accountants, and so there's a fear that if they have to disclose then they may go somewhere else.
So it's not a costless reform insofar as the accounting profession is concerned, but I think it's very helpful to the markets, because we met with the groups from the investor community, and they all were very enthusiastic about having this kind of information.
It seems to me that it's a positive step. It's a conservative step, and I think it really ought to be done.
My second point has to do with your main focus of testimony today, which is the scope of services. I don't oppose the substantive provisions in the proposed rule-making dealing with the scope of services.
If I were required to make a decision with respect to this question today, I think it would be my judgment, as it was the drafter of the rule, to go this way. But as I'm not required by events to make such a judgment, the lack of good information with respect to a correlation between any increase in the provision of non-audit services to audit clients and a decrease in reliability of financial statements precludes me at this time from endorsing it.
But I recognize that it is a question of public importance, and the proposal is certainly one that reasonable people might make and, as I say, if I were required to make the decision today, I would make it along these lines.
With respect to the third point, how I would suggest that the proposal be modified, respect for the process that I've been involved with with the people that are sitting up here and other people who are not up here, constituting other members of the Independence Standards Board and the staff of the Independence Standards Board, we've had a very long process with respect to each of those independent standards that I mentioned.
We made informed judgments, I think, about a hostof problems, and therefore I ask you to consider adopting the Independence Standards Board's standards for promulgation in this rule.
Now, the fact is that the rule does largely track the Independence Standards Board's standards on the subjects that the Independence Standards Board has spoken to.
CHAIRMAN LEVITT: Is that the question of family relationships?
MR. ALLEN: Yes, sir. Family relationships is one of them. Employment with clients is the other. I don't think there's any difference at all -- a third is appraisal and valuation services. I think there's no differences whatsoever, and the differences are not so large.
It's just that I think out of loyalty to the process that I've been involved in -- that I should ask you to --
CHAIRMAN LEVITT: So if we substituted your language in your proposal as part of this rule --
MR. ALLEN: Yes, sir. I will ask our staff to suggest specific language. That would be our request for you to consider doing that.
CHAIRMAN LEVITT: Right. I see your point. What you're really saying is that this group has put in a great deal of time and effort in a very difficult area, and you've come to a conclusion which is not very far from thoserecommended in our proposal.
And I think it certainly gives meaning to and substance to the work of the ISB, and to treat that as a side bar might be a diminishment in some way. I understand that. I think that's a point well taken.
MR. ALLEN: Thank you. The fourth point that I mention is really a point of a bit of confusion on my part. I think that we're dealing with the structure in the ISB structure which was conceived at one point in history and is going through an evolution that may not be entirely planned.
It's, sort of, reacting. We have this conceptual framework. We've been working on it for a couple of years, and it's still probably a year away. It's designed to give the largest thoughtful frame for thinking about issues of independence.
Your proposal rule-making has what I think of as a fairly minimal conceptual structure. I don't disagree with it. It has these four notions -- mutuality of conflict of interest, reviewing your own work, advocacy, et cetera.
What is unclear is how this conceptual underpinning of the proposed rule is going to affect everything hence forward, because there's this whole group that has been doing this conceptual framework and coming back to the board, and so forth.
What they've been doing has a threats andsafeguards theory to it; that is, it focuses on particular areas in which there might be independence concerns or problems, and then once it focuses on such an area it invites you to consider whether this requires a prohibition, whether there may be safeguards that would satisfy the world that the situation does not constitute an unreasonable risk to independence.
The proposed rule does not adopt a risk and safeguards approach. I think that the SEC, particularly through the enforcement aspect, is suspicious that safeguards are a reasonable way to proceed.
And I think that somehow we have to get agreement or deep understanding either with the Commission or with the staff or somebody. We need some guidance because there seems to me a fundamental difference between the underpinnings of the proposed rule and where the ISB has been.
So that I just sort so the raise as a red flag and say no more about it.
Let me conclude, then, my remarks. It's a pleasure to appear before you, and I'm sorry I don't have insights that are -- Dean Hunt this morning said that these were strongly held views. Well, I wish I could have some more strongly held views about this, and I could, perhaps, be more help to you.
But I do very much appreciate the proposal ondisclosure. I think I'm a minority in thinking it's a very important thing, but I do think it's an important thing. Let me turn to my colleagues.
MR. JOHNSON: First, let me thank the SEC for the opportunity to testify before this organization today, and I'd also like to applaud the SEC and Chairman Levitt for addressing this issue in a very timely fashion. I think it's very important, and thank you for letting us talk about it today.
My background is as an economist with the Federal Reserve, so I'm a layman in this area. But as Chairman Allen pointed out, we have acquired some knowledge, maybe enough just to be dangerous but certainly have acquired some knowledge in this area and feel like we have some opinions but certainly not expert opinions.
First, the U.S. capital markets are the strongest globally by far because investors trust or system relative to all others.
It would be impossible for the U.S. to finance an unprecedented economic expansion like we've had while running a huge trade deficit unless foreign investors -- as well as domestic but especially foreign -- were confident that their hard-earned savings would be protected, and the financial information they were provided regarding prospective investments was accurate and comparable across the economy.
One of the foundations of this successful system is the independent audit of business financial statements. This is the element of our system that reassures investors that the financial data they receive from companies conforms to a common set of accounting standards.
It's critical that the audits of business financial statements not only be independent but be perceived as independent by the investing public. Perception and reality must be the same for confidence in our financial system to be maximized and allow the economy to reach its full potential.
Over the years, changes in technology and the work place environment have made it possible for individuals to vastly expand their investment options as well as pursue job opportunities throughout the economy at all possible levels.
Two worker, two investor families have become common. Also, large accounting firms have grown even larger and much more diversified as they've sought to provide an array of technical assistance to business firms across the economic spectrum.
While much of this trend, especially in the area of worker and investor opportunities, is obviously good, the growing complexity of financial and economic relationships and the extent of non-audit services provided to audit clients by the major accounting firms have significantly increased the perception and the potential for conflicts ofinterest and threatens the integrity of the independent audit function.
Now, one of the measures to deal with this problem was the establishment of the Independence Standards Board of which I'm a member by the SEC and the AICPA in 1997. The purpose was to create an institution that would modernize and streamline a series of old rules and guidelines with new principle-based standards for the determination of auditor independence.
Chairman Allen has described the efforts of the ISB, so I won't repeat them here except to say that considerable progress has been made in addressing many of the problem areas we're all concerned with.
However, I do feel it's important the SEC undertake a new rule-making not only to strengthen the standards and guidance of the ISB but also to directly address in a timely fashion the difficult policy issues surrounding the proper scope of services appropriate for accounting firms charged with the trust of performing independent audits.
Now let me endorse what the Chairman and I think most of my other colleagues have said and are going to say here. I'm pleased that the SEC, in it proposed rule-making, has adopted the approach followed by the ISB in its deliberations on employment with audit clients, family relationships and financial interest.
However, I do not see the need to develop separately from the ISB a completely different set of guidance and definitions that support such similar rules in these particular areas.
The ISB has developed a deep infrastructure to deal with the details of guidance and implementation which we think can be relied upon by the SEC. I thought it was useful to hear the Chairman's interest in this.
I think that, again, in some cases, the ISB is a little more stringent on these details, and, in some cases, the SEC is. But I think overall it's hard to really see substantive differences in these points of detail, so I think it makes a lot of sense to adopt what the ISB has worked very hard on and has brought a lot of expertise together to put together.
So with that, I'll stop and thank you very much.
MR. DENHAM: Mr. Chairman and Commissioners, I appreciate the opportunity to testify. My background is as a practicing lawyer for most of my clear in private practice. For a time, I was general counsel of a large and complex public company.
I had internal audit reporting to me in that role, an internal audit group of about 100 auditors, so I know a little something about internal audit. I've been CEO and chairman of a large and complex public company as well.
I first want to express my agreement with the points of view put forth by Chairman Allen with maybe one or two nuances that I'll spend most of my time focusing on.
The disclosure proposals relative to disclosing the non-audit service fees I think that's a very good idea. I commend you for putting that forward.
Incidentally, I think the proxy statement is not the best place to put it. I think proxy statements are better documents if they're tightly targeted toward disclosing the kind of information that is material to the votes that are being taken, and I don't really think that this information is of particular significance to what shareholders are voting on.
I think a better place for it is in notes to the financial statements or in the 10-K. It is information that has some relevance to investment decisions but has very little or only quite tangential relevance to voting decisions.
Secondly, scope of services. I guess I have a less judicial -- I certainly have a less judicial temperament, I'm sure, than Chairman Allen, and so I'm willing to be less agnostic than he about the proposed rules relating to scope of services.
I think that they represent a very thoughtful, rationale, coherent set of proposals. I'm sure they're notperfect. I'm sure that the Commission, as a result of the process that you're going through, will improve on them, but I think that they are an excellent starting point and recognize some very real problems that have been developing.
I do believe that there are costs imposed by some of these rules. I've been in the role of making judgments of places where one-stop shopping was an advantage and places where I thought it wasn't an advantage.
I think that in a market economy that's highly competitive any time services are being acquired in a particular way that suggests that the participants in the economy have found advantages either of cost or quality or both in the way those services are being provided.
So I think there are some costs that would be imposed by limiting scope services. I think, though, in most and, perhaps, all the cases that the Commission addresses in this proposal those costs are more than justified by the benefits.
The area that I find it easiest, perhaps, to think about is internal audit out-sourcing. I'm not an opponent of out-sourcing in general. I think there certainly are circumstances where the company isn't large enough to have a substantial enough internal audit function of its own employees so that it makes sense to out-source.
But I can't imagine a situation where, as a memberof an audit committee or as a member of management, I would want to out-source to the accounting firm that was doing my audit. Good internal auditing, in my experience, requires the internal auditor to be very closely integrated with management.
The internal auditor is a part of the management team. He or she is identifying problems and providing reports that help management correct those problems, and you can't have that kind of integration with management, I think, without losing the objectivity that is needed to do the attest function.
So on that one I'd be willing to call that now and say that accounting firms just shouldn't do that for audit clients.
On the issues of employment with audit clients, financial interest, family relationship, which are issues that the ISB has been addressing, I join Chairman Allen in encouraging the Commission to consider looking to the rules that the ISB has developed or is well along in developing in these areas.
The differences between what the ISB has proposed and the Commission proposal are, in my view, quite minor. I don't think any of them are the kind of things that a good reporter could get a paragraph out of for a story, much less an article or, more importantly, that would cause an investorto change their view one way or the other in reliance on audited financials.
If there's going to be an ISB process -- and there doesn't have to be one, but if there's going to be an ISB process, I think it's worth considering the consequences of placing the ISB in the role of proposing only.
If all the ISB does is propose, and then the Commission and the Commission staff takes that, perhaps is influenced by it but changes it in various details, it's going to be hard to get serious people to spend serious time thinking and working hard on those issues.
I have enjoyed the opportunity to work with the ISB, and if it's useful to the Commission and to the process, I look forward to continuing to work with you to address these very important issues.
CHAIRMAN LEVITT: Thank you very much.
MR. BOGLE: Thank you. And thank you, Commissioners, for allowing us to be with you today. I'm just going to add briefly to the statement that you have before you.
First of all, I want to make it very clear that I heartily endorse the Commission's focus on independence. It's absolutely critical to the interest of investors, and therefore the public interest of the United States.
I particularly support the provisions onproviding -- against providing non-audit services to audit clients. And I've heard, to be honest, and read nothing today to change that view and, indeed, quite a bit to reaffirm that.
Of course there is no clear evidence on this subject, but as your proposal says, your rule proposal says very aptly studies cannot always confirm what common sense makes clear.
But the stakes are high, and when consulting fees come to be many times more important than audit fees, it just must be obvious to anybody that independence is clearly likely to be impaired.
I know it's subtle. I know it's a state of mind. But when self-interests predominate, trouble comes not far behind. And it seems to me it comes into special focus as a profession becomes a business.
In this case, the profession of accounting turns into the business of consulting and cross-selling. It's potentially very adverse consequences to the public interest. Actually, to be honest, I forget who brought this up, maybe Commissioner Carey, the distinction.
When I talk about is business and profession or profession and business between church and state might not actually be too far from the mark.
If you'll forgive me if I add a parallel to my ownexperience in the mutual fund business, which used to be a business of trusteeship and investment management and has now become a business of marketing, and the public interest, in my judgment, has not been served thereby.
So I feel strongly about the divorce of outside services from the audit services.
Now turning to the other services, you've heard from my fellow members of the ISB on the subject, so I won't add too much to that except to say that those other services of a significantly different dimension, in my view, should best be left to the Independence Standards Boards.
The rules you have here parallel those we've put together, and we put them together, I think, in a very constructive, deliberative and positive, remarkably positive process with the participation not only of the public members here represented, I found the professional members, the members of the auditing profession, to be singularly helpful putting some practicality to what we're talking about, and we've also had terrific participation from Chief Accountant Turner and your own staff in putting together rules that I think are pretty good.
We've actually come and reasoned together and brought out reasonable rules that will help the public interest. And I think conflicting rules or even a conflicting rules structure will vitiate the ISB mission.
So I hope the Commission will consider strengthening the ISB perhaps even by a larger public representation on that board.
Finally, I want to add two cautions based on some of the things I've heard today. First, do not overestimate the value of disclosure. It is necessary. Your release has it exactly right. But it is not sufficient to rectify the kind of problems we're talking about here.
And second, don't overrate the stock market. I hear these opinions that these issues will all be worked out on the wonderful stock market. Let me assure you the stock market is imperfect.
The stock market is flighty, and these issues are but only one set of issues and but no means the most important of an infinite number of issues the stock market takes into account in valuing companies. And there is no way to find much linkage in my own experience.
Now, I know that James Carville wanted to be reborn as the bond market, but I don't think we should have independence issues reborn as the stock market because it's not, I assure you, going to resolve these issues.
CHAIRMAN LEVITT: You know, there are moments in this most extraordinary job that has been bestowed upon me where I just feel so good to be part of it, and you sure havegiven me that moment.
If there is such a thing as a public interest hall of fame, the four of you should be charter members. You've just been terrific, and I think Americans who never even heard of you owe you an enormous debt of gratitude, and I'm deeply, deeply grateful for the privilege of having been able to work with you.
MR. BOGLE: Thank you, sir.
CHAIRMAN LEVITT: Colleagues.
COMMISSIONER HUNT: Thank you one and all for joining us today. I want to join with Chairman Levitt and I'm sure my other colleagues in thanking you for your hard work on these important issues.
It's over a relatively short time so far, but I hope it will last for a long time, and I assure you, Mr. Denham, we will continue to find it useful. So I hope all of you will continue to work at it.
Chairman Allen, I agree that disclosure is important, but I'm troubled because I don't think -- if there's a real problem of lack of independence or at least a real problem in the appearance of lack of independence, it's not clear to me that -- we all know that disclosure is the mantra of our securities laws, but I'm not sure in this instance disclosure alone would solve the problem absent something else.
MR. ALLEN: I agree. Disclosure is, in my mind, a wonderful default remedy that there are a whole lot of other remedies. For example, we on the ISB have been thinking about appraisal and valuation services that's in the proposal.
And we came to the conclusion that it just wasn't right to have someone affiliated with the auditor giving a value and then having the auditor checking that value.
And so that was a clean area. But for example, if you're considering something like Professor Coffee's suggestion this morning, just a general cap, what disclosure does is it allows a greater range of choices instead of a rule setting an on/off switch that says the amount of your audit fees it says disclose.
So if you think, you as an investor, think 60 percent of audit it's is beginning to worry you, you knew that, and you begin to be a little concerned somebody else has a -- so I think it's a good, sort of, background default. I don't think it's the whole answer either, Mr. Hunt.
COMMISSIONER HUNT: I also wanted to clarify whether you think that a relative lack of data vis-a-vis what you just talked about, the comparison of audit fees and consulting fees compared to the data today although that might change very quickly, should preclude us from acting.
MR. ALLEN: I wouldn't presume to tell you. Imean, I think that when you decide to act, how much information you have is itself a judgment.
I mean, you know how much data you have, and you have a sense about the nature of the problem that you perceive. If I were in your position, I would be going --but I don't have any easy answer to tell you what I would do. COMMISSIONER HUNT: For my part, I want to thank all of you for appearing and for all of your hard work on the ISB and to wish you continued success. Thank you for coming.
COMMISSIONER UNGER: Should it be us or you on these issues?
MR. ALLEN: I think, on this issue, the four of us feel that it is different -- "this issue" being the scope of service issue, the four of us feel that it is a different --it's different in kind than a lot of these other issues.
For my own part, I think it's helpful to think of scope of services and break it down into the various services. I think they might be a little different in part, but, basically, in my mind, it's a policy choice. How much risk -- because we don't know how much it costs to have perception problems in the market. We just have an intuition. We don't know how much it's going to cost the economy, what Professor Antle talked about, the economies of scope, and so it's not well-suited for a board of our character. It's really a public policy choice that thegovernment needs to make, I think. And that's, I think, the view of us all.
COMMISSIONER UNGER: Well, how would you advise us on the issue? Even if you didn't have to resolve the issue, do you think that --
MR. ALLEN: I think the three smartest people on this panel already advised you. And as I say, I think it's just my judicial experience that leads me not to -- I wouldn't advise you not to do what you're doing, but I'm agnostic on it. I mean, I don't know what I would do. I would lay awake for a while thinking about it.
COMMISSIONER UNGER: Not if you had all the reading materials we had. Well, thank you. I do look forward to reading your testimony in more detail as well and learning more about this issue. So maybe we'll call on you in the future for more guidance on this issue.
MR. ALLEN: Well, any of us would be happy to be of help.
COMMISSIONER UNGER: Thank you.
COMMISSIONER CAREY: With the mention of separation of state and no agnosticism, we seem to be getting somewhat off course. I want to ask you --
MR. ALLEN: This is my baptism in appearing before the --
COMMISSIONER CAREY: For those of you who happened to be in the room, and I don't know if any of you were, the panel of three of the Big 5 firms, their refrain that there is no evidence -- and they cite what I said was the less than representative sentence from the O'Malley report -- that no one can point to an impairment of independence as a cause for a calamity of accounting breakdown.
MR. ALLEN: We haven't done that study. I don't know if anyone else on our board could do it. I mean, everyone has said to you I think the same thing, that there's suspicions. I mean, if you look at this Sendant case, the same firm is involved in doing the audit that employed the internal people. There's no proof of it.
I mean, I would think that what you would need to find would be -- Commissioner Hunt was asking for information. You'd have to take, say, 100 firms that --
COMMISSIONER CAREY: A representative sample.
MR. ALLEN: -- follow the Pfizer model and 100 firms that have -- audit firms that do other things in a significant way and then see if you have a greater experience of audit failures.
COMMISSIONER CAREY: It would almost seem that there are some in this argument who are trying to say, "Well, we did no harm." And I would say that the integrity of a public auditor is that they have greater responsibility thanthat. Would you agree?
MR. ALLEN: Well, I would agree that when you don't have good empirical information the argument is about what is the default; that is, who has the burden of proof.
And one group is trying to say, "We do no harm," meaning you have to prove that we do harm to regulate, and the other group says, "Well, we're concerned to protect the public, and we have to prevent reasonable threats that we see." And I take it that for those that have propose the rule this is the reasonable position.
COMMISSIONER CAREY: Jack, do you have anything?
MR. BOGLE: No. I don't know of any evidence, Commissioner Carey, of anything that has actually happened. But I think we're dealing -- and some of the testimony you'll hear later in the afternoon which I read in a couple of break points this morning gets into this whole matter of self-interest and subjectivity and people living in a world where they don't even know it's going on, because it's the way of the world to do all these things together.
So I think you have to really look through -- there is certainly no big fraud, but are there marginal decisions that are made because of the tremendous power or interest in getting substantial -- a consulting contract with very substantial economic amounts.
We heard of one case where the consulting contractmight have come up to $100 million. Well, when you got a little $2 million audit fee at the end of that, I don't think you need evidence there's a problem. I think the problem speaks for itself in terms of its potential.
CHAIRMAN LEVITT: You're right on there in terms of this is very, very subtle, and it's a combination of lots of small things. And I think it would be a terrible mistake to look away from it merely because there isn't a so-called smoking gun. If there is any validity to perceptions, you simply can't stand back and say that those relationships are meaningless. Now, the representatives from the Controller's Office, Jerry Hawke, this morning was very concerned about the out-sourcing of the internal audit function, which some of the representatives of the firms felt was absolutely essential once again to performing better audits.
I'd be interested in your view of that out-sourcing.
MR. JOHNSON: Similar to Bob Denham I think that the internal audit function is, basically, an arm of management to try and actually make sure that systems are working and that the organization is functioning properly, but it's still a tool of management.
Now, I've been involved in audit committees and chaired audit committees, and the internal auditor reports --in the experience I've had reports separately to the audit committee, and the audit committee tries to hold itself separate from management.
The ones I've been involved on don't involve management and outside board members. Nevertheless, we've always viewed internal audit function as part of the internal operations of the firm and reports to the top management, and we've always treated it as such.
And I think to out-source that to accounting firms that are providing the audit then certainly makes it an advocate of management in many ways. I think that you could change the audit function, internal audit function, and treat it more like an outside auditor, but you have an outside auditor. So I think it would be a problem.
CHAIRMAN LEVITT: Might it be different with a small country bank that already was hard-pressed to have any such thing as an internal audit, and it's an option between out-sourcing or not doing it?
MR. JOHNSON: I'd have to give that some thought, but certainly it's a more difficult issue for small organizations, business organizations that they may not have the expertise. But I would still think that they could hire the services of an accounting firm that's not the auditor.
MR. DENHAM: I've been on an audit committee. I've chaired an audit committee that decided to out-source. Itmade sense, in my judgment, in that environment, but we didn't -- we never seriously considered out-sourcing with the attest firm.
CHAIRMAN LEVITT: Anything else?
MR. DENHAM: I'd like to address for one second, Commissioner Carey's previous question. I think it's a mistake to focus too much on the cases of major audit failure and try to draw lessons from whether independence played a role in those.
Those cases, fortunately, are relatively few and far between. They're idiosyncratic. They involve lots of bad and messy facts.
I think the better question for guiding the Commission, I would suggest, is what set of rules is more likely to produce better accounting, better financial reporting in the ordinary circumstances of the good companies, the companies that aren't trying to engage in major fraud? What set of rules about scope of services is going to help produce an environment that will encourage better reporting?
COMMISSIONER CAREY: I would agree with you, Mr. Denham. I guess, in listening to your responses, it's not the spectacular accounting disasters, but what we have to seek to prevent is the incremental impairment of accounting standards that would have an exponential impact on investorsand on the public.
MR. DENHAM: That's the issue, sir.
CHAIRMAN LEVITT: Thank you very much.
(A brief recess was taken.)
CHAIRMAN LEVITT: In time-honored fashion, we abandoned the scheduled break. I welcome representatives of our eighth session.
As I look at these faces in front of me, and I didn't know you, and I wondered what you did for a living, I'd say you were a group of psychiatrists, but you are academics.
We have George Loewenstein, Professor of Economics and Psychology -- that's close -- Carnegie Mellon; Max Bazerman, Professor from the Kellogg Graduate School of Management Northwestern and a Fellow at Harvard Business School; Douglas Carmichael, Professor of Accounting at the Baruch College, City University and former Vice President of the AICPA, and Curtis Verschoor, the Research Professor, DePaul University.
Gentlemen, thank you very much for taking the time to be with us today.
COMMISSIONER UNGER: I don't know about you,
Mr. Chairman, but I could use some counseling. So if you don't mind.
MR. LOEWENSTEIN: Okay. Let me begin by sayingthat Professor Bazerman's and my testimony are kind of a package. We wrote this paper together on auditor independence, and so ideally, if you could let the two of us go before asking us any questions, that would be perfect.
As the Chair said, I'm a professor in economics and psychology at Carnegie Mellon University. Let me begin my testimony by noting that I'm not an expert in accounting or auditing. Instead, my expertise is in the psychology of human judgment.
I believe that the findings from psychological research on human judgment have important implications for the specific policies being evaluated by the SEC and for other types of policy changes that have been discussed in the past and that might be discussed in the future.
The research on human judgment is relevant to debate over changes in policy because, ultimately, the proposed rule changes are designed to influence the judgmental processes of auditors.
The rule revisions being discussed today are intended to mitigate problems associated with a lack of independence and auditor judgments. There appears to be a growing concern that some auditors are not scrutinizing the accounts of their clients with sufficient objectivity to ensure that the public is supplied with high-quality impartial judgments of companies' financial health.
By eliminating some conflicts of interest, the proposed rule changes are intended to reduce some of the incentives that auditors would otherwise face to submit audits that benefit the firms they audit rather than the general public.
My goal is not to discuss the specific changes in rules that have been proposed but to talk more generally about the psychological underpinnings of auditor bias and the ramifications of what we know about human judgment bias for different types of policies intended to mitigate bias.
Arguments for accounting reform have often been based on the assumption that auditors are intentionally biased; that is, that they deliberately misrepresent information for their own benefit.
A lot of the testimony that we've heard in the session before the last one from the Big 3 of the Big 5 accounting firms was premised on this kind of assumption.
If this interpretation were correct, then the bias might be potentially rectifiable by more suasion and/or the threat of sanctions.
While it is true that some auditors may deliberately misrepresent information the research conducted by myself and my colleagues suggest that a more fundamental challenge to auditor independence results from the existence of unintentional bias.
This research shows that bias typically enters unconsciously when people process information to arrive at a judgment. When people are called upon to make impartial judgments on the basis of complex information, those judgments are likely to be unconsciously and powerfully biased in a manner that is commensurate with a judge's self-interest.
When people would like to believe that some assertion is true, they sift through the data looking for information that supports what they want to be true. They systematically ignore or react skeptically to information that contradicts the conclusions they want to hold. This is what the psychological research shows.
Parents, for example, can be amazingly blind when it comes to noticing problems with their children that they wish did not exist. Doctors and psychotherapists -- they come into play again -- are adept at figuring out why patients need just the procedures that they have to offer. Psychologists call this the self-serving bias.
While the idea that auditor bias is unintentional and thus not due to corruption, which is what I'm proposing, may be appealing, the less happy implication of this assertion is that auditor bias is likely to be pervasive because it will not be limited to corrupt individuals but results from psychological processes that are common to allpeople.
In a series of experiments examining a self-serving bias that I believe present a close analogy to the situation of auditing, my colleagues and I presented research subjects with diverse materials from a lawsuit resulting from a collision between an automobile and a motorcycle. These included depositions, police reports, doctors' reports, and so on.
We randomly assigned subjects to either the role of plaintiff or defendant in pairs of plaintiffs and defendants, attempted to negotiate a settlement in the form of a payment from the defendant to the plaintiff.
If the pairs were unable to reach upon a settlement amount, they paid substantial penalties -- this was all done with real money, although it was scaled down from the actual lawsuit -- and they were told that the amount paid by the defendant to the plaintiff would be determined by an impartial judge who had earlier read exactly the same case materials and reached a judgment.
Before they negotiated subjects were asked to predict the judge's ruling. They were told that this estimate would not be communicated to the other party and would not affect the judge's decision, which had already been made.
Nevertheless, plaintiffs' predictions of thejudge's award were substantially higher than those of the defendants. Defendants, on average, predicted that the judge would award the plaintiff $20,000. Plaintiffs expected the judge to specify a payment of $33,000.
Moreover, the degree of discrepancy between plaintiffs' and defendants' predictions of the judge was a strong predictor of whether they settled the case, as opposed to relying on the judge's decision and paying penalties for not settling.
In a number of follow-up cases, we attempted to intervene in various ways to reduce the magnitude of the self-serving bias. In several studies, we paid participants for accurately predicting the judge's ruling. This intervention had no measurable effects.
Participants consistently believed that the judge would come out on their side even when we paid them for estimating the judge's rule accurately.
We also attempted to reduce the magnitude of the self-serving bias by describing it to participants in some detail and administering a test to them to make sure they understood the description.
The experimental intervention was successful insofar as participants became convinced that the negotiating opponent would be highly biased, but participants believed that they themselves would not succumb to the bias.
The fact that participants are unable to rid themselves of the bias when rewarded for doing so and when they're told about the bias and their belief that they weren't subject to the bias both demonstrate clearly that the self-serving bias is unconscious and not deliberate.
Other findings from the same series of experiments point to a likely psychological mechanism underlying the self-serving bias.
Participants were presented with eight arguments favoring the side they'd been assigned to; that is, either plaintiff or defendant, and eight arguments favoring the other side. They were asked to rate the importance of these arguments as would be perceived by a neutral third party.
There was a strong tendency to view arguments supporting one's own position as more convincing than those supporting the other side, suggesting that the bias operates by distorting one's interpretation of evidence.
Consistent with this interpretation, in another set of experiments, when the parties were presented with their role; that is, they were told that they're either the plaintiff or the defendant, only after they read the case materials, the magnitude of the bias was substantially reduced, and almost all of the pairs reached rapid agreement on damages.
The task faced by auditors is, of course, differentfrom that faced by participants in our studies. However, there are many similarities. Like our participants, auditors need to sift through large amounts of information to arrive at a judgment.
In fact, auditors possess much greater amounts of information than participants in our experiment and there is, therefore, likely to be commensurately greater scope for biased interpretations of the information.
Also, just as our participants identified with either the plaintiff or defendant in the legal case, auditors are likely to identify with the firms they audit.
Needless to say, this is especially true if auditor firms are providing consulting services to the companies they audit or have a financial interest in the firm. In this case, they'll have a strong desire to view the firm as a healthy profitable enterprise and will process the information accordingly.
Even in the absence of such explicit conflicts of interest, however, there are a variety of reasons why auditors may have an interest in taking a positive view of the firm they're auditing.
First, the people who will be hurt by any misrepresentation are statistical. They cannot be identified at the time the decision is made. Researchers have found that people tend to be far less affected by imposing harm onstatistical victims than on known victims.
If a biased audit results in losses to investors, many people might lose a small amount of money, but it isn't clear who will lose money. In contrast, the auditor is likely to be well-acquainted with the people who would be hurt by a negative opinion on the audit.
Second, the adverse consequences of a negative opinion are likely to be immediate; that is, loss of the client's friendship or potential loss of the client; whereas, the effect of a positive report when a negative report was appropriate are likely to be delayed in time and contingent on problems in the audited firm becoming known publicly.
Third, auditors often form ongoing relationships with the organization they audit, and any deterioration in the audited company is likely to unfold gradually.
In a process sometimes referred to as a slippery slope, auditors may unknowingly adapt to imperfections in the company's financial practices and not notice when these cumulate into serious problems.
While the proposed rule changes move in the right direction by attempting to eliminate some of the most egregious sources of conflict of interest, they leave impact other features that can continue to produce bias.
As Professor Bazerman will discuss, in an ideal world, auditors would not be hired by the firms they audit. One possible objection to this line of the argument and to the applicability of the self-serving bias studies to auditors is that auditors, unlike the participants in these studies, have professional training and experience.
There is no evidence, however, that such training reduces the magnitude of the self-serving bias. Indeed, the self-serving bias has been demonstrated in studies of professionals such as lawyers, judges and union negotiators.
In sum, auditor judgments are likely to be biased in favor of their own and their client's interest. This bias does not result from deliberate misrepresentation but from judgmental processes that even the most honest, conscientious auditors are likely to exhibit.
Because the bias is unintentional and people are not aware of it, they are unable to eliminate it from their own judgments, and it is also likely to be impervious to attempts at moral suasion or the threat of sanctions.
Most auditors are probably not corrupt, but they are human. The only way to eliminate the self-serving bias and, hence, to ensure auditor independence is to eliminate all explicit and implicit incentives for providing a favorable audit.
MR. BAZERMAN: Commissioner Unger, you requested advice from the panel, as you've requested from panels before, and I'm going to try to provide that.
But first, I want to briefly comment on the connection between Professor Loewenstein's research and the testimony that you're hearing. Professor Loewenstein is suggesting that any auditor who has any self-interest in a more positive audit is likely to unconsciously be biased in the task of auditing.
I would also suggest that you've heard a large number of people who I would assume to be honest today offer a variety of advice on how the Commission should proceed, but I want to suggest that Professor Loewenstein's research is relevant to testimony given by people who have a vested stake in the advice that they're giving you.
COMMISSIONER CAREY: I've never met a witness that didn't have a vested stake.
MR. BAZERMAN: I'm going to do my best to make --
COMMISSIONER CAREY: People are witnesses because they are generally advocates for a point of view.
MR. BAZERMAN: Your comment is interesting, but I'm not sure what Professor Loewenstein's self-serving motivation would be as a professor who doesn't do consulting in this industry.
As for myself, a little bit of background. I do have an undergraduate degree --
COMMISSIONER CAREY: But he is an advocate for the body of work that he's here to represent.
MR. BAZERMAN: That's interesting, and I think advocating science over advocating the search for a position that helps your own financial position are two fundamentally different things.
What I would argue is that we are both here advocating what social science tells us about the problem that you're facing. If anything, in terms of direct motivation, my testimony before you is likely to do me financial harm.
I've spent a considerable amount of time doing executive education and consulting for three of the Big 5 firms. I don't think that my testimony that you're going to hear is going to help gather that work in the future.
The other piece that I want to start with and come back to later on has to do with the Commission's request on is there any evidence of cross-selling affecting any single audit.
And I want to comment on that directly, and I want to comment on it distinctly from a scientific perspective. To put it in perspective, I want to first tell a quick overview of one episode that I would assume that the Commission is familiar with, but I think it will highlight your question of is there any evidence on a single episode by focusing on an episode.
The episode that I'm going to quickly review is1992 Phar-Mor incorporated, the nation's largest discount drug store chain, filed for bankruptcy court protection following the discovery of one of the largest business fraud and embezzlement schemes in U.S. history.
Coopers & Lybrand, Phar-Mor's auditors, failed to detect financial manipulations that resulted in $985 million in earnings overstatements over a three-year period. Coopers & Lybrand was found liable.
There was a particular partner relevant to the story by the name of Gregory Finerty, and one question is was he dishonest? Was he biased because of the incentive to produce a more positive report?
And without tapping into his mind I would argue that it is impossible to know for sure whether or not a specific individual was being dishonest in terms of his representation of his own judgment.
What Professor Loewenstein's research does suggest is that under the current system that governs the auditing practice it's not reasonable to expect that an independent audit was possible in that context or in many other contexts. COMMISSIONER CAREY: Would that be because in this particular instance Mr. Finerty had a motive to be dishonest or a motive to be biased in the outcome he sought?
MR. BAZERMAN: He had benefit, possible benefit in presenting a more positive picture of Phar-Mor. And I'mgoing to assume that Mr. Finerty is an honest man. I do not know him.
What Professor Loewenstein's research suggests is once he has the incentive of additional work, once he has the incentive of maintaining the client, the possibility of true independence, as the SEC would want, is no longer possible.
And there are at least three direct challenges to this independence. One of them the SEC is currently working on, and that is the investor issue.
I have a few comments on that even though you're making excellent headway, as we've all been reading, but what I found striking as I followed the investor issue starting with the news that broke in January about Price Waterhouse Coopers was that according to the New York Times Price Waterhouse Coopers said that it did not believe that any audit had been compromised.
I believe that that's quite possibly true, but what the evidence would suggest is that since Price Waterhouse Coopers' auditors are human, once they have an incentive it's not possible for them to be purely objective.
Much like the plaintiffs and the defendants in Professor Loewenstein's studies, it's not possible to have purely objective judgment when you have a strong incentive in the audit in a particular form.
Similarly, with the issue of consulting services,once a firm has a strong incentive to maintain a positive consulting relationship, as Mr. Bogle was expressing in the last session, it's no longer possible for their audit to be completely independent and unbiased.
And finally, as long as auditing firms are hired by their clients who can hire and fire and negotiate with them at will, the possibility of true independence no longer exists because a negative report has negative implications for the auditing firm as well.
So we see three conditions, one of which the Commission has already addressed, one of which it's thinking about addressing, and the issue of the fact that auditing firms are hired by their client is something that we haven't been reading very much about, and I would encourage, in fact, should be on the table.
Now, I've been here since a little after 1 o'clock, and you've asked a number of folks about the issue of is there any episode in which we know that an audit has been tainted because of one of these issues, most commonly the issue of consulting services.
And no one has come up with an example, and here's an easy prediction. If you wait another 15 years, you still won't get an example. The reason why is you can't. When we have a biased audit, there are too many factors going on to know that it was the consulting services that, in fact, werethe main cause creating bias in a human's judgment.
We can't observe the judgment being affected, so we can't get comprehensive, clear evidence in any single case. You could also ask the question is there any evidence that cigarettes have killed any specific person.
The answer to that question is no. We have no evidence that cigarettes have killed any specific person, but we know that cigarettes have killed people. We just don't know which ones.
Professor Loewenstein's argument suggests that as long as auditors have a strong incentive to provide more favorable reports there will be bias out there, but it will be of the incremental type that you were talking about, Mr. Carey, in the last panel. It will be incremental effects that we aren't able to directly observe.
I want to close by talking about some of the suggestions that industry would like time to adapt to the SEC concerns. I would suggest that they've had a fair amount of time to adjust to those concerns.
In the case of investors, what's interesting is the leading accounting firms have engaged in a very fruitful discussion with you only after ample evidence came out that they were in violation of SEC laws and that it had already been pointed out, and they failed to act. That's what led to this fruitful discussion that has occurred in recent months.
In 1997, in a paper, the Sloan Management Review, we argued that the industry should identify economically appropriate solutions to create true independence before government intervention was required. That was a number of years ago, and the issue of independence has been talked about far longer than that.
Yet, the industry has not responded on their own, and thus, we believe that the failure of the leading accounting firms to recommend mechanisms to create true independence and their continued denial of the existence of the problem, which is, we would argue, quite obvious from a scientific perspective, forces the Commission to take strong and comprehensive action.
CHAIRMAN LEVITT: Thank you very much. Mr. Carmichael or Verschoor. Mr. Carmichael.
MR. CARMICHAEL: Thank you. I should point out I am handicapped by the fact that I am an accountant. Also, I did, in my statement, point out a few things that I've worked on. I've been studying the matter for a long time.
I was the research director and principal writer of the Cohen Commission report, and the Cohen Commission, as I'm sure you know, is named after Manny Cohen, former SEC Chairman. It was an independent study group looking at the expectation gap between auditor performance and public expectations.
I was also a consultant to the GAO on their 1996 study of the profession. I did do a review of the practices, policies and procedures of a CPA firm to maintain independence under an SEC order. It was an enforcement action, and I was designated to do that review.
And I have been an expert witness or consultant working in over 50 auditor malpractice cases. All those things shape the views that I have.
I think the proposed approach for articulating basic principles and building implementation guidance on them is sound and, in fact, essential. The work that I've done with firms would indicate rules have taken on a life of their own.
They're increasingly detailed, and that detracts from independence as a core value. So I think the proposed approach of articulating basic principles, a few basic principles that everybody can understand and building on those will go a long way toward changing those viewpoints and toward restoring independence as a core value of the profession.
I think the four principles you've identified are both appropriate and comprehensive. They've been criticized. I realize the basic principle on no mutual or conflicting interest has been criticized. I think these are mere quibbles.
I think it's quite apparent that the no mutual or conflicting interest applies to things that would impair the auditor's ability to act in the interest of users of audited financial statements, and if clarification on that is needed, that wording could be added to the proposal.
The proposal is a logical and integrated approach, one that I think should not be considered on a piecemeal basis. In other words, if you were to do that, if you were to adopt the rules on financial interests and not deal with rules on restricted services, that would be going back to what I think has been a discredited view of independence being viewed as just a bunch of rules, things that need to be avoided.
The package that you have presented in the proposals I think is a logical integrative one and one that flows from those basic principles. It's something that has long been needed.
I don't believe the detailed evidence that consulting services have actually impaired independence should be a prerequisite for restrictions of those services much for the same reasons that others have told you.
I do want to point out, however, that there is evidence that consulting services have impaired independence going back to the Cohen Commission report issued in 1978. The Cohen Commission, an independent group composedof people from outside the profession and practicing public auditors, expressed the conclusion that in the Westec case providing consulting services had, in fact, impaired audit independence, and that involved providing merger and acquisition consulting, structuring deals, giving advice on how they would be treated as pooling or purchase and then coming in and making independent judgments on those things in the audit.
The Cohen Commission did conclude that there was an impairment. I would suggest that merger and acquisition consulting be added to your list of prohibited services for the same reasons that the Cohen Commission found an impairment in the Westec case.
Now, I'm not suggesting, I want to make clear I'm not suggesting that one case over 30 years ago should be the basis for your setting policy today. I do think it's significant, though, that every AICPA committee and every POB committee that has spoken on the topic since 1978 has refused to recognize that the Cohen Commission clearly did point to a case in which consulting services, in their judgment, did impair independence.
I'd also like to add that the realities of litigation today make it very unlikely that there is going to be a smoking gun that clearly proves that impaired independence has been caused by consulting services.
The basic reasons are, first, that most cases are settled, and second, that a lack of independence is not usually even alleged in cases where there's clear evidence for good reasons. Let me elaborate on that.
In the case of Teachers Management and Investment Corporation, which was audited by KPMG Peat Marwick, there were allegations in the complaints filed of a lack of independence.
And one of the bases for those allegations was lucrative consulting work for the client and the prospect of future consulting assignments. The case was scheduled for trial early in 1998, but it was settled, as most cases are, shortly before going to trial.
The case of AUSA versus Ernst & Young is my illustration of the other factor. I don't know whether you've had an opportunity to read the decision. It was a bench trial, so there's a decision by a federal judge. I've never seen a judge lay into an independent auditor the way that judge did to the firm.
He referred in very creative ways to the partner of the firm lacking backbone in most creative phrasing, referred to invertebrate flexibility and, in a sentence I chose to quote said, "Obviously, an audit becomes a pointless exercise if the auditor, after discovering substantial errors in a publicly-owned company's financial statements supinelyacquiesces in the client's refusal to correct the errors and certifies the statements."
Anyway, in that particular case, there were consulting services provided, but, in the trial, those issues simply were not raised. And I did go back and I asked the attorney that presented the case and the expert witness that testified why they didn't do that, and they said, "Well, simply, it was the case that we had a home run presenting a case based on poor quality of the audit.
"Why would we come into court and try to get to first base on an independence issue when that is so difficult to prove?" As many other commentors today have said, you can't really get inside the auditor's mind.
A plaintiff's attorney and an accounting expert are going to be very reluctant to put forward an argument that they have a chance of not being able to sustain and detract from a very solid case.
I also want to go to my own experience. I am working on a case currently where the auditor failed to adequately investigate a very large audit difference detected near the end of the audit, and at the same time the firm was negotiating with the client for a very large consulting assignment.
And if the firm had gone ahead and insisted on investigation of that audit difference, it would havecertainly delayed the earnings announcement, angered management, and it would be likely they wouldn't get the consulting engagement.
Absent members of the audit team coming forward and saying, "Yes, we admit it. Our independence was impaired," you really can't, even looking at that extreme and what I regard as a very egregious situation, come in and say independence has been proven to be impaired because of consulting.
The counter-argument that consulting improves audit quality I think is also unproven. I think firms separate consulting and auditing. In my own experience, for example
-- I won't relay the point in the statement -- that at one point I favored internal audit out-sourcing for the same reasons as the CPA firms have testified. It seems like it has a potential for improving audit effectiveness.
Having seen some cases where it has actually worked in operation, it's my conclusion that the independent audit did not benefit in any way from the internal audit out-sourcing and that the involvement in being an arm of management, which internal auditors inevitably have to be, did, to some extent, impair independence.
So for those reasons, I would urge you that the restrictions on non-audit services are necessary. I don't want to take too much time, but when I compare what'shappened with journalistic organizations that inevitably, when they become a part of larger organizations, there is, inevitably, a dilution of journalistic values. I think that can happen with CPA firms also.
CHAIRMAN LEVITT: Mr. Verschoor.
MR. VERSCHOOR: Thank you very much for this opportunity to be present today. As a matter of introduction, my perspective is long-term. I passed the November 1992 CPA exam when, of course, it was much more difficult back in those days. And it's varied.
And before I joined academia, I was an auditor with Touche Ross and their national education director for ten years and then was chief accounting officer and chief internal audit executive of several large international public corporations.
I would like to try to put a new thrust here that what we need to think about is better ethical performance. We have a code of conduct in the AICPA that really sets forth a lot of the things that we need to do, of which independence is one, but there are other indications.
John Biggs -- where a lot of us in academics have, most of or much or some, at least, of our personal fortune --he went back to New York to work for us, and I'm glad to see that, he described an ethical dilemma.
The hole was there, and it's the auditor that had the ethical dilemma didn't want to spend the money to go out to take a look at the hole. He would have known that the hole was a hole if he would have ever looked, but he faced an ethical dilemma and made a poor ethical choice.
I agree with the thrust of what you're attempting to do. I think the staff did an outstanding job of presenting the background of why we're here. As a matter of fact, I think they may have even understated the case.
They didn't even mention the pressures that auditors now face because so much of executive and even down-the-line compensation is based on stock option gains. And so here an auditor really should take a look at putting a function in their consulting for the actual compensation of what the CEO and even the CFO is going to be paid.
You're talking about, really, a conflict of interest of having a CFO determining his own paycheck by deciding what the numbers that are going to be reported to the public are.
Taking a look at scope of services, I'd ask that perhaps maybe you want to take a look, in view of the interest that you've shown, in the numbers of what people are reporting as consulting and auditing.
The SEC Practice Section, I called them. They don't provide any guidance on what the firms put in thisbudget of accounting and auditing. And really, auditing is almost, kind of, nonexistent nowadays because it's assurance business advisory services.
Internal auditing out-sourcing, of course, is one of the big items that's in what they're calling accounting and auditing, and some others are as well. So it's the same non-audit services. Perhaps we ought to be looking at non-financial statement audit services, services that aren't related to the audit of financial statements.
Back in 1995 I did some research for the Bank Administration Institute of bank auditing costs. For respondents that had over 3 billion in assets, fees for services other than the annual financial statement audit amounted to more than 60 percent of the audit fee, which I consider to be very significant, not 100 percent, as I think Professor Coffee said he would be disturbed about that.
For 43 percent of the cases, so more than half --or almost half of the banks were paying back in 1995 more than 60 percent of their audit fee in other services. So I think we ought to be looking at -- I disagree with Professor Coffee. We ought to be looking at the profitability of other services that are likely to be much more profitable than just the revenues. We ought to be looking at what their profitability is.
So the bright line, if you choose to have one, inmy view, should be much lower, 10, 15 percent of the audit fee, not any 25, 50 or even 100 percent.
The scope of services issue. I'm sure you're looking at Microstrategy. I mean, my gosh, that looks to be like a classic case where the partner-in-charge of the office knew what to do, and he didn't do it.
Now, we'll never know why he didn't do it. He didn't call the national office. The rules say you've got to call the national office. He didn't do it. This is in the New York Times. It's a very clear article.
So it's just unreasonable to prove cause and effect like you're having a laboratory experiment. You're just not going to show that you can prove one thing or another. I hope my colleagues in the psychology department would agree with that.
I guess I forgot in my introduction to also say that now that I'm retired, why I'm an investor, and I'm mad that, you know, Bank One doesn't seem to get the word on what you're talking about on big bath adjustments, big bath reserves. A billion, nine. I know you're busy, but please, I hope you're looking at Bank One. If that isn't a big bath -- and they're coming out saying, "Oh, yeah. Everything's going to be great after that because we won't have to have any bad debt expense." Sure. Anyway, sorry.
And another one, Mattell. I lost money on thatone, too, where the whole thrust of the doggone issue is that they relied on faulty financial statements when they bought Learning Corporation, and yet the attorneys aren't suing the accountants. It's too hard now.
That's where I'm agreeing now with Coffee that it's too hard now because of the new laws. Well, sorry about that.
Down to the general standards, I believe that when we're measuring appearance we ought to take into account other stakeholders. I know stockholders, investors is the first item, but we ought to mention other stakeholders, too, because other stakeholders are going to rely on this information.
And also, I agree with the four generally, but I think there ought to be a fifth governing principle that would determine when an auditor is independent, and it should be a behavioral principle. I was very interested in hearing the psychological testimony that we just heard.
We ought to make a statement that when an auditor either has any relationship or engages in any activity that gives the appearance that independence may be impaired that that's something that ought to be proscribed.
If you say, "Well, how do we enforce that?" well, we do have an existing ethics rule forbidding acts discreditable to the profession. So that's a behavioralrule. We already have one, and I think we need another behavioral rule that deals with the ethical concepts of the foundation of our profession.
Okay. Down to non-audit services. I would hope that this whole -- I was disappointed that Chairman Allen didn't clarify whose responsibility it was to talk about the ethics regarding non-audit services, because the Ethics Executive Committee was the one that came out with a release on non-audit services.
And yet, the Independent Standards Board is supposed to be doing that, I thought, but then -- anyway, in the omnibus '99 ethics release, we've still got the Ethics Executive Committee talking about non-audit services.
With respect to the issue of internal audit out-sourcing or out-sourcing of the internal auditing function, I've written extensively on this as far as back as 1993, and maybe your files have some of my diatribes on the first total out-sourcing of internal auditing that was with our Chicago company Commonwealth Edison.
The literature is very clear. Internal auditing is a management function, and to have the whole function, which is what really is connoted when you're talking about out-sourcing to the same firm that you're doing -- that's doing the external audit, that's a contradiction and ought to be proscribed.
Internal auditing is different than external auditing. There are different objectives, different standards. The firms have different staffs that do it. "Out-staffing" was a term that I tried to coin. Firms didn't like that at all.
On to quality controls. It seems incongruous for firms to be required by auditing standards to evaluate a client's ethical control environment or corporate culture as a part of every audit engagement, and yet, with one exception, the firms have no counterpart control mechanism themselves.
Clearly, maintenance of professional behavior that protects the public's interest is too important a subject for firms to continue to ignore the control mechanisms that have been made a part of U.S. jurisprudence.
I'm talking about ethics programs that are the keystone of the Defense Industry Initiative and has been adopted by the overwhelming majority of large public corporations. The Ethics Research Center here in Washington came up with recent results of their survey that -- again I've done some research that shows the beneficial aspects of a code of conduct for corporations. Ethics Research Center has similar results.
So that's what I'm urging, two things: One, adding a behavioral rule to your general rules; and secondly,encouraging the CPA profession to assume a leadership position in ethical behavior by developing and implementing a world class exemplary ethics and business conduct program under the oversight of the hopefully to be soon reinvented Public Oversight Board.
CHAIRMAN LEVITT: Thank you very much. Dr. Verschoor, you touch on something that I think few of our witnesses have mentioned today, and again that is because this profession, in my judgment, has been given a special franchise.
And because of that franchise I think they have a special responsibility, and that responsibility is one we hear less of than I think I'd like to, and that is the public interest.
So much of the dialogue through the years has related to rights and wrongs and what we should do and what you can make us do, and so forth, and, in some ways --Dr. Carmichael, I note that you have been associated as a vice president of the AICPA -- it should be partially the responsibility of an organization that is at least partly a self-regulatory mechanism in the absence of a legislated solution again to talk about the public interest rather than to be merely a trade association.
And the whole question of public perception is so subtle and made up of so many different parts that the kindof fortress mentality in which this dialogue has taken place defies the rational solution that is the only answer.
I don't believe any set of rules as such represent the total answer. I think unless there is a recognition of the issue and the importance of public perception, as Max and George, your studies have touched upon, I think there is going to constantly be a kind of tension which will not lend itself to a solution.
I really wish that all participants recognize that the public interest will best be served by a clearer understanding of what the issues are not to be determined in a court of law, not to be determined by a specific set of rules and regulations but, rather, by an understanding of the importance of perception and how that must be addressed and how behavior plays a part in that.
This is not a short-term issue. This is a cultural change that we're calling for, and that doesn't come easily.
MR. VERSCHOOR: Well, I think that's your tough decision to decide whether one organization can be part of the regulatory framework of a legislated monopoly and at the same time be the advocate of an organization -- or of a profession that wants to have all the advantages of free enterprise. Is that asking too much for one organization? I think that's your tough decision.
MR. BAZERMAN: It sounds to me like your life wouldbe much easier if the leading auditing firms had, sort of, taken up this issue and put forward a set of recommendations that were acceptable over recent years.
But I would point out that you've been arguing for stronger forms of independence for a while. There have been many, many articles written in the press over the last eight years which I've tracked down, and I'm shocked to see just the magnitude of press around this issue.
And despite all that activity primarily there has been denial, and there's been an emphasis on where is the evidence of a single audit being tainted, which, as we've argued before, you're never going to find it because we're talking about observing judgment.
We can simply make inferences, as Mr. Bogle suggested, that even if we don't know which ones we do know audits are being tainted. And the industry isn't coming forward with proposals up until the point where they are forced to, which they were recently on the investor issue.
But we continue to see denial of a problem on the issue of cross-selling and consulting services. So from my perspective, the hope that I hear in your comment is well-placed three or four years ago, but the industry hasn't responded to that hope, and that's why the Commission is faced with a tougher task.
MR. LOEWENSTEIN: I'd like to add that I think theproblem doesn't lie in public perception; that, if anything, public perception is probably too optimistic, that the public has the same, kind of, implicit model of auditor psychology that the auditors themselves have and that the public probably thinks that with improved oversight or sanctions that the problem would go away.
And that, in fact, the problem is deeper than the public probably recognizes and that improving the public perception wouldn't take us very far in the right direction.
MR. CARMICHAEL: The lack of public interest perspective in the standard-setting process of the profession is a much deeper and broader problem than just the independence issue.
And I think it's reflected in the way independence has been dealt with and the denial that consulting services can impair independence and the unwillingness to deal with the problem.
And to continue -- it's just a small piece, but the refrain for over 30 years when the Cohen Commission did point out that there was a consulting service impairment of independence, for every group that followed to come and say no case has ever been identified I think is a symptom of the problem.
CHAIRMAN LEVITT: It plays out in many different ways in many different forms. As you probably know, whensome of the great tensions between the business community and the accounting standard setters developed, it's interesting to note how loud the profession is in support of the standard-setting process.
Perhaps one of the greatest debates on that issue took place seven or eight years ago with respect to how to account for stock options, and the FASB stood virtually alone on that issue again because the tension between client interest and a regulatory standard-setting judgment was put into play. So it's in many different areas that this does play out.
MR. BAZERMAN: Can I make one more quick comment on that issue? In terms of the public interest, the partner we heard from earlier from Arthur Andersen argued that the marketplace would help solve the problem.
What I think is important to note about that comment, which I disagree with, is that that would be true if auditing was only for the client rather than for other public sector purposes as well.
So that the shareholders and the marketplace will react in terms of the incentives of the client but not the many other constituencies that depend on the audit, and that includes the public service that you're addressing.
COMMISSIONER HUNT: Well, obviously, I want to join with my colleagues in thanking you all for coming andthanking you for your thoughtful comments.
I like the characterization, Professor Bazerman, of a state of denial. I think that's what we have seen, in some instances, that unless we have a smoking gun there's just no problem with which to deal.
And I think that has been a huge mistake for a long time, and that's probably one of the reasons we're sitting here today, because we think it's a huge mistake to accept that view of reality. It's just not, in my judgment, accurate. But thank you very much for participating in our deliberations today.
COMMISSIONER CAREY: What I would like to add is more an observation than a question. I am somewhat concerned on the conclusions of some of the panelists are that there does not exist within the accounting industry any possibility of getting an unbiased result, and there's no such thing as an independent audit.
I would hesitate to join in that conclusion because it's not the place where the Commission has come down, or am I mistaken in my interpretation?
MR. LOEWENSTEIN: If that's directed towards me, I wouldn't characterize my view that an independent audit is impossible, but I would say that the structural arrangements that exist now make it very likely that many audits are not impartial.
And as we've been discussing all along, it's impossible to determine which ones are impartial and which ones are biased, but my colleague, Professor Bazerman, identified three different structural arrangements that ultimately are going to bias some fraction, and maybe a large fraction, to some degree of audits. So --
COMMISSIONER CAREY: I guess --
MR. LOEWENSTEIN: -- statement sounds extreme, but, in fact, it's not really that far off in terms of my own views.
COMMISSIONER CAREY: The instance I would, sort of, posit is that if you have the results that you've gleaned from your subjects, if you take instead people who have invested tremendous amounts of work, energy and years into obtaining a professional pedigree, what they have to lose needs to be evaluated, because should they lose that reputation they can never work again.
MR. LOEWENSTEIN: Just one point on that. I think the recent episode of Price Waterhouse Coopers is very instructive on that. As I read the articles in the paper, the partners were informed that their investments were going to come under scrutiny. They were actually given warning, and they didn't act to divest themselves of the investments in the firms that they were auditing.
This is a very unusual situation in which peopleare actually being warned that their investments are going to come under scrutiny. In the typical situation, there is no warning, and yet they didn't divest themselves.
So the prospect of sanctions like losing your license, various types of sanctions are likely to be very remote, even more remote than the possibility of sanctions were for the Price Waterhouse Coopers partners who were actually warned.
MR. BAZERMAN: If I could draw an analogy to Mr. Bogle's comments, because he tied this issue to the mutual fund industry, which is focused much on marketing, and the interesting effect is that index funds out perform three-quarters of the mutual funds out there.
And if you got honest opinions from mutual fund managers, most of them believe that they're going to out-perform the market not because they're liars but because they're biased in their interpretation.
COMMISSIONER CAREY: And they believe they'll be the one out of four.
MR. BAZERMAN: They'll be the one out of four.
CHAIRMAN LEVITT: None of us have talked about, however, what I regard to be a very real disincentive to not manifesting obvious independence standards or standards of obvious independence. And that is the very fact that their reputations are on the line every time they provide astatement, and I don't want to disregard that.
This is not that clear cut an issue. We're not dealing with a bunch of hide binders on one side and a group of moralists on another side. We're dealing with what I regard to be a very subtle cultural change, an important one. In spite of what you have said, I do not think that the only answer or the best answer is a take it or leave it regulatory fix. I think there is more to it than that.
I think there has to be some greater understanding of the problem and greater understanding that, like so many other things, it's in the long-term interest of the profession to avoid the fortress mentality that presently exists in denying what is a real perception and standing apart from being part of the solution.
And I think only when the sides can get together and work towards this constructively are we going to make any progress.
MR. BAZERMAN: I think it's important to recognize that we weren't accusing any auditors of being corrupt, just being human. And because they're human, that means that they're going to be biased as long as the firms that hire them and can fire them are one and the same with who they are auditing.
CHAIRMAN LEVITT: Sometimes regulators are human as well.
MR. BAZERMAN: Absolutely.
MR. VERSCHOOR: This issue has been researched. The Scottish Institute of Chartered Accountants back in 1993 issued a report called "Auditing Into the 21st Century" in which they said that this issue was so strong that there should be a panel from the stock exchanges that appoints the auditor, determines their compensation, so on and so forth.
They've also come out with a follow-up that the Scottish Institute and the Dutch Institute have worked together on. They asked me to write a preface, and I did it back in March, and it was supposed to be published in May. Here it's July, and I haven't heard about it. But still, this is on the literature front.
CHAIRMAN LEVITT: We greatly appreciate your testimony and the sincerity with which you speak and the very different kind of analysis that you bring to this issue, which is very helpful for us. Thank you very much.
Okay. Last but not least we have Dan Goldwasser of Vedder, Price, Kaufman & Kammholz; Alfred M. King, who is Chairman of the Board of the Valuation Research Corporation; and Nimish Patel of Pollet & Richardson.
MR. GOLDWASSER: Thank you, Mr. Chairman. I am Dan Goldwasser of Vedder, Price, Kaufman & Kammholz. I want to thank you for inviting me here today to testify and also for listening to the comments that have been made before me, mostof which were very interesting and actually helped me change some of my views so that the materials which I previously sent down to you will not completely parallel the remarks which I'm about to make.
As by way of background and full disclosure, I started out my career as a corporate securities lawyer representing a lot of small companies who did public offerings and, therefore, have the perspective of those companies which the recent Coso report found to be the source of a predominant number of financial frauds.
I've also spent a great deal of my time as an advisor and defender of the accounting profession. I represent about 125 accounting firms and have defended them in approximately 200 lawsuits involving audit and other accounting issues. And so I have a background of where audit problems arise from.
I'm also a member of a public company board and serve on its audit committee, and I'm a member of the ABA Law and Accounting Committee and Federal Regulation of Securities Committee, and I now chair the National Conference of Lawyers and CPAs.
I want to applaud the Commission for its efforts in this area. I think the Commission's foresight in recognizing that the importance of financial statements to the securities markets has been critical to the growth of the capitalmarkets in this country and making it the center of capital markets throughout the world.
I do have some deep concerns about the proposal, however, which I'd like to share with you today. My fuller comments are set forth in my letter.
My first concern is that it does not address what I consider to be a fraud which has been perpetrated not only by the accounting profession but by its regulators for many, many years, and that is it does not deal with the question of the importance, economic importance, of the client to the audit firm. Instead, it focuses myopically on non-audit services.
I think you really have to look at the client as a whole, and that is what does this client mean not only to the firm economically but to the particular office that is engaging in the audit as well as to the partner in charge of the audit.
It's one thing to say that nobody in the firm's wife or spouse owns a single share of stock in the client; but, on the other hand, if we lose this client, my husband is out of a job and out of a career. That's a fraud being perpetrated on the investing public who think that the audit profession is independent when, in fact, it has not dealt with this particular issue.
And one of the things that I would recommendstrongly is that you empower the ISB to look into this issue and look into it quickly, because any set of rules that does not deal with this really is leaving the barn door open.
My second concern is a concern which you have, to some extent, answered today, and that is that I believe that these proposals tend to undermine the position of the ISB. I think the ISB, from everything I've seen from it to date has done an excellent job in thinking through the issues and carefully analyzing that.
And the fact that much of what the Commission has proposed is drawn from the ISB testifies to that, and I would hate to see the perception that the ISB is really a second-rate agency because the Commission has brushed them aside and put out their own proposals.
And therefore, I do endorse what you were alluding to earlier; namely, to adopt the ISB proposals as a part of this simply as a reinforcement of their position in the standard-setting process.
Lastly, I would like to get to some of the particulars of the rule that has been proposed. Let's start first with the guiding principles.
I don't have trouble with the guiding principles as goals to achieve in terms of audit independence. I think they are important, although I have some questions about the concept of auditing one's own work, and I'll come back tothat in a minute.
My concern is that I don't think they work well as guiding principles. You could call them goals. You could call them concerns. But to say that they're a guiding principle raises a difficult problem because, as a lawyer, I'm faced with a problem of what happens when we have a new situation arising?
It is not dealt with by any of the Commission's rules, and therefore I must advise my client as to how to treat the problem. Well, the guiding principle that says if you have a conflicting interest with your client, then that violates independence.
Well, if there's any conflicting interest, I've got to advise my client that this impairs his independence. That may not be the case, however. So as a guiding principle, it does not work very well because you don't know where the guiding principles kick in and where they don't kick in. So I think calling them a guiding principle is a problem.
I'd like to also talk about auditing your own work. I'm troubled by the concept because I look at, as an investor myself, what would I rather have.
Would I rather have certain judgments made about the accounting whether or not we should take a reserve for a particular contingency, should we have a reserve for a warranty, should that be made by a CFO who has a financialinterest in stock options, or whatever, or should it be made by somebody outside the firm; namely, an independent accounting firm?
My own money I would actually prefer that it be made in the first instance by the outside person, not by the CFO. Because if it's made by the CFO, the outside administrator is only going to review it for reasonableness, is not going to simply put his own judgment on it.
And so the better determination, in my opinion, comes when the decision is made in the first place by the outside person, and so therefore the whole concept of auditing one's own work bothers me because I can you get a more reliable set of financial statements if judgments are made in the first instance by somebody outside the company who does not have an interest.
So that underlies a lot of my concerns about the whole consulting area, and what I would think that you ought to do in the consulting area is you've got to look at the balance, because I think many consulting services actually improve the audit.
As somebody who has had to defend a lot of accountants' liability cases, I can tell you that there are lots of things that slip by the audit. The audit concept is a test check concept. It is not one in which the auditor comes in and looks at every transaction, and therefore knowseverything from the fact that he has audited.
The auditor knows precious little. He has to make certain judgments about the financial statements based upon his test checks and his checks of a firm's internal control. It doesn't give you a great deal of assurance.
And so for my money, the more the audit firm knows about the client the better the quality of the audit, and so I would look at those consulting services which actually adds to the auditor's knowledge of the client's management, the client's internal controls and the client's overall operations.
Those, in my opinion, would benefit the quality of the audit, and I would be very reluctant to throw those out too quickly simply to maintain the appearance of independence.
Independence, in my view, is a means to an end. It is a means to help achieve quality audits. The end, of course, is to achieve the quality audit, and where the independence rules conflict with getting quality audits I think independence as a concept must give way. That's my own personal view.
CHAIRMAN LEVITT: When do you think they conflict?
MR. GOLDWASSER: Well, I do think that they conflict if you say that you're auditing your own work, and therefore that impairs independence. I think there is aconflict there because I think there is a net plus, as I explained earlier, from doing some of the work by having the outside audit firm do some of the work in the first instance. I think that's a conflict.
Let me go on further and talk about the disclosure. I'm concerned about disclosure. As a securities lawyer, I'm schooled to believe in disclosure, but in this particular case I have problems with it, and I have three particular reasons why.
First of all, I think that people rely upon the system in terms of audit independence. We heard Mr. Biggs earlier today talk about all the companies that he gets and how they have to rely on the financial statements and how they assume that the auditor who audits those financial statements is independent, and I think that's true. They assume. What is he assuming? He is relying upon an overall system. He's relying upon the integrity of this Commission. He's relying upon the integrity of the audit firms. He's relying upon the enforcement proceedings brought by this Commission and by state accountancy boards.
All of this goes into the system. That's what he's relying upon, and to say that he's relying upon any particular element such as whether somebody owns a stock or whether the accounting firm does so much in consulting services is nonsense. He's relying upon a whole package.
The problem of saying, "Okay. We're going to disclose this element as to how much non-audit services go," is an unbalanced disclosure. It's unbalanced because there may be lots of other factors within the accounting firm which may offset that.
The accounting firm may have systems itself that will offset that particular problem. And indeed, when you get into the whole question of how economically important the client is, you're going to find that you have to have offsetting systems. This is something that Mr. Allen referred to earlier in his testimony.
So if you simply disclose one side of it, you're not giving the investor balanced disclosure. But there's a third problem with it.
The third problem is that this Commission and the Independence Standards Board or whatever standard-setting body has made a decision as to what is appropriate. Now you're telling the reader that there are other things out there which are not comprehended by your rules.
What that really does is undermine the confidence of the reader and the financial statement user in the very system which you've established, and that bothers me. I think it undermines the system rather than enhances the system.
Lastly, I'd like to talk about the voluntaryprogram that you've got. I'm concerned about that. What concerns me is that here we have uncovered literally thousands of violations, and from my perspective this Commission has done nothing about it. The AICPA has done nothing about it. The state boards of accountancy have done nothing about it.
If it were one of my smaller-firm clients, they would have jumped on them. I think if this Commission is to maintain its credibility on the independence issue it must take action. And then to create a voluntary program on top of that whereby you're going to excuse hundreds, maybe thousands more violations I think also undermines this Commission's credibility. I think the Commission has to act. CHAIRMAN LEVITT: You're referring to the independence violations involving the ownership of stock by family members? Is that the issue?
MR. GOLDWASSER: That's correct.
CHAIRMAN LEVITT: Well, I think I have to differ with you there only because if the rules have outlived their usefulness, even though those rules were accepted by all parties, we've got to move toward a better understanding and make some judgments in terms of which of those rules are relevant to today's circumstances and which of those rules really are not.
MR. GOLDWASSER: If that be the case, then why do you do it with respect to the other four?
CHAIRMAN LEVITT: Because I think that it is apparent to us that all firms had similar problems. It isn't just one firm. All firms had those problems. Again, it's a question of allocation of resources.
Is it worthwhile for the Commission to engage in the kind of prolonged, searching, people-intensive process that was involved in Case No. 1 where we satisfied ourselves that a good deal of these violations were inadvertent and not venal, and the process we established was one where, in those instances where there was culpability, the firms were under an obligation to reveal them.
This is not the first time that that kind of resolution of issues of this sort have been arrived at. The foreign corrupt practices violations early on presented a similar problem that simply could not be addressed in any other fashion.
Is it totally without problem? No, but I think I'm satisfied it was the only practical way the Commission could have allocated its resources to bring this thing to a resolution and move on to the more fundamental issues that we're talking about today.
MR. KING: Is it on?
CHAIRMAN LEVITT: It is on.
MR. KING: Good. Thank you very much. Originally, one of my colleagues from another firm was going to join me, but he's unable to be here, so I'll try and handle it for both of us.
Valuation Research and Marshall & Stevens are two of the largest independent valuation firms in the country, and the valuation units of the major accounting firms are direct competitors.
Based on a comment from one of the presenters this morning, I can say this, that the Big 5 accounting firms did not get into the valuation business until about 1983 or '84. The industry is over 100 years old, so it's hard to say that this was a service that they innovated.
In terms of personnel and the retention of personnel on their staff, it's sort of interesting that the industry is rife with people changing jobs. Many, many people in the appraisal industry have worked for one, two, three or four different appraisal companies.
So this question about the retention of staff is not one that I have particularly great sympathy with, particularly since our firm is one of the sources for these accounting firms to develop expertise and valuation.
Neither now or at any time in the past have we believed that public accounting firms should be precluded from providing valuation services to non-audit clients. Accounting firms have just as much right as anyone to compete for business.
The valuation arms of accounting firms are good competitors. They provide excellent service at, essentially, competitive fee levels and, at times, they have recommended our firm to their clients where there is a perceived conflict.
We do feel that for any accounting firm there is a basic incompatibility between developing value information for a client and then auditing that same information. Let me give you an example.
In a business combination accounted for as a purchase, and the current FASB proposals may require that all business combinations be accounted for as a purchase, there is a lot of professional judgment required in separating out the fair value of tangible from intangible assets.
Further, additional judgment is required in determining the appropriate lives to be assigned to each asset or class of asset. The impact of these valuation assumptions on a purchase price allocation directly affects the balance sheet and the current as well as future income statements.
This information can and should be independently audited. It has been our observation that when the same firm does the original work and conducts any subsequent audit orreview that there is often little or no independent review.
We have been in numerous competitive situations over the years in which we have lost a valuation assignment for allocation of a purchase price to a prospective client's auditor.
Subsequently, upon asking the reason for the client's decision we've been told that they chose to have their accounting firm perform the valuation assignment to allocate the purchase price because, "We were told the audit would go easier if we had them do the work."
Alternatively, we have sometimes been told, "Well, your fee was lower, but our accountants said they would match your fee, and then we would save money because the auditor would not have to spend time reviewing the work." This is the real world.
On the other side, we've also had numerous situations where our clients' independent public accountants do carefully review our appraisal report. It is the audit firm's valuation professionals who typically perform this review.
Knowing this review will take place and knowing the type of questions they will ask as well as the depth of their probe keeps us on our toes in performing our work. We end up doing better work, and the client, as a registrant, obtains better and more supportable valuation answers.
There is no substitute for having the work of one professional reviewed by an independent professional.
In the United States, and the rest of the world, for that matter, we are moving towards a fair value basis of financial reporting and accounting. Both for balance sheets and the determination of periodic income, the use of value information is becoming an increasingly important element.
As examples of the U.S. GAAP requirements for valuation, look at such areas as asset impairment, IPR&D, stock options for compensation, lease residuals, financial instruments and many types of liabilities for which the exact amount may be a matter of valuation judgment.
The reason that it essentially requires a professional appraiser to review some other valuation is straightforward. Valuation principles are simple and easily understood. Determining which of many possible appraisal principles and methodologies is most appropriate in a particular situation is not so clear.
Should we use as the premise of value the assumption that the assets would be sold, or do we look at replacement value, assuming that the assets will continue in use? Do we accept management's forecast and assumptions uncritically, or do we question them closely sometimes requiring changes in such management forecasts? Do we utilize the market comparable approach to value, or is itmore appropriate to utilize the cost approach?
Answers to these fundamental valuation questions are often not explicitly spelled out in the final valuation report, and therefore a reader of the report may not realize what the truly key questions should be.
Quite frankly, many auditors, in terms of training and background, do not have the experience or expertise to understand fully the implications of the choice of appraisal assumptions. An accounting firm's valuation professionals do have this expertise.
So to sum up, then, we believe that valuation information is becoming an ever more important part of financial reporting. Valuation requires judgment. The judgment calls of an appraiser should be reviewed by those with valuation background.
If the same firm performs a valuation and then audits its own numbers, it is highly likely that the so-called review would be more for form than for substance. Self-review per se is not acceptable in this era when a single penny-per-share change in reported earnings can swing the price of a stock 10 percent or even 20 percent or more.
A change in valuation assumptions will often affect earnings by way more than a penny a share.
You've asked for comments on the costs and benefits of your proposals. It is our considered opinion that, ifyour proposals are adopted, costs for registrants may increase slightly. Our analysis is follows:
When audit firms perform a valuation for their audit client, the valuation fee is usually non-competitive. Our experience suggests that in this instance the valuation fee tends to be higher than what the client might have paid to an independent appraisal firm or another Big 5 firm.
Offsetting this is that less audit time and fee is incurred in reviewing their own work. If audit firms are precluded from performing valuation work for their audit clients, they will most likely spend more audit review time on the valuations prepared by other firms.
On balance, there will likely be a slight increase in total costs for registrants.
Offsetting this, we believe that there will be significant benefits. Valuations will be better than inasmuch as they will be subjected to additional scrutiny.
It's human nature if one knows that a peer is going to review one's work one will try just that much harder to avoid undue criticism. Additional oversight by a second firm will challenge the appropriateness and supportability of the key assumptions that go into every appraisal and valuation report.
As ever more financial information is affected by requirements for fair value, it will become increasinglyimportant for valuations to be reviewed independently even at slight additional cost.
CHAIRMAN LEVITT: Thank you very much. Our final speaker this evening, final witness, is Nimish P. Patel, and I greatly appreciate your coming here from California. I'm interested that part of your background in securities has been the representation of so-called new economy type companies.
Arguments have been made in opposition to some of the notions put forward by the Commission in terms of the fact that we are inadequately supportive or inadequately sensitive, I should say, to the needs and the imperatives of the new economy.
You come from the new economy, and we'd be interested in your thoughts.
MR. PATEL: Well, good evening and good afternoon, whichever the course may be. Mr. Chairman, Commissioner Hunt and Commissioner Carey, my name is Nimish Patel, and it's truly an honor and a privilege to be here today to provide testimony to the Securities & Exchange Commission.
By way of background, I am currently an attorney at the law firm of Pollet & Richardson based in Los Angeles, California. My area of concentration is corporate securities law for both private and public companies.
I received my law degree from the University of SanDiego in 1998. In addition to my legal background, I have a master's in business administration and am a licensed Certified Public Accountant, though I am not a practicing CPA. Finally, I am also an investor in the U.S. securities markets.
My law firm does not represent any national or local accounting and auditing firms, nor am I here today to represent any particular group, association or organization.
I requested the opportunity to testify here today simply to provide or impart any personal knowledge I may have had regarding the proposed rules governing auditor independence.
My background allows me to comment on the proposed rules from various sides. As a former auditor from the national accounting firm of Deloitte & Touche, I was subject to the current auditor independence rules as they exist today, so I am familiar with the duty and the burden of being independent.
As a legal counsel for publicly-held companies, I assist my clients with their registration and reporting obligations with the Securities & Exchange Commission, and, as a result, I have the opportunity to work with auditors who practice before the SEC.
As an attorney, we are not governed by the principles of independence, unlike my auditing counterparts. I have over the years seen a trend of non-audit services being provided by audit firms. I do believe that certain of the non-audit services being provided by audit accounting firms do jeopardize their independence.
Finally, as an investor in the U.S. securities markets, I frequently review the audited financial statements as part of my due diligence in selecting companies to invest in.
I believe that today's proposed rule will continue to ensure investor protection and further increase the confidence that investors have in financial statements.
Let me begin by stating that I support the proposed revised auditor requirement rules and that, in my opinion, it fairly balances the interests of the public and the burden it places on the accounting profession.
We have heard today that the nature of the accountant and the client relationship in itself creates a violation of the fundamental principle of independence, since the very auditor that is rendering the audit opinion is also being paid by the company.
Short of having the accounting profession voluntarily provide their audit services as a pro bono public service I do not believe that the costs and the burden placed on the accounting profession and on the taxpayers justify a resolution to this problem today.
The proposed rules, as written, attempt to ensure that independence is maintained, given the fact that there are many relationships that can exist between an auditor and his or her client.
Is independence a factor the public benefits from? I certainly believe so. Without independence there can be no credibility or comfort on the opinion of the audit firm that so many groups rely on, including creditors, stockholders, investors and other stakeholders.
Unlike the legal profession and other service organizations that serve companies, auditors cannot be advocates or allies to the company. The auditor's role must be limited to being independent observers and to report the financial statements without any undue influence from the internal or external sources.
Why is the profession of accounting, unlike the other professions such as legal, treated so differently? From my own experience, I believe it comes down to the point of whom the profession represents.
An attorney represents his client's interest only, within the law but senior to all others. As an attorney, we are required by the professional rules to zealously represent our clients in the most favorable light.
Auditors, however, owe a fiduciary duty to the public, including creditors to the company and investors inthe company's securities. Because of this duty to the public auditors cannot be placed in a situation which would cause a conflict of interest or would cause the public to question the integrity of the auditor.
During my years as an auditor I did not have direct financial interest in my financial clients because of a general prohibition against independence in fact and in appearance. I must admit, however, it was tempting.
Putting aside the issue of insider information, a person who has an opportunity to review and analyze each line item of a company's financial statements, observe and confirm the assets and liabilities of the company and have the opportunity to interview management on the fluctuation of their ratios would indeed be deemed to have a wealth of investor knowledge.
Such knowledge is priceless in making a determination whether to invest. As auditors, we are charged with a duty to remain independent both in fact and in appearance. I urge the Commission not to view this burden placed on auditors lightly. It is never an easy task to abstain from prudent investing or, worse, requesting a family member to do so.
The national accounting firms have an excellent reputation for their professional standard of care. They invest what seems to be large sums of funds and resources inproviding their employees with the most current technology and up-to-date information regarding the practice of accounting and auditing.
There is no doubt in my mind that the national firms are dedicated to ensure the high quality of their work and are willing to take all necessary measures to ensure the independence of audit professionals.
As indicated in the proposed rules, accounting firms and the public benefit when firms have effective quality controls that ensure the independence of audit professionals. These controls protect the public and the firms on whose audit the public relies.
Public companies benefit as well since they are able to access capital at a lower cost through the capital markets. As a result, for those firms that have certain quality controls, the proposed rules provide a limited exception from the independence rules for certain independence failures.
My comment to the Commission is why do the rules stop short in that it only encourages firms to have quality controls rather than making it a mandatory requirement.
Generally Accepted Auditing Standards does require that certainly internal controls be present to provide reasonable assurance that personnel maintain their independence. Therefore, imposing a mandatory requirementthat there be quality assurance would not be too much of a burden to the auditing firms.
An audit firm that recklessly fails to take reasonable measures to ensure independence which causes an investor to detrimentally rely should be accountable and liable under the federal securities laws.
Finally, I would like to take a moment to talk to you briefly about the importance of the audited financial statements.
Earlier on, Mr. John Biggs, Chairman and CEO of TIAA/CREF, illustrated the perfect example. His firm invested in a company that was audited by a Big 5 accounting firm. The company inaccurately stated an asset on their financial statements.
The audit firm failed to detect the inaccuracy. TIAA/CREF relied on the audited financial statements to its detriment, causing a loss of millions.
Assuming that the problem was not due to independence, this example illustrates a perfect example of how much importance investors put in the audited financial statements. Without the audited opinion investors would have to do their own due diligence and work which increases the cost of capital to the company and makes it a less efficient market.
This Commission has done wonders with proposingthis rule. I want to bring to your attention that the slogan that's outside of this door of William O. Douglas, "We are the advocates of the investor," and I think today these investors are, in fact, advocating on behalf of the investor. CHAIRMAN LEVITT: Thank you.
COMMISSIONER HUNT: Well, first, obviously, we want to thank all of you for taking the time to appear before us on what we regard as an important series of issues.
Mr. Goldwasser, I really appreciate your being forthright with us in terms of the positions you took that are contrary to some of the proposals in our rules because we need to hear from all sides of this from everybody, and we will take your comments into serious consideration.
I'm sorry you disapprove of our voluntary program with respect to the other auditing firms, but I think, as the Chairman explained, we thought under the -- if you will give us all the money we need, we would go about doing something else even at this late date.
But as you know, we don't have that kind of resources, but I do appreciate very much your forthrightness in talking to us about your views.
Mr. King, I appreciate your comments on the valuation of assets in a merger and acquisition position and how if the same firm is doing it originally and doing it in the final analysis that almost creates an obvious conflict ofinterest.
You're not going to put as much time into auditing your own firm's work as you would put in as an audit firm evaluating your firm's work. I mean, that's just human nature. "We've done it once. We don't need to do it again." So that is a real conflict.
I think I agree with you that there might be an increase in cost, but I think for most firms, although I am more concerned about the smaller firms, the small banks that have been talked about here, the country banker, I think the Chairman mentioned, for some small firms, the separation of the services may impose a considerable burden vis-a-vis the size of those firms.
But overall I think that the possible increase in cost that arise if an audit firm is precluded from being the original evaluater of assets is well worth, in most cases, the marginal cost that will be increased in a merger or acquisition. So I appreciate that comment.
And Mr. Patel, thank you for coming. Thanks for your views as an auditor, a former CPA and a securities lawyer. We still are trying to be the investor's advocate. I hope we will continue to satisfy you that we are. So thank you very much all.
COMMISSIONER CAREY: I'd also like to echo Dean Hunt's remarks in thanking all of you for being here. I wantto particularly thank Mr. Patel, who, as a young professional, had to undertake some sacrifice to spend a day here with us, and I applaud you for that.
I do want to add one point of clarification, which is on our look-back, and that that was a voluntary agreement, and we often do enter into voluntary agreements when we are able to assess that it would benefit investors to be able to reach a consensus agreement and be able to move forward from there. And I think that this was a very well-made decision, and I thank you.
COMMISSIONER UNGER: Not to be outdone by my colleagues, I join them in their thanks to you. I apologize for not being here for all of the panel. Unfortunately, I had some previous engagements I couldn't get out of.
I do think that you raised an interesting point, though, which really goes to, perhaps, a more fundamental question of independence. Does the person who pays the bill, can they ever actually be independent, or can the audit ever actually be independent?
Fortunately, we don't have to go that far in resolving the issues before us, but I guess that does raise the other end of the spectrum in terms of the range of ideas that we are looking at and what's out there.
So I appreciate that perspective and perception which, as we have talked about a lot today, is part of thereality of what we're looking at.
The one question I did want to ask was what impact do you think, Mr. Goldwasser, the firms that now have separate consulting firms or are in the process of separating out their consulting services, what impact do you think that would have on the firm overall?
MR. GOLDWASSER: It's hard so say. I'm concerned. My concern is the quality of people who will do tomorrow's audits. There is no question in my mind that the consulting services are viewed as value-added services.
That means that they provide more value to the client, at least in the client's eyes, and therefore, the client is willing to pay more on an hourly basis for those services.
If you take those services away from the firm, you make the firm less profitable. And I disagree with some of the gentlemen who spoke earlier from the accounting firms. I think they're also the faster-growing services.
It's a younger market. It's a more wide-open market, and the audit service market is actually a fairly filled market; it's a mature market. So I think that there is going to be more growth there.
The key factors in attracting good quality young people are is the firm going to be profitable? Is it going to have a position of partnership for me down the road? Andgrowth and profitability are the key to those particular decisions.
So I think that there will be a negative impact in the long run on the quality of person that goes into the audit firm if you divorce the consulting firms out.
COMMISSIONER UNGER: So you think, then, that audits would suffer overall because the talent won't be at the firm where the consulting practice isn't?
MR. GOLDWASSER: That's my concern.
COMMISSIONER HUNT: Mr. Goldwasser, would you be concerned if they could do consulting work for non-audit clients so that, you know, they have this -- or do you think that would be less efficient?
MR. GOLDWASSER: No. I think that's fine, and I would love to see them do that. My concern in that regard is what one of the gentlemen from the accounting firms said this morning.
That is, if you've got a consulting practice that can only service 75 percent of the market, as opposed to 100 percent of the market, will they stay around? Is it not worth more to be separate? And my answer is it's probably worth more to be separate.
MR. KING: In terms of responding to your comment about attracting and retaining staff, we are competing with the Big 5 firms for attracting and retaining staff. And thefact that we don't have this vast array of services has not impinged on us in any way whatsoever.
By the same token, the Big 5 firms don't seem to have had any trouble in attracting people to their valuation staffs, so I'm not sure this is a real issue.
CHAIRMAN LEVITT: Well, again, we've finished seven minutes ahead of schedule.
COMMISSIONER HUNT: By taking away all of our breaks.
CHAIRMAN LEVITT: And there hasn't been a single witness or a single panel today that hasn't, in some way, impacted my thinking about this issue. We owe you an enormous debt of gratitude. Thank you very much.
COMMISSIONER UNGER: Thank you.
COMMISSIONER HUNT: Thank you.
(Whereupon, at 5:25 p.m., the proceedings were concluded.)
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