UNITED STATES SECURITIES & EXCHANGE COMMISSION
HEARING ON AUDITOR INDEPENDENCE
Wednesday, September 20, 2000
PROPOSED AUDITOR INDEPENDENCE RULES
William O. Douglas Room
Securities and Exchange Commission
450 Fifth Street, N.W.
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner
JONATHAN G. KATZ, Secretary
DAVID M. BECKER, General Counsel
LYNNE E. TURNER, Chief Accountant
Opening Statements by the Chairman and Commissioner Hunt
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
SENATOR HOWARD M. METZENBAUM
on behalf of Consumer Federation of America,
Consumer Action and Public Citizen
Director of the Office of Investment, AFL-CIO
Legislative Counsel, Consumers Union
Attorney General of Connecticut
WAYNE A. KOLINS
WILLIAM D. TRAVIS
National Director of Assurance
BDO Seidman, LLP
Managing Partner, McGladrey & Pullen, LLP
HOWARD M. SCHILIT
Litigation Support Consultant
Lane Gorman Trubitt, LLP
President, Center for Financial
Research & Analysis, Inc.
JAMES J. SCHIRO
PHILIP A. LASKAWY
Chief Executive Officer,
Chairman and Chief Executive Officer,
Ernst & Young, LLP
THOMAS M. ROWLAND
Principal, Kohn Financial Consulting,
representing Association for Investment
Management and Research
Senior Vice President, Fund Business
Management Group, Capital Research and
ROBERT L. RYAN
JAMES W. BARGE
Chief Financial Officer, Medtronic, Inc.
Controller, Time Warner, Inc.
CLARENCE E. LOCKETT
Corporate Controller, Johnson & Johnson
JOHN J. COSTELLO
STUART M. GRANT
Senior Director of Litigation,
Gursey, Schneider & Co., LLP
Director, Grant & Eisenhofer, P.A.
General Counsel, Andersen Consulting
JOSEPH F. BERARDINO
JAMES E. COPELAND, JR.
Managing Partner, North America Assurance
and Business Advisory Practice,
Arthur Andersen, LLP
Chief Executive Officer,
Deloitte & Touche, LLP
Chairman and Chief Executive Officer,
American Express Company
Arizona State Board of Accountancy
Texas State Board of Public Accountancy
THOMAS J. SADLER
Washington State Board of Accountancy
Iowa Accountancy Examining Board
RODERICK M. HILLS
Founder and Partner, Hills & Stern
CHARLES C. COX
Senior Vice President, Lexecon, Inc.
PHILIP B. LIVINGSTON
President and Chief Executive Officer,
PHILIP D. AMEEN
Chair, Committee on Corporate Reporting
Partner, Goldstein, Golub & Kessler
WILLIAM R. KINNEY, JR.
Professor, McCombs School of Business,
University of Texas at Austin
JOSEPH F. LONG
President, Passavant Hospital Foundation
Chief Operating Officer, MyCFO, Inc.
P R O C E E D I N G S
CHAIRMAN LEVITT: Good morning. I want to thank all of you for being here. Today is the third of four public hearings the Commission is holding on proposed rules to ensure greater independence of America's auditors.
These forums, I believe, are a crucial part of the open and comprehensive dialogue that is so important to our rule-making process. Only through such discussions can we craft meaningful and effective rules that serve the profession and this country's investors today as well as during the decades to come.
I look forward to hearing the important views and candid remarks of each of you testifying. I thank you for your participation here today. This is an issue, in my judgment, which has enormous meaning and impact for American investors.
COMMISSIONER HUNT: Thank you, Mr. Chairman. Again, good morning, ladies and gentlemen. Thank all of you for taking time out of your busy schedules to be with us today.
As Chairman said, this is the third, I guess, of four days, three and a half days of public hearings we're going to have on this crucial issue. This issue has been around for a very, very long time.
There are strongly held views on both sides, sincerely held views on both sides. But like the Chairman, all of us, we look forward to hearing all of your valuable testimony. And again, thank you for coming.
Panel 1 (Morning)
CHAIRMAN LEVITT: The first panel features Senator Howard Metzenbaum, a man of enormous public spirit, enterprise, and energy who well represented the state of Ohio in the Senate for 19 years; Bill Patterson, the director of the AFL/CIO Office of Investment; and Frank Torres, the legislative counsel for the Washington office of the Consumers Union.
SEN. METZENBAUM: Thank you, Mr. Chairman. I appear before you today in my capacity as Chairman of the Consumer Federation of America, a non-profit consumer advocacy organization. I also have the privilege of speaking for two other consumer organizations, Consumer Action and Public Citizen, on whose board I also sit.
Our organizations, which together represent tens of millions of individual consumers, have a strong interest in investor protection issues related to auditor independence.
Our nation's current prosperity and future financial security are tied up as never before in our financial markets. For that reason, whether they know it or not, Americans are enormously dependent on independent auditors, both to the ensure the reliability of the information they use to make individual investment decisions and to ensure the efficiency of the marketplace in assigning value to stocks.
Stock prices are simply the response of buyers and sellers to information about public companies. Some of the most important information investors rely on is contained in companies' financial statements.
It is the auditors' job to ensure that these financial statements are prepared according to Generally Accepted Accounting Principles and therefore are reasonably reliable.
Day in and day out auditors must make decisions; in other words, to write off or capitalize a purchase, to depreciate over 5, 10 or 20 years, to write off or capitalize new program development, training programs, developmental efforts, and so much more.
The faith that the markets place in the pronouncement of auditors is founded on the auditors' independence. If auditors' independence is called into question, then the reliability of the financial statements of public companies is also called into question.
There's no doubt about it. Auditors today are less independent than they were just a decade ago. Having transformed themselves into multi-disciplinary professional service firms, the nation's biggest accounting firms now get more revenue from non-audit services than from their core business of auditing, and the disparity is growing rapidly.
Of particular concern for auditor independence is the recent and rapid increase in the marketing of non-audit services to audit clients. Can anyone reasonably argue that there isn't a conflict when an auditing firm is simultaneously trying to sell the audit client on a multi-million dollar consulting contract?
All the more so if the consulting contract stands to produce far greater profits for the company than the audit.
The fact that some auditors, perhaps even most, may not succumb to the pressure because of a commitment to professional independence, that's not the point. The point is that practices such as these raise serious questions about the independence of the audit. That is bad for investors, bad for the financial markets and bad for the reputation of the auditing profession.
Critics, including leaders within the accounting profession, have raised questions about the adequacy of existing independence standards for decades, particularly in light of the growing provision by auditors of non-audit services.
The Commission has studied the question for years. Chairman Levitt and his fellow Commissioners are to be congratulated for recognizing that the time has come to act.
The rule proposed is based on a simple and appropriate premise. Markets hate uncertainty, and the actual state of mind of the auditor can rarely, if ever, be known. In that context, the appearance, just the mere appearance -- good morning, Mr. Commissioner -- the appearance of a conflict of interest in an auditor can be as damaging as an actual conflict.
Therefore, practices that would seem to a reasonable, informed person to create a conflict of interest just are not acceptable. From there, the rule proposal offers four fundamental principles that govern determinations of independence. It then specifies a number of services an auditor might offer that would create an unacceptable conflict of interest if provided to an audit client.
In light of the degree to which the proposed rule simply codifies and brings clarity to existing Commission interpretations and to standards recognized by the industry, it may seem surprising that it is met with such violent opposition from some in the accounting profession, too many in the accounting profession, I might say.
This becomes less surprising, however, when you look at how dependent some of these firms have become on revenue from non-audit services. These opponents have built their case around four key arguments none of which holds water.
First, they claim auditors gain crucial knowledge about the firms they audit when they also serve those firms in other capacities. Armed with that knowledge, they are able to perform better audits.
While we agree that, in a perfect world, more detailed knowledge of an audit client should result in a better audit, this is far from a perfect world. In some instances, the auditor may ignore the conflict and produce a better, more informed audit. In other instances, the auditor may succumb to the conflict and compromise the quality of the audit. In every instance, the reliability of the audit will be subject to question by reason of the conflict.
Secondly, audit firms will be unable to attract to specialists in areas such as information technology if they aren't able to market consulting services to audit clients. Although it may not be as interesting and attractive as consulting, auditing is still a well respected, very well compensated profession.
It is therefore unlikely to suffer a dearth of talented experts any time soon. But even if you accept the questionable argument that the lure of consulting is necessary to attract the best experts, the proposed rule does nothing to prevent audit firms from attracting top talent.
After all, firms will still be free to offer those experts ample opportunities to use their skills in consulting for non-audit clients.
Third point, audit firms would be force to sell their consulting units. When they then rehire the same consultants to assist in the audit, they would have no control over their compliance with independence standards.
This argument starts with a false assumption --that the rule will force auditors to sell their consulting units -- and builds to a faulty conclusion. While a clean break between audit firms and consulting firms may be an attractive prospect, there is nothing in this rule proposal that would force that outcome.
In fact, though it has won them no thanks from the rule's opponents, the SEC has not proposed to simply ban auditors from providing non-audit services. The proposed rule fully preserves auditors' ability to provide non-audit services to non-audit clients. It even reserves the ability of auditors to provide audit clients with some non-audit services that the Commission believes would not unduly compromise auditor independence.
Having started from a phony premise -- that consulting units will have to be sold -- the opponents now attempt to throw scorn on the proposal by claiming that those firms will likely simply turn around and hire the same consultants as outside experts to assist them in the audit.
Only now, the argument goes, they won't have any control over the experts' independence. The result, they imply, is more questions about independence, not fewer.
This ignores the fact that the expert who is assisting in an audit of his or her own work or the firm's work for the audit client is hardly independent, regardless of whether he or she meets all other tests for independence.
It also assumes that auditors will have no ability to write conditions about independence into their contracts with outside experts.
Finally, it ignores the fundamental conflict that exists when a firm is simultaneously auditing a client and competing for a consulting contract from that client. Such a situation creates the very real danger that the client will pressure the auditor to lighten up in its scrutiny of the firm's accounting if it wants a shot at the potentially more profitable consulting contract.
When the bulk of the audit firm's revenues come from non-audit services, the pressure to go easy might not come just from the audit client.
Finally, and this is offered as the real clincher, opponents note that the SEC can offer no proof that an audit has ever been compromised by the provision of non-audit services to the audit client, and, therefore, the rule is unjustified.
As more than one person has noted, independence is a state of mind, and no one can see with absolute certainty into another person's mind. Therefore, unless the compromised auditor is careless enough to leave a paper trail or guilty enough to come forward with a confession, the SEC may never prove that a bad audit resulted from a lack of independence.
If absolute proof is missing, however, there are plenty of cases that raise questions in a reasonable observer's mind. Massive audit failures at Cendant and Sunbeam, Microstrategy and Waste Management, to name just a few of the most prominent recent examples, have all raised questions of whether consulting ties or incentive compensation for cross-selling consulting services may have compromised the audit.
Unless the practice of serving audit clients in due all capacities is checked, those questions will only grow. The rule is needed to eliminate this growing uncertainty about auditor reliability in the face of eroding independence.
As a parallel effort to defeat the rule, opponents have attempted to slow it down, hoping, presumably, for a more favorable political climate after the November elections. "What's the rush?" they ask. But a more compelling question is, why wait?
A problem has been identified. It has been carefully studied by the Commission and numerous outside experts. A measured and well thought out proposal has been put forward. Ample opportunity for comment and debate is being provided. It is time to act. Speaking for consumers across the country, we urge the Commission to move forward expeditiously with this important rule proposal.
I thank you, Mr. Chairman and I commend you,
Mr. Chairman, and the other members of the Commission for taking on this challenging issue at this point. I hope that you will see fit to move expeditiously and that there will be no delay.
And I, for one, say that if there is any effort in the congressional halls to put a stop or halt to your efforts between now and the end of the session, I know I and other consumer groups will be on the alert to see that such a provision not be inserted in any bills.
CHAIRMAN LEVITT: Thank you very much. Mr. Patterson.
MR. PATTERSON: Good morning, Commissioner Levitt -- I mean Commissioner Hunt, Chairman Levitt. My name is Bill Patterson. I am the director of the Office of Investment for the AFL/CIO, I want to address the impact this rule-making has on the huge amount of worker savings that are held either directly by pension funds or in 401(k) plans, stock plans.
Workers are beneficiaries of approximately 7 trillion in retirement assets through pension funds, 401(k)s, stock ownership plans. In total, these plans own approximately 25 percent of the equity of American corporations.
Members of AFL/CIO unions are the beneficiaries of over 2.5 trillion in assets subject to collective bargaining, including more than 400 billion in union-sponsored multi-employer pension plans.
While some plans are among the largest institutional investors in the country, most union-sponsored plans are much smaller, and, of course, many workers, both union members and non-union members are investors on their own behalf.
And it's on behalf of this huge amount of worker savings that I want to take up my comments. The AFL/CIO supports the proposed rules on auditor independence, and again I want to commend the work of Commissioner Hunt, Commissioner Carey and Arthur Levitt in bringing us this far in the process today on this issue.
In my comments, my initial comments, I want to join Howard Metzenbaum in focusing on one of the more controversial aspects, the prohibition of certain non-audit services to audit clients, since that's what's generating the most controversy.
The argument in favor of stricter rules limiting the provision of non-audit services to audit clients is clear and, to me, compelling. Unlike other functions for which a firm may turn to an outside provider, the audit also serves a public constituency.
Without the auditor, there would simply be no way for investors to know if the financial information provided by public corporations is trustworthy. This gatekeeper function keeps the auditor quite different from other providers of financial services.
The vast majority of audits I'm confident are carried out according to the highest and strictest professional standards, but the danger of an auditor placing a higher priority on maintaining a relationship with a client than on assuring the quality of the client's financial reporting is indeed a real one.
This danger is especially serious when the value of consulting and other services provided by the auditor exceeds, perhaps by a wide margin, the income a firm receives from the audit function itself.
A number of non-audit services provided under this proposal create clear conflicts with the audit function. If an auditor is providing valuation services to an audit client, for instance, this places it in the situation of having to critically assess and perhaps even challenge its own work.
Here I'd like to emphasize a point which has been made by a number of commentators, but I believe it bears repeating, and that is that the perception of auditor independence as well as the reality is what matters.
The strengths of the U.S. market rests more on any single factor on investor confidence. It is not enough that the auditors offer an objective assessment of the firm's financial statements. It must be absolutely beyond a doubt that their assessment is objective.
Now, we at the AFL/CIO have criticisms of the U.S. financial markets, but this is one area we are wholehearted defenders of those markets. It's the area of transparency and accountability.
And in terms of providing dependable information to investors, the U.S. is second to none, and it is an issue of equal concern, whether it's a small regionally based pension plan or to the large pension plans TIAA-CREF and CALPERS, all of these pivot around transparency and accountability.
Again, what matters is confidence or perceptions. The U.S. today is the beneficiary of an enormous in-flow of foreign capital, and this in-flow is of immense value to our economy. It is a reflection of the confidence foreign investors have in the integrity of the U.S. markets.
And to maintain this confidence to assure investors, U.S. and foreign, that the statements by which they make their decisions on can be trusted beyond a shadow of a doubt, this should be worth a good deal from the point of view of the broad public interest.
Much is made of the synergies between the audit function and the role of management consultant. However, it is unclear to us if any of these synergies are free from unacceptable conflicts which we are discussing today.
Additionally, I should also point out that the extent of these conflicts is not at all clear. The Big Five accounting firms are divided on how great a difficulty a ban on non-audit service would create for them as auditors. Two of them have already spun off their consulting firms, a clear judgment on the limited value of these synergies.
The former CEO of Deloitte & Touche has testified here recently and took a similarly skeptical view of the value to the audit of consulting and non-consulting audit services and has decided in favor of the new rule.
According to earlier testimony before this committee at least three-quarters of audit clients' purpose no other services from their auditors.
Now, this is a very competitive business, and if it is possible to run an auditing business without providing non-audit services to the same client -- and clearly it is --the benefits of combining audit and non-audit services simply cannot be that great; otherwise, why would we find any firm or any issues foregoing these benefits.
There are two issues I'd like to address next. First is the audit committee itself. Some opponents of the new rule suggest that while there may be, in some cases, a perception that auditors are not fully independent, this rule is not the way to address those perceptions.
Clearly, the only case where the auditor would come under pressure to overlook inappropriate or misleading fraudulent reporting would be the firm's own commitment to full and accurate disclosure where it was lacking.
So if something needs to be done, the argument goes, it is to strengthen the institutions within the firm that ensure the accurate reporting, particularly the audit committee itself, perhaps by requiring it be composed only of outside board members.
Now, I should make it clear that this proposal is unacceptable to our institution, the AFL/CIO. We have long been in favor of a larger and stronger role for independent directors and specifically suggested that only outsiders should sit on the audit committee. However, we don't think this should be a substitute for the current rule.
The argument's logic would suggest that there is no need for outside auditors in the first place, but there will always be companies, for whatever reason or at some point, do not wish -- they do not wish to issue accurate financial statements. And that is why we have auditors in the first place, as a second line of defense for investors.
Second, it would not address the perception
CHAIRMAN LEVITT: Mr. Patterson, we're really running low on time. If I could ask you to submit your testimony and kind of wind up.
MR. PATTERSON: All right. Let me just conclude, then.
We believe that the proposed changes to the auditor independent rules by extending the range of financial business employment relationships are deemed to create conflicts of interest and will ensure auditors are genuinely independent, and we are fully in support of the rule-making here today.
CHAIRMAN LEVITT: Thank you very much. I'm very sorry to have to curtail that. But we have such a full schedule, and witnesses are waiting to testify.
MR. TORRES: Good morning, Mr. Chairman, Commissioners. I'll try to be very succinct. On behalf of Consumers Union, thank you for the opportunity to appear before the Commission today. Of course, it is always an honor to be on a panel with the ultimate consumer advocate, Senator Metzenbaum, and we agree wholeheartedly with his testimony as well with the comments of Mr. Patterson.
Consumers Union supports your efforts to ensure that audits are the result of a credible and independent process. Technological advancements, a good economy and a host of other factors has spurred more consumers to put their money in financial markets than ever before.
Consumers who may have never thought about investing before are banking on Wall Street. While your proposal talks about protecting investors, in today's environment, what you're really talking about is protecting consumers.
Consumers have a variety of investment information sources at their disposal. The value of that information, however, is based, in part, on its reliability. A reliable audit can be a critical resource for both existing shareholders and potential investors to use in making rational decisions about where to put their hard-earned money.
The increasing amount of non-audit consulting work undertaken by audit firms raises concerns, especially where the audit and consulting work are done for the same company. Conflicts of interest, either real or perceived could lead to the appearance of impropriety and erode consumers' trust not only in the audit process but, perhaps more critically, consumers' confidence in the financial markets themselves.
It is crucial that there be no doubt as to the motivations of the firm preparing the audit. Consumers assume that an independent audit is just that, independent. Consumers shouldn't have to worry that the outcome of an audit was influenced by the relationship between the audit firm and the company being audited.
If consumers have reason to question the voracity of the information contained in an audit, the audit itself may be of little more real value than information from an unknown or unreliable source from the internet.
And if the audit firm ends up in the position of auditing its own work, it is difficult to see how this is any different than allowing the company to audit itself.
And there is another cause for concern. To the extent that audits are used by bank examiners and other regulators for purposes of determining the safety and soundness of the banking system, the credibility of those audits takes on increased significance.
Consumers Union shares the concerns raised by both the Comptroller of the Currency and Federal Reserve Board member Lawrence Meyers in his testimony just last week. Now, the Comptroller stated that an effective audit process is an essential component of risk management for the banking industry.
The audit is becoming more critical as banks expand into new products, services and technologies. Most importantly, he noted, is that the audit contributes to safe and sound banking operations. Because these institutions are taxpayer-backed, it is ultimately the American consumer, the taxpayer, who would wind up paying for any missteps here. The audit takes on a huge significance in this regard.
Consumers Union appreciates this opportunity to comment on the Commission's proposal to take steps to ensure that actions that compromise independence are curtailed. As Senator Metzenbaum has said, why wait?
Consumers Union will work with the Consumer Federation of America and other consumer groups in strongly opposing any congressional action to stall the Commission's efforts in this area. Thank you.
CHAIRMAN LEVITT: Thank you very much. Commissioner Hunt.
COMMISSIONER HUNT: Again, I want to thank all of you for being with us this morning. Senator, I think you well summarized the arguments for and against our proposed rule. We may make some modifications.
I'm not sure we will necessarily, but I deeply, personally deeply appreciate the testimony of all three of you and look forward to working with you as we go forward to craft a useful and beneficial rule for investors. So thank you for appearing.
CHAIRMAN LEVITT: Commissioner Carey.
COMMISSIONER CAREY: Mr. Patterson, it could be said that you represent more investors than any witness who has appeared before us. I just wanted to ask if you feel that the rule as proposed is something that would inure to the benefit of the AFL's investors, their ability to have confidence in the investment decisions made by the portfolio managers you hire.
MR. PATTERSON: We strongly believe that this is the appropriate way to address the potential conflicts of interest of audit committees. What anchors our support here is, as we've seen, several companies, Cendant and Sunbeam, engage in widespread auditor reform, and many portfolios of our pension funds have suffered because of this.
So we believe this is a very concrete exercise and believe this is a very important measure that directly benefits the pension fund savings of employees as well as the individual savings of workers.
COMMISSIONER CAREY: I'd love to ask you about Social Security privatization, but that will have to wait for another day. Senator Metzenbaum, let me say that the Senate has not been the same since you left the chamber.
I want to ask you, as a policy maker and a lawmaker,do you think that sound policy can be made on the basis of qualitative evidence, which is mostly what exists here, and not any empirical evidence or what our opponents have called the smoking gun?
SEN. METZENBAUM: I think it can be very well argued and persuasively on the basis of qualitative evidence. I think, as a matter of fact, it's almost self-evident in this particular case that there is an obvious conflict that exists.
And unfortunately, the conflict weighs heavily against independence rather than in favor of independence. So I would just say that I think the members of the Commission, each of you, in his or her own right, is entitled to really a tremendous vote of confidence, besides a vote of thanks for moving in this direction.
To me, it's just amazing that the issue has not been taken up publicly previously, whether by the SEC or some other body had spoken out against it, governmental body or otherwise. It's just so wrong on its face that it's reassuring that government -- people say government doesn't work, but, in this instance, I think government is working and working very well for the American consumer, for the American people.
COMMISSIONER CAREY: Well, I thank you for that, particularly because it's my belief that the American consumer has no greater champion than you.
COMMISSIONER CAREY: Thank you very much.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: I apologize for missing some of the testimony. However, I did have a chance to read it. So I guess I would start by asking Senator Metzenbaum do you have a sense from your constituents, the investors, that they are focused on the issue of auditor independence and that they sense that there's a problem or systemic issue with respect --
SEN. METZENBAUM: I'm not sure I got that question. COMMISSIONER UNGER: Well, I wasn't done with it. Which part?
SEN. METZENBAUM: Well, you asked if I had a problem, and I'm frank to admit I don't think I have the world's greatest hearing.
COMMISSIONER UNGER: Okay. Alright, well, I'll talk more directly into the microphone.
SEN. METZENBAUM: Thank you.
COMMISSIONER UNGER: What I'm asking is whether you have a sense from your membership, your constituents, not your old constituents but your new ones, about whether people are having, perhaps, a lack of faith in the financial statements of public companies? Whether there's a sense that they understand what we're talking about today?
SEN. METZENBAUM: Not overall. There isn't a general pervasive attitude of a lack of faith that they're not getting straight answers, but every so often something comes on the horizon that causes the investor and American consumer to say, "Hey, what goes here?" And it is those instances that cause a deep hurt.
Now, with a market such as we experienced in recent years, that doesn't become as much of an irritant. It doesn't become as much of a problem because they're isolated instances.
But let there be a big problem in the market, and then let some of these instances come about, and I think you'd have a large cry, "Hey, where has the SEC been? Where has the government been? Why hasn't something been done?"
And that's the reason I think it's so much to your credit that the SEC is contemplating acting on this issue before that kind of scandal develops, because there's no question about it that there have been some scandalous situations. I mentioned some of the corporations in my testimony.
But I think the confidence is still there, but it's an upbeat market. Let that market fall rather rapidly, and then let's find some defalcations with respect to the accounting procedures, and I think that you'd find really sort of a revolutionary attitude on the part of the American people.
COMMISSIONER UNGER: Mr. Torres, how about you?
MR. TORRES: I would have to agree with what Senator Metzenbaum has said. I think American consumers, from my experience, don't like the idea that they might get had, and they're investing -- a lot of people are relying on their own resourcefulness to find out information.
And the thought is -- one example in somebody else's testimony was it's like allowing high school seniors to grade their own college board exams and use that as a determination as to whether or not they get into good colleges or not, and would we have faith and confidence in them that they would do the right thing.
And I think, probably -- you know, that's one of the better analogies I've heard as far as this process goes. So while there might not be the smoking gun, there are some examples of this issue, kind of, creeping up, and if we want to encourage consumers to invest more and have some independent, reliable piece of information that they can use, then we need to keep the process independent.
COMMISSIONER UNGER: I did like the analogy of grading your own exams. However, I think that maybe that analogy goes a little too far because I'm not sure that investors really look at the financial statements themselves. It's more of what impact does it have on the companies of the marketplace and how that information is absorbed into the marketplace generally, which goes to my question to you, Mr. Patterson.
What is it that you look at in terms of what your investment decisions on behalf of the AFL/CIO, and what do you see in terms of the financial statements, if anything?
MR. PATTERSON: The auditor statements are part of what our fund professionals routinely review to make investment decisions. The integrity of these statements are very important.
Now, the individual investor, I think their interest in the process is really catalyzed again around these high-profile irregularities like Cendant, Sunbeam, Lucent and Waste Management. I think these are warning shots to investors that this is a problem that has to be addressed. So I would agree with my co-panelists here that we're looking at -- we think this is a very important measure to take in the event of the market not going just sideways but maybe even a downturn.
COMMISSIONER UNGER: And you think it's an overall confidence in the marketplace, or is this specific confidence in a company's financial statement?
MR. PATTERSON: I don't think you can separate them. I think that these are an important measure of investor confidence. The integrity of these statements are integral to just the overall confidence that investors, particularly small investors, place in the marketplace.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: I thank all of you for your testimony. I think if there is a common theme that I've heard it's that the consumer interest in this issue is something of great importance, and that while consumers may not be intimately involved in complex financial analysis they have taken for granted one of the most precious elements of our markets and the element that gives the greatest amount of confidence to America's markets, and that is the sanctity of the numbers.
And while there are not consumers outside the Commission clamoring for independence of auditors, believe me, when we have an instance of a Cendant or a Sunbeam or any of those or if there is any compromise of the audit, the sense of despair and the sense of disillusionment might have an impact that goes far beyond the immediacy of the issue.
I greatly appreciate your appearance today.
Panel 2 (Morning)
The next witness I'm really pleased to welcome to the Commission this morning is Richard Blumenthal, the 23rd Attorney General of the State of Connecticut. He was first elected in 1990, re-elected in 1994, and then re-elected to an unprecedented third term in 1998.
I think of all the attorney generals throughout the United States none has been more fearless, more effective and a more tireless advocate for consumers, the environment, children and the civil rights of Connecticut's children.
And it's a great honor for us to welcome you here this morning.
MR. BLUMENTHAL: Thank you, Mr. Chairman, and members of the Commission. I very much appreciate that, I'm afraid, somewhat overly excessively generous introduction, but I will take it and repeat it. I do thank you for that introduction and also for the opportunity to be with you today on an issue of supreme importance to the consumers of my state and the entire nation.
And I want to thank you, Mr. Chairman, for your courage and leadership and other members of the Commission in tackling an issue that is enormously complex, difficult to explain to the general public but profoundly significant, particularly at this point in our history.
And with your permission, Mr. Chairman, I'm going to very briefly summarize the points I have to make in the interest of time rather than reading my testimony.
For all the reasons that have been stated this morning already and that have been set forth to you in the two days of hearings that you've had so far and the speeches that have been given by you, Mr. Chairman, and other statements made by members of the Commission,the independencee of this auditing function is tremendously important and really ought to be guaranteed in good times. As Senator Metzenbaum said, we need to fix the roof while the sun is shining.
We will not find a great human cry. There will be no clamoring when the stock market returns are as good as they are now among the general public because of the complexity of this kind of function.
But I think that the general public does have now a confidence and a reason for confidence that they do take for granted, and we have seen in Connecticut instances of that confidence being betrayed.
I provided details in my testimony of one instance in particular involving Arthur Andersen and its involvement in the Colonial Realty investments where Arthur Andersen Consulting was performing various non-auditing functions for this investment group involved in preparing and assembling real estate designs and plans, even involved in helping to brief sales representatives for Colonial Realty, who then aided in recruiting investors, going with those sales representatives as members of the auditing team; in other words, performing even at that time, which was back in the 1990s various non-auditing functions at the same time as Arthur Andersen auditors were giving their seal of approval to the numbers that other Arthur Andersen employees had been involved in helping to prepare.
The net result of these 18 syndications and most particularly of the Constitution Plaza investments was that thousands of Connecticut investors lost their life savings, and these were not people who could afford to lose those savings. They counted on them for their retirements, for their children's college education.
They were blue collar people from Waterbury and the Hartford area who literally sacrificed their life savings as a result, and the result, of course, was investigation by my office and the Board of Accountancy, eventually the payment of a $3.5 million fine which was very, very large for Connecticut and for those days, and he repayment of $2.5 million in the fees that had been paid to Arthur Andersen.
There were criminal prosecutions. There were civil lawsuits, but the investors were never made whole. They never got back in full the savings that they had invested.
So I offer that as an instance of how the current system is inadequate to deal with this problem, but I think it also goes to the question that you asked, Commissioner Carey, of the smoking gun.
How do we know there's a problem? How do we deal with the point that inevitably is made by the other side that there has been no proven need for this change in rules?
And the problem is that when the need is proven very often the examples are so egregious that the opponents of this rule change can say, "Well, there are other laws to deal with it."
Because the problem of enforcement, as you well know as members of this Commission, that wrongdoing has to be detected. It has to be proved, and in this kind of area the evidence is very, very difficult to adduce.
And so very often what we have is simply the position of the audit management partner compromised because he or she becomes a marketer for the firm, and there may never be a judgment call that can be termed absolutely wrong or egregious but nonetheless goes over the line and is compromised as a result of that person being an advocate and a seller for the firm.
I hope that other AGs, other attorneys general across the country would join in this effort. I've spoken to a number of them. They're very interested. I think that like the public in general the complex and difficult nature of the subject matter may be an obstacle to overcome in enlisting broader support, but I am hopeful that a number of them will join this cause.
And from the standpoint of process, as I listened to questions that were posed to Senator Metzenbaum, I think this Commission is the place to do these rules. It shouldn't be Congress. This Commission has the expertise,the experience, the accountability to provide the kind of guidance that traditionally it has done.
And so I hope there will be no movement in Congress to in any way impede or impair your effort, but I would certainly add my voice to Senator Metzenbaum's and hope to mobilize other public sentiment in the event that there is.
CHAIRMAN LEVITT: Thank you very much. That story about Colonial Realty in which we had some involvement, and as a Connecticut resident I am aware of that as instructive as to what's at stake in the Commission's proposal.
You mention that Colonial paid its auditor $2.5 million for its audit and consulting work. Do you recall, by any chance, how much of that sum was for consulting and how much was for auditing?
MR. BLUMENTHAL: I do recall that a major share, I think, in fact, in the range of one half of the amount -- but I can verify that figure for you -- was for consulting rather than auditing.
CHAIRMAN LEVITT: When your office looked into Colonial, did you learn about pressure that consulting fees generated on employees to provide a favorable audit?
MR. BLUMENTHAL: The consulting fees became a source of very substantial pressure. Of course, there were also gifts to the auditors. There were family relationships that compromised the independence of Arthur Andersen in that instance, but the prospect of the business became a very important factor.
The effort of Arthur Andersen to broaden and increase its involvement with Colonial Realty, its potential future involvement drove a lot of its involvement with Colonial Realty.
CHAIRMAN LEVITT: Would you be able to submit your report on that case to the public comment file for our rule-making?
MR. BLUMENTHAL: Absolutely. I'd be delighted. I brought a copy of the executive summary, but I will have a full copy sent right away.
CHAIRMAN LEVITT: That would be great. I think we would be interested in hearing from other attorneys general about their views on this subject.
COMMISSIONER HUNT: Thank you, Mr. Chairman. I want to join the Chairman in thanking you, Mr. Blumenthal, for testifying. I think that your idea of getting other attorneys general to testify or to contribute to these hearings is a very useful idea. I hope we can somehow arrange that.
Unfortunately, you're not the only one who has had a Colonial Realty in your state, so the experience of other attorneys general might be very useful. And I, like the Chairman, I would be very interested in seeing the file of your investigation of that matter.
I don't think we need to wait for a smoking gun in order to move in this difficult area, but I think it's useful to have evidence on our side to show that it has occurred and so we're not -- though we don't have a smoking gun we're not blowing smoke. So thank you very much.
CHAIRMAN LEVITT: Commissioner Carey.
COMMISSIONER CAREY: I want to join my colleagues and thank you for coming to Washington and for providing such a compelling illustration of why steps to ensure auditor independence are necessary. And I would also encourage you to spread the word among your fellow attorneys general to act in the manner you have today.
MR. BLUMENTHAL: Thank you.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: Well, I join my colleagues in their compliments. I find your testimony very interesting. And I guess you surpass the Chairman in longevity in terms of number of terms served. Arthur has one to go.
My question is I guess in the overall case, and I don't think we want to spend a lot of time talking about the specifics, especially if you're going to give us a report, but one thing I've been curious in all of this, is is it one or two particular things that are so obvious in terms of the compromises to the audits by the relationship of the audit and consulting work done by the same firm and individuals, or is it just very subtle because there are so many issues involved in an audit that require discretion?
And, a little bit of discretion in favor of the client can go a long way, and cumulatively, perhaps, that's really where the compromise comes in, or is it just a couple of really stark examples?
MR. BLUMENTHAL: Well, I have to confess, first of all, I make no claim of expertise in this area. As I once told a court of appeals, I'm just a country lawyer from Connecticut. But I think what's most troubling is the shift in the balance of the kind of work done from, I think it was, 37 percent of the work in 1977 was auditing work by these firms now to only 30 percent. And by the same token, the rate of growth in auditing fees, I think it's 9 percent a year since 1993; whereas, the consulting work has been 23 percent in terms of year-by-year growth.
So I think to put it in sort of common sense terms, the dog and the tail have become out of proportion. The tail is now the auditing work. The dog is more and more the consulting work, and so there is more pressure on the auditor, even the best intentioned auditor, to use that discretion, tremendous discretion.
COMMISSIONER UNGER: But what about when you considerer that 80 percent of the firms revenues are coming from non-audit clients, that, in fact, they're really only providing consulting services to 20 percent of the clients that they also audit?
And when you look at the fact that they're getting 70 percent, some, of their revenues from consulting you say, "Oh, my gosh. That's unreal," but then, when you say, well, "it's only 20 percent of their auditing clients," then I don't know where the rest of it is coming from, I guess non-audit clients, but then you have to, sort of, step back and wonder specifically what is the issue in terms of the compromising.
And I do believe that there is an inherent conflict in the relationship, but I'm just wondering how it manifests itself in terms of the financial statements.
MR. BLUMENTHAL: Well, I think that's a very good point and a legitimate one, but I would answer it this way: Having been in a firm, in a law firm, and having talked to some of my friends and having some exposure to the world of accounting I don't think those dollars are any less attractive simply because they're 20 percent of the total revenue.
I think those clients that represent 20 percent of the income of an accounting firm are every bit as precious and important as the other dollars and particularly the auditing partners who are involved in those accounts.
Their careers, their lives, are on the line. And their position has to be seen in terms of their everyday judgments, the pressures on them to cross market, the mergers and acquisitions, the pension services, the other kind of work and what are the informal or less visible kinds of pressures that come into play.
I was trying to do a better job of the analogy of the grader of the exams. And I think the analogy really is that the person taking the exam is paying the teacher grading the exam to prepare that person specifically for the exam.
COMMISSIONER UNGER: I thought maybe to pay them to grade the exam.
MR. BLUMENTHAL: Well that's even better. But I do think that that number is an important one the 80/20, but in terms of the outlook I think the work is still important.
COMMISSIONER UNGER: Thank you very much.
CHAIRMAN LEVITT: Thank you. When I think of public service, I can think of no better example of someone who has given his life to the public interest not just for your own advancement but for causes that are so valuable to our society. We're honored by your presence. We're honored by your interest in this issue. On behalf of consumers and on behalf of the Commission, I want to thank you.
MR. BLUMENTHAL: I'm deeply grateful for those comments, particularly from someone like yourself who has devoted so much of your life to public service and other members of this Commission who are doing such a great job here. And I hope that this cause is one that I can help you to advance. Thank you very much.
CHAIRMAN LEVITT: Thank you.
Panel 3 (Morning)
The next panel is William D. Travis, the Managing Partner of McGladrey & Pullen; and Wayne Kolins, National Director of Assurance, BDO Seidman. Mr. Kolins.
MR. KOLINS: Good morning. Thank you for giving my firm the opportunity to testify in this very important matter. My name is Wayne Kolins. I'm national director of assurance for BDO Seidman.
Our business consists overwhelmingly of assurance and tax services, and our clients are mainly middle market companies. I will focus my remarks on a few of the concerns which will be contained in our comment letter. These include the disproportionately adverse impact of the proposed rules on middle market and smaller accounting firms and the provision of tax services by auditors.
Before I explain these concerns I want to express my firm's support of your efforts to maintain and enhance the focus on the public interest by all participants in the financial reporting process.
We also support the Commission's effort to modernize the investment and employment relationship rules and encourage you to move forward with that aspect of the proposed rules in concert with the ISB.
We recommend, however, that the Commission bifurcate the rule proposal and let the ISB adopt a conceptual framework that provides more clear guidance than do the proposed four principles.
The four principles would adversely affect middle market and smaller firms and their audit clients because those clients generally have less in-house expertise and are thus more likely to turn to their outside auditors for advice.
However, those auditors may be unwilling to provide this advice, even on issues such as the application of complex accounting standards, that would raise questions about whether they're auditing their own work or serving as an employee of or advocate for the client.
If firms like ours can't provide that type of advice, our clients may do without the advice or turn to other more costly consultants, if any are available. In these cases, the company and its shareholders would be adversely affected.
The proposed definition of affiliate of an accounting firm would also have a disproportionately adverse impact on firms like ours because it's imprecise an appears to capture more relationships than we believe the Commission intends to cover.
For example, some accounting firms like BDO have strategic alliances with other autonomous accounting firms that are intended to provide the alliance members with access to accounting, tax, audit methodology and training expertise. These alliances enhance audit quality and benefit the shareholders of the alliance firms' clients as well as the firms themselves.
It appears, however, that an accounting firm that's a member of an alliance, and perhaps certain of its partners and employees, would have to be independent of the public clients of the other members of the alliance, even if the accounting firm has no control over those other members.
Requiring BDO and its other alliance members to monitor the relationships and investments of each other would be extremely complex, expensive and time-consuming, assuming that we could monitor them at all.
The alliance members don't control each other, and, therefore, we may have significant problems obtaining the necessary information.
Also, any terminations of strategic alliances resulting from the adoption of the proposed definition could trigger severe contractual penalties along with other costs. This should be considered by the Commission in its cost-benefit analysis of the proposed rules.
As an alternative to the proposed definition we recommend that the Commission consider using a control test. This would enable accounting firms to comply with the independence rules and still enter into appropriate and necessary strategic relationships.
On a positive note, we strongly support the exclusion of tax related services from the list of prohibited non-audit services. Smaller companies particularly need to be able to obtain tax related services from their outside auditors because they often lack the internal expertise to handle sophisticated tax issues.
We're concerned, however, that certain statements in the release and the four principles themselves may suggest that certain tax services adversely affect independence.
For example, the release states that the Commission's decision to exclude tax services from the list of prohibited services was based only on its evaluation of traditional tax return preparation.
The advocacy and auditing your own work principles also cast doubt on the acceptability of certain types of tax services. In contrast to one of the four principles, tax ethics standards actually require service providers to play an advocacy role.
However, this duty is counterbalanced in the ethics standards by a duty to the tax system itself. These standards and established enforcement mechanisms provide the needed protection for shareholders.
To avoid potential confusion, we recommend that the Commission revise the rule proposal to specifically permit the provision of tax related services. Without this clarification public clients may believe that they must retain a new tax service provider, increasing their costs of necessary services, to the detriment of shareholders, and precluding them from receiving the services from the best informed practitioner.
Now I'd like to turn to the recently adopted audit committee rules. These initiatives have great potential to strengthen this critical element of the financial reporting system.
We commend the Commission for its leadership role in this process. Because of its enhanced role, the audit committee is in the best position to consider all the facts relating to possible independence issues, including the existence of effective safeguards.
The urge the Commission to allow these multi-faceted initiatives to realize their full impact before adopting rules relating to non-audit services.
Throughout BDO's history we have emphasized integrity, trust, professionalism and independence.These values are an integral part of our culture. Like the Commission, BDO is dedicated to serving the public interest.
In that regard, we are committed to working with all the participants in the financial reporting process to strengthen the ethical fabric of our markets. Thank you.
CHAIRMAN LEVITT: Thank you very much. Mr. Travis.
MR. TRAVIS: Thank you. I've been a member of the public accounting profession for 25 years. McGladrey & Pullen is a firm -- one of the eight largest firms in the U.S. We're focused on mid-sized and emerging growth companies.
We appreciate the opportunity to provide testimony on the proposal, and we're supportive of the undertaking to modernize the independence ruse. We also appreciate the efforts of the SEC on this and other very important initiatives this past year.
There are many positive elements of the proposal; for example, establishing broad guidelines to provide a foundation for and simplified understanding of independence and also addressing the overly-burdensome restrictions on investment employment relationships.
Let me take a couple minutes and just highlight some items from our written testimony to save on time. Item No., working together. I'm very proud to be a CPA. It's a profession known for technical competency, personal integrity and objectivity, and I do know that the SEC and the profession have a mutual commitment to excellence and the public interest.
However, I believe there has been way too much negativity surrounding this debate from both sides which will ultimately lead to nothing more than wounded egos and hard feelings.
As a result, we suggest that the SEC and the profession work together with the ISB to address the input, identify the issues and to refine the proposal.
Item No. 2, the general standard. I'd like to talk about the definition of appearance. We certainly agree that appearance is an important element of independence along with the facts surrounding the issues.
We believe that the proposals should define who is capable of a fair and objective assessment of the appearance of independence. This requires both a reasonable understanding of the facts and the rules of independence.
We also believe that we need an organization with a balanced objective view to assess complex situations like the ISB. We also disagree with the advocacy principle. We believe mid-sized and emerging growth companies need and expect advocacy from their audit firm within reasonable bounds of professional integrity and objectivity.
These companies are faced with limited resource in terms of dollars and in terms of experience and expertise. They consistently rely on the input and counsel from their experienced and trusted audit and tax advisors.
We believe strongly that advocacy is acceptable and manageable within reasonable parameters.
Item No. 3, investments by the audit client in the audit firm. The proposed rule relates to direct investments by the audit client or its affiliates in the audit firm or its affiliates.
We suggest the rule include provisions to cure unintentional violations on a timely basis. For one thing, the auditor has limited ability to prevent and detect such violations by the client before they occur.
Second of all, it could lead -- the auditors could be faced with the extreme situation of a real or threatened intentional violation by a disgruntled client to pressure the auditor to do things they don't want to do.
We also suggest that the investment by audit client proposal consider materiality of these investments. We suggest you incorporate the concepts of ability to influence or control under this rule. It would be very difficult to cost-effectively identify and monitor immaterial investments since many are held in street names or investment funds.
Our logic is the potential influence on the auditor in the absence of control or significant influence is really no greater than the client pressure that results from outstanding audit fees or the threat to put an engagement out for bid.
Also, we strongly believe the audit committee process with improved communications and relationships between the audit firm and the audit committee should help for any attempts by management to unduly influence the audit firm.
Lastly, under investments by the audit client, we agree with the proposed rule which excludes audit client management and board members from the investment prohibition. We don't believe such investments by these individuals adversely impact auditor judgment nor create a mutuality of interest. The auditor certainly doesn't audit the value of those holdings. We recognize this is a change in the SEC's position, and we agree with this direction.
Number 4, scope of services. Obviously, a tough topic with strong views on both sides. We certainly understand the SEC's concerns and reasoning on this issue.
We believe the rule proposal needs to better consider the basic personal characteristics of the overwhelming majority of professionals who become auditors. They're involved in the profession for much more than financial gain. They have very high personal integrity. They take their professional responsibility to the public very seriously. And they would never sacrifice audit quality or their reputation.
We suggest that the scope of services proposal be given greater time for research and analysis, not to slow down, keep moving very quickly, but let's make sure we have all the facts before we make significant change.
I strongly believe the profession is willing to address problems supported by factual evidence and market demands. We also want to make sure -- consider the following: the potential magnitude of these rule changes on the public interest and on the profession is significant, particularly for mid-size and emerging growth companies.
We suggest you take the time to assess the impact of the audit committee changes which we fully support. We believe those changes should help in this area. In our view, let's move quickly, but let's get the data to do it right the first time.
We do disagree with certain prohibitions; for example, services that are oriented towards developing a system that management would approve and operate. Certain IT systems and HR systems are really done at the behest of management. They operate it. They approve it. It's their number. We believe this is significantly different than an actuarial number which the auditor would create.
We're concerned about the internal audit service prohibition. We agree certain of these services are a concern. However, the AICPA's ethics interpretation on extended audit and internal audit out sourcing seems quite clear, so we would like the proposal to be more specific on what components of internal audit out sourcing are a problem. We also disagree with any direction that would result or prevent the auditor from helping the client improve their business. As I said, emerging growth and mid-size companies need this help. In particular, tax services, as Wayne mentioned, are a critical issue.
As an aside, we trust that other regulatory organizations will carefully weigh the service restrictions proposed by the SEC on public companies before applying them to non-public companies.
Item 5 -- and I'll be done in a minute. Definition is unintentionally too broad and will include firms outside the audit firm's ability to control or significantly influence. This will add significant cost to tracking and monitoring independence compliance for no apparent benefit to the auditor -- or to the public. I'm sorry.
Thank you for allowing me to present our thoughts. I ask that you consider them in the spirit of the public comment process. I think we're all interested in the same thing, protecting the public interest and the health of the capital markets as well as the audit profession. Let's work together to address these issues. Thank you.
CHAIRMAN LEVITT: Thank you very much, Mr. Travis. I greatly appreciate the spirit that characterized your testimony, and I greatly appreciate your mention of the public interest.
The accountants of America are a superb and wonderful and honorable profession, and I think all the Commissioners feel that way. I wish that more emphasis had been placed upon the public interest, because the accountants that audit publicly owned companies have received a government franchise, and the public interest is a very important consideration. And your mention of that I find singularly important.
I think what you are asking for is reasonable in that it calls for balance, and I think that's the way the Commission intends to approach these proposals.
You talk very reasonably about a proposal about the investment of audit clients and their auditor. That is a complex issue, and I think we have to approach that with great circumspection. I think as this proposal develops your concern about providing tax services also will be taken note of.
And we, too, recognize that materiality is difficult to administer. I think if more of the leaders in the profession were willing to work as constructively as you we could avoid the negativity that I think both of us lament. I've done all that I can to engage in a dialogue with the profession. I've had constructive talks with some leaders in the industry like you, but others have rebuffed this, and I wonder how we can reduce that negativity and work more constructively.
MR. TRAVIS: Thank you. I think we just have to decide it's the answer that's important and that to work together in the public interest to assess all the facts, to assess the public interest, gaining all the intelligence we can and come up with good answers that, in the long term, will be for the good of the public interest, the profession and the Commission.
CHAIRMAN LEVITT: Mr. Kolins, your point about the four principles has been expressed to us before. I think all of us recognize the importance of those principles, and probably there would be very little argument about the philosophic background for those principles.
Do you think it might be useful as guidance if we remove them from the rule and modified them?
MR. KOLINS: Yes, I do. I think if we characterized -- the four principles were characterized as ideals or goals, something to aim for, something the people can get their arms around, I think that could serve a much more useful purpose rather than having it in a proposal which would then result in a service that is really good for the company, good for the shareholders somehow inadvertently tripping over that particular rule.
CHAIRMAN LEVITT: You mentioned concerns about the definition of "affiliate." Could you suggest ways that we could change the definition that would address your concerns but still protect against relationships that might tend to impair independence?
MR. KOLINS: Well, certainly one of control is one that we have suggested in our comment letter.
CHAIRMAN LEVITT: How would that work? How would that control test work?
MR. KOLINS: Well, control could be control the way "control" is defined under the accounting standards, the ability to control the operation of a particular company. It could be not necessarily ownership interest of a majority of the quo but ability to control the operations of the company would certainly be a threshold that would, obviously, in my view, come within that definition.
Whether there's an absolutely large economic interest that the accounting firm has in the other entity's ongoing activities, particularly with respect to the client that's being served, that could be another test.
CHAIRMAN LEVITT: Why don't you think that our rule would result in a reshuffling among the consulting practices of accounting firms?
MR. KOLINS: Well, the reshuffling argument is an interesting one, particularly when we're dealing with medium and smaller accounting firms.
If a medium-sized accounting firm had to give up an audit client, that medium-sized accounting firm may not necessarily be the beneficiary of a non-audit client of another accounting firm that had to give up its non-audit services because the client may be more apt to go to a more well-recognized name. So the reshuffling argument, I think, will not necessarily work out for the medium or smaller accounting firms.
CHAIRMAN LEVITT: Do you think that audit clients will move their business to non-accounting audit clients rather than to accountants who aren't their auditors? Is this because the opportunity for cross-selling by auditors would be lost?
MR. KOLINS: I think that they may go to other accounting firms but I think more well known accounting firms.
CHAIRMAN LEVITT: I might say to both of you that having started any number of small businesses and believing in the importance of medium and small businesses in terms of job creation in this country you're probably the most vital element of the whole universe of the accounting profession, and I am sincerely concerned about your well-being, your thinking, which is too easily lost in issues that appear to be of greater concern to the larger firms.
COMMISSIONER HUNT: I want to thank both of you for appearing. I particularly appreciate the spirit of your testimony. It's a little different from the spirit of some testimony we've heard from members of the profession, in my judgment, in earlier sessions of these hearings.
I think your comments were thoughtful. Mr. Kolins, I appreciate your comments on the alliances and affiliates. I think that's something that we have to look at. I appreciate your thoughts on what the provision of tax services might do to small and medium-size clients and the necessity for the auditing firm perhaps providing those services to those size clients.
And Mr. Travis, again, I appreciate the spirit. I want you to know that we very much want to work with the profession. We are in this together. I personally -- I don't think any of us up here desire a hostile relationship with the profession.
This is a complicated issue. It has been with us a long time, and I hope we can move expeditiously but not too rapidly to fashion a satisfactory conclusion.
Let me ask both of you do you think that these proposed rules in their present form would negatively impact medium or small-size auditing firms more than large firms?
MR. KOLINS: Yes, I do. I think because of the nature of the clients that we deal with, as I mentioned, most of our clients look to us for advice, sophisticated tax advice, business advice, advice in terms of evaluating the competence of a prospective employee, which would seem to be precluded by the rules.
I think it's these types of clients that we deal with would have a tendency to run afoul of those elements of the rule.
CHAIRMAN LEVITT: Well, if that were addressed in some way, you'd be more comfortable with it, I gather.
MR. KOLINS: Yes.
MR. TRAVIS: I would echo Wayne's comments, and I would also add that I would be very concerned about the application of these rules to non-public companies because I believe the users of the financial statements are substantially different in their ability to have dialogue with the client about the financial statements and the issues surrounding the financial statements.
And to blindly apply these rules would cause medium and small-size CPA firms great concern because it is the relationship of trust and respect, and the competency of the auditor that drives the ability to help these companies grow and prosper.
CHAIRMAN LEVITT: Well, you don't think that there should necessarily be different standards for private companies, though, do you?
MR. TRAVIS: Well, there are today.
CHAIRMAN LEVITT: That's an interesting argument.
COMMISSIONER HUNT: I also think that your comments about -- frankly, I hadn't thought of this side of the audit client investing in the audit firm. I mean, I think we have been focusing on the members of the auditing firm investing in the client, or the client's securities and what kind of conflicts of interest that might create.
But I think that the other side of the coin is a valuable point you raise, and I thank you both for the spirit and the thoughtfulness of your comments this morning.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: I'm going to borrow Mr. Blumenthal's line and tell you, I'm just a country regulator, and I wonder if you could indulge me with some of the more practical aspects of your business and how it works.
For example, for each of you, what percentage of your revenue is from auditing, as opposed to consulting as we sit here today?
MR. KOLINS: For us, accounting and auditing is about half. If you include tax, it's about 85 percent accounting, auditing and tax services.
COMMISSIONER UNGER: Mr. Travis?
MR. TRAVIS: You can get the exact numbers from the AICPA annual report, but I would say our numbers are very close to that as well.
COMMISSIONER UNGER: So substantially most of your revenue is from auditing?
MR. TRAVIS: More importantly, substantial --
COMMISSIONER UNGER: And accounting.
MR. TRAVIS: More importantly, substantial chunks of our profit are from the audit practice. It's not a loss leader. Let's put it that way. It's a very profitable part of our business.
COMMISSIONER UNGER: Have you ever offered a loss leader -- I guess that's the official term -- but a sort of discounted audit fee in exchange for or in hopes of obtaining consulting business?
MR. TRAVIS: I think every time you propose on an engagement that involves competition, you try to package the service in accordance with the needs of the company that's looking for the proposal. Then you try to price the service according to those needs. So I don't believe we wholeheartedly go out and offer audit services for free. We don't go out and have audit sales. But we do look at the competition and what the market will bear in terms of pricing our services.
MR. KOLINS: To the extent that firms do do that, do low-ball a fee, I would love it if somehow -- and I know you have to deal with the FTC, probably, but somehow if the Commission could come up with a rule against low-balling and make it work -- I think Texas has something that's akin to that -- I think that would be helpful.
COMMISSIONER UNGER: Something that wouldn't resemble price fixing.
MR. KOLINS: Yes. Exactly. That's the problem.
COMMISSIONER UNGER: I was listening to the Chairman's question to you, and I think I didn't catch the whole question or answer. What percentage of your client base is public companies versus private companies?
MR. TRAVIS: I don't know the answer to that off the top of my head, but I'd say it's about 15 percent of our revenues.
COMMISSIONER UNGER: Private or public?
MR. TRAVIS: Public.
COMMISSIONER UNGER: Public.
MR. KOLINS: It's about the same for us.
COMMISSIONER UNGER: So do you think there are -- I guess, to follow on what the Chairman was talking about, do you think there are different incentives or conflicts inherent in a relationship with a client that is a public company?
MR. TRAVIS: Well, I think the public company independence rules are built around or trying to be built around the public interest. I think a private company has a different set of users in the financial statements.
And it's much like the rules on projections on forecast. If you have the ability to have a dialogue as a banker with a client about what's going on in those financials, I think it creates a different fact pattern than an investor in ABC Company on the New York Stock Exchange.
I have no ability to contact those folks and understand the details of the financial statements. I think that's different. Would I like to see a common set of rules? If we can get to a great answer for both sides, yes. But I think the facts of public versus private entities has to be considered in the debate.
COMMISSIONER UNGER: Mr. Kolins.
MR. KOLINS: I share those views. There is also an additional disincentive in the public arena, and that is the threat of litigation is just so much more. I think that's a countervailing influence in terms of maintaining independence.
COMMISSIONER UNGER: Well, if you have a mix of client base, though, the way you both do, is that confusing, or would that be confusing to have two different standards?
MR. KOLINS: Yes. The more standards you have that aim at the same goal the more confusing it is. There should be ultimately one set of standards.
MR. TRAVIS: I would respond to that by saying our independence and conflict of interest rules for the firm as a whole and the individuals in the firm are much more restrictive than either the AICPA standards or the SEC standards, so it doesn't create a problem for us.
COMMISSIONER UNGER: What was I going to ask you? I don't remember what I was going to follow-up on, so I'll have to get back to you on that. But the other question I had wanted to ask was when you do provide consulting services do you provide them to the same clients that you're auditing?
MR. TRAVIS: Again, I don't know the exact mix, but I would say that from what I know approximately 50 percent of our audit and tax client base are also buyers of consulting services. So 50 percent of the consulting revenues come from non-audit and tax client base.
COMMISSIONER UNGER: And how does it work personnel-wise? Do you use the same individuals who are --this is the synergy question. Do you use the same individuals on the audit that you use on the consulting work?
MR. TRAVIS: Depends on the engagement. The more sophisticated and complex the consulting engagement the more specialists you have to engage in the process.
So generally speaking, for complex IT engagements, complex HR engagements we would use specialists, as opposed to generalists or auditors for those services. The clients are becoming more and more interested in specialists to help them, as opposed to generalist information.
COMMISSIONER UNGER: And how much specialists do you have working at the firm?
MR. TRAVIS: I have no idea.
COMMISSIONER UNGER: Mr. Kolins?
MR. KOLINS: I'm not sure. It's probably a couple hundred, I would imagine.
COMMISSIONER UNGER: The same question with respect to providing --
MR. KOLINS: Yeah. The more technical the area becomes the more highly specialized people need to be, and that will only increase in the future. And there is a very close relationship, because the audit partners on the engagement team are working on an audit engagement because most of our consulting work is for non-audit clients.
But to the extent there is an audit engagement, the audit partner is very concerned that his client is being well served. So the audit partner knows what's going on on that consulting engagement, so there is a sharing of information.
COMMISSIONER UNGER: So the confidence that you were talking about, confidence and trust in your auditor, is it with respect -- maybe I should just ask it open-ended. What is the confidence and trust in, in the knowledge of your company or personal relationships?
MR. TRAVIS: Well, I think the entrepreneurial CEO owner is very discriminative on who they will listen to for advice, and the audit partner has to prove their worth in terms of value of integrity, value of business advice and value of professional competency.
COMMISSIONER UNGER: Well, when you put it in that context, my dad was an entrepreneur, so it's very rare for them to listen to anyone.
MR. TRAVIS: You said that.
COMMISSIONER UNGER: Speaking from my limited personal experience. And I did remember what it was I wanted to ask you before. That is, who are the users of the financial statements that you prepare for the private companies? Mostly sophisticated members of the industry.
MR. TRAVIS: Typically, the entrepreneur would have maybe a venture capitalist who is very sophisticated, a banker who is very sophisticated and their stockholder group. And that is really the audience that the financials go to. Occasionally, vendors and suppliers will ask for financial statements, but they, too, have the ability to have dialogue with the client about those financial statements.
COMMISSIONER UNGER: Is there anything you wanted to add?
MR. KOLINS: Same group.
COMMISSIONER UNGER: Okay. Thank you both. I very much appreciate that education.
MR. KOLINS: You're welcome.
MR. TRAVIS: Thank you very much.
MR. TURNER: You're in, kind of, a unique situation because McGladrey did sell part of its practice to H&R Block.
With respect to what you kept, is the tax advice now being given by the H&R Block side or by McGladrey's side, and did McGladrey retain and do you currently have an IT consulting practice, and, if so, what portion of your revenues are coming from the IT practice are going into the design and implementation systems?
MR. TRAVIS: The IT practice, Lynn, was part of what was sold to an affiliate of Block, so the consulting practice is owned in entirety by Block. You don't have the time to be bored by the complexities of the tax side of the agreement, but some of the tax side went to Block -- and the public accounting aspects side remain in the CPA firm partnership. I don't know the particulars. I can get you the information.
COMMISSIONER CAREY: That would be helpful. But the IT consulting prohibition that is in the proposed rule wouldn't affect you, then, because it is in the H&R Block side of the business.
MR. TRAVIS: Well, no. I think it would, because, as you know through our discussions, when we tried to set up this new structure we do view the two organizations together in terms of independence issues. So I think the answer is it would affect us, and we are interested in the outcome, we're trying to abide by the rules of the game as you and I define them.
CHAIRMAN LEVITT: Thank you very much.
Panel 4 (Morning)
The next panel is Wanda Lorenz, litigation support consultant for Lane Gorman Trubitt; and Howard Schilit, President of the Center for Financial Research & Analysis. Ms. Lorenz.
MS. LORENZ: Good morning, Chairman Levitt and the Commissioners. I am really honored to be here today and to be able to present my views.
I'm not going to read my testimony. I know you're running short on time, and there are some things I would like to emphasize. So with your permission, I'll just, kind of, jump right into the things I would like to emphasize.
As far as these proposed rules, which I do commend you all on, I believe it is a bold step you've taken, and it's a hard step for to you take. I understand that.
My comments go to one, the four basic principles. While I agree with them, I believe that they are overly broad right now. I serve on the rules and enforcement committees of the state board. And I usually look at something in terms of can it be interpreted so that there will be an enforcement process that's effective. You can apply it to the real world. I believe they need some tweaking in that area.
For example, the first principle, mutual or conflicting interest has a lot of rules behind it, including business relationships. It goes fairly far out. If somehow you could at least get in the general rule, take a look at those again. I believe mutual or conflicting interests, not all of them create an independence problem, and so perhaps things that would cause or have the appearance of causing an auditor to render an opinion or do work inconsistent with the matter they have found.
The second and third principle relate to when someone audits their own work. I think it relates to crossing over that line when you're truly acting equivalent to management. I don't believe that out on an audit, when we have to prepare journal entries for the client, or we sometimes have to help a client with footnotes on a new accounting principles, that that is going to circumscribe our integrity and independence.
And then the fourth principle, I share the views of my colleagues that in the advocacy area I think it should exclude the traditional type services that we've done for years and I think are a service to our clients, and I do not believe it impairs our independence.
Other concerns I have are some of the others have had, the definition of "affiliate." We also belong to peer groups that are totally autonomous firms. There's no cross-ownership or cross-control, but we do share ideas, and we have meetings and exchange literature, exchange a lot of different things, just a kind of a brainstorming session.
And I believe that pulling us into an affiliate process would be clearly unworkable and would hurt certainly smaller firms like ours.
I didn't preface it by saying our firm is local, single-office local firm in Dallas with 110 people, and that gives us a great advantage to be able to belong to alliances like that where we can, if our client needs someone in the UK or something, we can recommend someone and know about that firm.
There are a couple of areas where I believe it would impair, and that is if two firms get together and jointly perform an audit, then I would believe they would have to be independent at least with respect to that client. Or, as in the case of some of the affiliations who not only allow but even would like for you to present your report on the affiliation's letterhead, that would be a different story. But the rank and file alliances that are autonomous I think should not be pulled into that.
I also am concerned about the affiliation as it's applied to leasing of employees. I can see where that could be a problem in some instances, but a lot of us, with the shortage of professionals may lease or at least hire some employees on a temporary basis to help with audits during the busy season, and it would be -- I think create a large problem if you're getting someone from AccounTemps and the whole of AccounTemps has to be independent of your client base.
Certainly, those people you've hired have to be independent to the client base they're working on, but I don't believe the fact that they stay on the job for the duration of the audit is going to compromise the audit as long as they are, and I don't believe that the people that you're leasing them from has to have that same type of independence.
Another comment is that I would encourage you to look at the chain of command. I think it's overly broad when it tries to pull in any person who -- and I think the key word is "may" review or determine, or influence performance appraisal.
I think that people -- staff works for a lot of different managers and partners, and they may work on a lot of different jobs even in separate cities, and all of those people will probably do an evaluation and will probably deal with things that might tend to influence that person's salary, but I don't think even if Manager A talked to Manager B and said, "I didn't have a very good experience with that person on my job," I think that may make Manager B cautious about that person and supervise them more, but I don't see where it compromises the audit independence-wise, even though they are evaluating that person, effectively.
And then finally, my two favorite things, I guess, that really aren't in your rules but I believe that have brought us to where we are is that I believe that peer review, as it was envisioned, does not have the teeth it should have.
I think that we could deal with peer review in some way that it could be used better. The rules as they stand have us look at a lot of things at the peer review process but don't particularly allow the peer reviewers to look at things in a way that would superimpose their judgment over the other firm's judgment.
I can't believe that some of the things I've seen that have been talked about here today in the litigation process were not pulled in the peer review in those firms. If it had teeth -- and I'm not looking for it to have teeth -- to the extent that it's not remedial, I believe it could be remedial if it were designed to look at actually somewhat how the work was performed and look at the independence of the client and the auditor.
And we ought to be able to work through that process with a CPA firm before it gets to the level of the courts and the level of the SEC as far as enforcement.
And finally, I do believe it goes to the problems that exist today especially with respect to publicly-held companies related to fee negotiation.
From what I've seen of -- someone alluded to the pressures on the partners that had these audits. Certainly, there is that pressure, pressure on them to sell -- pressure on them to retain the client, pressure on them to build fees. I have seen the fee process negotiated down to where I looked at it and wondered why did that auditor take that risk for that low a fee for maybe a 60 percent realization over and over and over again.
Usually, it involves somewhere along the way, they are picking up additional services with that client, but we become like a shopkeeper in a bazaar. They will take a lower fee in a lot of instances in the hopes of being able to do more lucrative work.
As a whole, clients don't argue with you about doing consulting services. They're seen as value-added; whereas, the audits are not seen as value-added as the consulting services.
I would like -- probably what I've said is not particularly practical, but there could be some kind of a fund that the clients pay into and somebody totally independent looks at hiring the auditor so you put that fire wall between the auditor and client so you don't have -- I like whoever alluded to the fact that you would be paying the teacher to grade the report, so you could get away from that process.
Having said that I wished there would be a fund, I don't know how feasible that is, but I do know that we've been talking here today a lot about things like General Motors and Cendant, and things like that, the large clients. There are a lot of smaller SEC clients that not only does people like our firm do, and McGladrey, and the Big Five do them as well.
I don't agree with everyone that the audit committee rules will catch all that. We've had clients that -- we had a client filed with the American Stock Exchange whose audit committee consisted of one of the officers, the counsel for the company and a shareholder. That is definitely not independent, and if it were independent, it would still probably be influenced because that is a small client empowerment. It's the same kind of thing.
So I don't think that audit committee is a cure-all except in maybe the very big companies. We're dealing with people with new IPOs. We're dealing with people whose audit committees are not independent and who, even if they are, like I said, I don't think it would be effective.
We've got to look at some way to deal with that as well as the fee negotiation issue. The fee negotiation issue I think is the genesis of a lot of the problems we're seeing. It wouldn't be so important to everybody to go out and get the consulting work if we could make the same thing.
CHAIRMAN LEVITT: Thank you very much. Mr. Schilit.
MR. SCHILIT: Thank you. I am truly honored to have the opportunity to address the Commission today, and I applaud you, Mr. Chairman, for this initiative and just the work you've done over recent years with the new staff accounting bulletins last year. It has given our organization quite a bit of work.
There are three parts to my brief testimony. One, I want to tell a little bit about my background, both academic and professional, some observations of the problems, not just over the last year, but this issue of auditor independence over the last 25 years.
And I know Professor Briloff is going to be testifying tomorrow, and you could go back into the 1960s and read some of the warnings about the problem way back when the amount of fees from non-audit services was tiny.
And the third part of my testimony is a proposed solution which is much broader than simply creating new standards and rules for audit independence.
CHAIRMAN LEVITT: If you can accomplish all that in the time allotted to you.
MR. SCHILIT: I will try to do that in five minutes.
CHAIRMAN LEVITT: Okay.
MR. SCHILIT: Twenty years ago, while a doctoral student, I wrote a dissertation which was entitled, "An Empirical Study of Auditors' Independence," and I interviewed several hundred auditors.
And my conclusions sadly at that time were that auditors in general lacked familiarity with the then standards and norms of audit independence and, frankly, they were very vocal in their disagreement over any of those restrictions. That should have been a warning.
Over the next 15 years or so I embarked on an academic career and came very close to the SEC -- in fact, spending many days in the public reference room reading your enforcement releases, wonderful source of information, and it really moved me in such a way to begin going back and studying some of the major accounting debacles in the last generation or two.
And I began writing articles for academics and others, and, in '93, wrote a book which was entitled, Financial Shenanigans: How to Detect Accounting Gimmicks and Fraud in Financial Reports.
And in the last seven years I have been working as an independent publisher of research for over 2,000 institutional investors -- again, warning them of various signs of problems, accounting problems, and the like.
My observations of the problems today, again looking at this 20-year period, is that things have gotten considerably worse, and I'm not just talking about the issue of audit independence, whether you can prove it, whether it's an appearance.
The problem is too many botched audits. An auditor is not learning from that. The second observation is that auditors in general have shown little interest in cooperating with initiatives to reduce auditor's concern and have become very adamant in their defiance, which I think is unfortunate. My proposed solution is three-fold, and the first one is what you're embarking on, and that is to tighten and simplify the rules and come up with rules and standards that are clear and are enforceable.
The second and perhaps more important is for the profession itself with the guidance of the Commission is to really step up the training. I think the reason why we have the accounting debacle, in large part, is that the auditors don't really understand the transactions.
In fact, as recently as yesterday there was a press release of a restatement on a company we had written two warnings on in the last year.
The third step, in addition to the clear rules and much better training is the SEC has enforcement responsibilities, and when there are clear signs that the auditors have been involved in a botched audit the Commission, I believe, should take some very substantial steps, whether it's prohibiting that CPA firm from engaging in any new SEC registrant in that industry, perhaps, for the next three to six months.
It has to be a penalty that hurts their pocketbook, that gets their attention to saying we will learn from these audit failures, and we will ensure that our staff will not be involved in these problems in the future.
I thank you for this opportunity, and I'll be happy to answer whatever questions.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: I'm curious, Ms. Lorenz, what do you do as a litigation consultant? What is your interaction with the companies?
MS. LORENZ: I primarily work in areas of GAAP and GAAS, either contract disputes, securities litigation, professional liability on occasion, but it has primarily been on the plaintiff's side.
COMMISSIONER UNGER: What does that mean? Are you a lawyer?
MS. LORENZ: Pardon me?
COMMISSIONER UNGER: Are you a lawyer?
MS. LORENZ: No. I'm an accountant.
COMMISSIONER UNGER: Consulting in terms of your expertise?
MS. LORENZ: Yes, interpreting areas of auditing standards and auditing principles.
COMMISSIONER UNGER: Only in the context of litigation, though?
MS. LORENZ: As a litigation consultant, yes, in the context of litigation vis-a-vis securities problems, failed audits, things like that.
COMMISSIONER UNGER: So if a company gets sued, they call on you to help them defend the suit? I honestly don't know. I'm asking --
MS. LORENZ: You can either defend, or you can be on the opposite side, the plaintiff's side. You can do either one. I have done primarily plaintiff's work.
COMMISSIONER UNGER: I was interested in what you were talking about in terms of what you called the lost leader engagement, the negotiation, the fees that the accounting firm charges to its clients, the bazaar type, "bazaar" with the "aa" type of negotiation.
What has been your experience with respect to those types of arrangements? And how have they, sort of, entered into the litigation context, if at all?
MS. LORENZ: Well, I've seen them enter into the litigation context by just observing that the fees were --you would like to have 100 percent recognition of your fees, and even on a fee that was probably a bit low for the work, you see 60 percent, 50 percent recognition, and it is generally -- there usually are some other services involved that I think help him make that up.
We have a rule in Texas -- I think someone else alluded to it -- that it would be good -- I think, the idea about a panel choosing the auditors probably would be nice but is not practical. But we have a rule in Texas that says you cannot perform an audit for below your cost, and we define "cost."
COMMISSIONER UNGER: So in seeing these types of negotiated fees, are you seeing them in the context of a conflict or analysis of a conflict between -- for the accountant providing that and consulting services?
MS. LORENZ: The accountant, I think, looks at a client as a -- in some instances, as a way to build a business and build more practice and do more work with that client. I'm not saying that's wrong, but I believe sometimes the audit and the intentions of the audit and the attempt to meet budget suffers.
COMMISSIONER UNGER: I assume you're seeing this in the context of litigation, and there is litigation for audit failures.
MS. LORENZ: I am seeing it sometimes there. I'm seeing it from the perspective of my own firm when firms I know with much higher rates than ours undercut us for a job. So I know it happens.
COMMISSIONER UNGER: So not much attention to the audit in what way? Not as much resources --
MS. LORENZ: In the litigation sense, not as much time spent in certain areas, not as much maybe higher partner time spent, those kind of things. It would be hard to name them all for you.
COMMISSIONER UNGER: Well, I'm questioning whether it's an issue of devoting sufficient resources or whether the relationship then evolves into one of providing consulting services, and there's, perhaps, a compromise in that regard.
MS. LORENZ: I think, generally, it's a way to get the relationship to evolve into other areas when it's done. If you're just going to perform the audit, you would like to get your full rates. Everyone is looking for more business. I believe that happens, yes.
COMMISSIONER UNGER: Thank you. Mr. Schilit, you had talked about the lack of independence and the lack of knowledge of the independence rules. I think you said that's more substantial today than 20 years ago?
MR. SCHILIT: I don't have any empirical evidence of testing today's auditors, but I think more than just the lack of knowledge of what those rules are, it's just a defiance of them and lack of the public interest in -- you should not be engaged in activities selling your audit client's product and have to look at a rule book to see whether or not there's a thou shalt not.
I think common sense should indicate that if you become an advocate selling your client's product, then you should not be auditing that client.
COMMISSIONER UNGER: And you're basing this on what?
MR. SCHILIT: I'm basing it on the recent disclosure with Microstrategy, the consulting relationship. In fact, listening to the previous panel I was surprised to learn that the people who are actually doing the audit were the ones who were involved doing the consulting work as well, in many cases, as opposed to having a completely separate team. That surprised me that the same person is wearing two different hats.
COMMISSIONER UNGER: Which is the issue. When you did your study 20 years ago, what type of constituency or what type of cross-section of accountants did you reach out to?
MR. SCHILIT: Large firms, small firms, medium size. All three groups were represented.
COMMISSIONER UNGER: Okay. I think that's it for now. Thank you very much.
CHAIRMAN LEVITT: Mr. Schilit, how can you suggest a better way for us to engage the accounting profession? We've met with a resistance to change and improvement not just during my tenure at the SEC but in talking to four of my predecessor chairs, they have experienced precisely the same problem.
MR. SCHILIT: That's certainly an enormous problem. Let's go to the second part of my solution, and that's to create rules that they have to have training -- for example, the big accounting failures in the last year. There should be evidence provided to the Commission that the lessons --case studies from those audit failures should be as well known to accountants as people who go to law school and study case studies from classic cases years ago.
So I think the track should be to encourage and to ensure compliance that the auditors are learning lessons from these past debacles. That's the only way you get smarter, by going back and know what happened at Equity Funding, and National Study Marketing, et cetera, et cetera. And I believe the auditors out there in the field are completely clueless about those lessons.
CHAIRMAN LEVITT: Well, I think that may be part of it. Also, looking at other industries and the way they approach the natural tension that exists between a regulator and regulated, in some instances, there is an awareness that a compromise to the integrity of any of them is a compromise to the integrity of all of them.
In some instances, there is an organization that represents them that is kind of a balance wheel and a way that the present organization representing the industry appears unable or unwilling to accept, and perhaps a truly independent POB -- I mean truly independent -- might offer a bridge that could be constructive.
MR. SCHILIT: I hope that indeed does come to fruition.
CHAIRMAN LEVITT: Thank you very much.
Panel 5 (Morning)
The next two witnesses will be Jim Schiro, the chief executive officer of Price Waterhouse and Phil Laskawy, the chairman and chief executive officer of Ernst & Young.
I would say that as I introduce these witnesses, your recognition of the issues, the complexity of the issues and your long-standing commitment to work toward constructive solutions of not just the independence issue, but the role of the Public Oversight Board and the role of the FASB and all of the very difficult issues that we face collectively, that the spirit that you have brought to these discussions and your willingness to engage in a dialogue makes our job much more fulfilling, and speaking for the Commission we appreciate that.
MR. SCHIRO: Thank you, Mr. Chairman. My name is Jim Schiro, I'm the CEO of PricewaterhouseCoopers, and I would like to begin by commending Chairman Levitt and the Commission for initiating this critical dialogue.
The SEC is providing appropriate and necessary leadership to help us achieve our shared objective in this rule-making process, safeguarding and improving the quality, significance and reliability of information upon which the investing public relies.
However, if we are to reach that goal, we must refocus this discussion, on reassessing the role of the audit and accounting firm in the 21st Century. We must resist the temptation to try to fashion rules that anticipate every conceivable future conflict or concern.
We have a larger mission to build upon the intellectual core of the profession, allowing it to grow and innovate to meet developing investor needs. Who knows what new assurance services will be demanded a decade from now or even a year from now.
Our challenge is to create a set of guidelines that will enable the profession to thrive and change. Let me quickly illustrate. As you well know, many, many technology stocks plummeted in March and April, decimating the portfolios of countless investors.
The reassessment of the technology sector has little to do with audited financial information. And that's my point. This profession's core mission must continue to be to protect investors and the public interest, an especially important role in times of dynamic change and economic transformation.
Yet, audited financial statements, which are the traditional heart of this profession, do not measure the very assets upon which today's companies are often valued. As a result, investors have little guidance in making investment decisions, leaving them at greater risk.
We need to create not merely a new set of rules but a new accounting and auditing model that reflects a whole host of factors upon which investors increasingly rely.
Investors want to know more about intangibles such as the potency of a company's market strategy or the value of its intellectual capital. They want to know whether companies are pursuing sustainable development, respecting human rights or addressing the global digital divide, the technology disparity that threatens to widen the inequity between the world's haves and have nots.
A decade ago, even a couple of years ago, most investors formed economic judgment, based solely on historical financial information. Today, a more complex set of factors has an effect on value. To make decisions in this environment, reliable, contemporaneous information supplied by a trusted and objective third party is increasingly necessary.
The future role of my profession is still being defined. The objectives have not changed. To provide assurance and to protect the public interest. The key is to recognize that new challenges driven by emerging technologies and innovative ways of doing business are arising every day.
And that brings me to the SEC's proposed rules. I'm here today on behalf of PricewaterhouseCoopers to contribute to the creation of rules that safeguard the public interest and allow the profession to adapt to the evolving needs of the capital markets, our clients and the public.
The right rules will ensure that this profession continues to be highly attractive to first rate people, professionals with strong character who posses highly sophisticated analytical skills, technological and interpersonal skills.
Make no mistake, the calibre of our people rather than the comprehensiveness of rules will be the investors' best protection. Our goal should be to ensure that the profession has an abundance of trained people with an objective mindset supported by firms appropriately focused on audit and assurance.
Over the past many months I've consistently said in testimony and in public statements that the profession needs to engage regulators on a global basis to address the challenges that now face us.
There has been too much rhetoric and too little reasoning owing to the mistrust that recently has arisen in the relationship between the profession and the SEC. It's time to reclaim that mutual respect and trust.
We are in a period of rapid change, and thus great risk should we fail to respond. The need for constructive dialogue is acute. There has been a lot of criticism of the current proposed rules.
I too, have had some disagreements with them, and I've made that clear to the SEC and to my partners. I believe, however, that dialogue and discussion is the route to a reasoned solution.
Therefore, my firm has been engaging the Commission staff, and we found them open to our ideas and interested in discussing the future of the profession. The time for action is at hand.
We're in the midst of a global information revolution as momentous as the agriculture or industrial revolution of the past. This is a revolution that moves at internet speed, and so we don't have years or even months to adapt to its demands.
Our profession and our people need clarity now. The financial markets, our clients and our industry cannot afford to wait. We have discussed these specific proposals with the SEC. We have submitted jointly with Ernst & Young proposed language to the staff for a new rule that we believe would meet the Commission's objectives and under which we could provide the services we anticipate that our clients will require in the 21st Century, information assurance services.
If the Commission is prepared to adopt rules along these lines, we will support them. Let me begin with the scope of services rule concerning financial information systems, because this is the core issue in the rule-making proposal.
We would support restrictions of the types of consulting services accounting firms provide, including internal audit outsourcing, because we believe that changing marketet forces are making it increasingly difficult for firms to provide these services alongside their assurance practices.
We made a decision which I announced a year ago to divest PricewaterhouseCoopers of its management consulting practice. We believe that our business has matured and developed a broader array of services.
We have become two distinct organizations under one roof. Each has a different mission. For one, the end game has been financial market integrity. For it, investor protection, objectivity and independence are crucial.
For the other, having a direct interest in client success is mandatory. These differences lead quite naturally to the evolution of very different cultures and very different business models.
The restructuring plan will allow each of our businesses to grow and prosper. PWC will continue to be the world's largest audit and accounting firm, and I am confident that we will be able to offer our people exciting and challenging careers.
The notion that we will not be able to conduct quality audits without an IT consulting practice is simply wrong. Let me summarize our views on four additional issues. Personal rules. The SEC has done well in addressing the need to modernize the archaic personal independence rules to reflect today's social and business realities. We have alerted the staff to a few areas that appear to have some unintended consequences.
Principles. The Commission has proposed broad governing principles. We would urge against writing these principles into the rules. By doing so, they would almost certainly become inflexible edicts rather than helpful guidelines.
Instead of assisting us in navigating an uncertain future, the principles would likely impair our ability to cope with changing investor demands.
Affiliate rules. We agree with the Commission that certain affiliations with audit clients pose independence concerns. However, other affiliations help the profession provide assurance on the increasingly wide array of information on which the investor relies.
Disclosure rules. We have always believed that transparency and sunshine are the most effective means of overseeing the profession. We have nothing to hide from clients, investors or regulators, and therefore, we would support disclosure of all aggregate audit fees and aggregate non-audit fees.
In crafting new rules, it is important to remember that currently we have three very important safeguards: audit committees, the Independence Standards Board and the Oversight Board.
These three oversight bodies are ideally positioned to determine whether auditors are engaged in practices that threaten their independence. We need to give them room to work.
Recently, a Blue Ribbon Committee on Improving Corporate Audit Effectiveness of corporate audit committees established at the behest of the Chairman Levitt, and on which I served, noted the importance of audit committees and strengthened the role they now play in the audit process.
The ISB on which I also serve is already deeply involved in independence standard-setting. I believe that given the degree of public representation on the board it is the best place to set future independence standards and resolve independence issues.
I would encourage the SEC to expressly acknowledge and respect the ISB's continuing role, and I recommend further bolstering the ISB's credibility by adding another member from the public to create a clear majority of public members.
Finally, we all agree on the need for a robust POB that will monitor the quality of the audit. I encourage others in the profession to join PricewaterhouseCoopers in supporting the POB's new charter.
Before I close, I want to caution that rules that work in this country and that protect our capital markets might not fit neatly in cultures elsewhere. The requirements and expectations of other countries must be taken into consideration in creating rules with global implications.
My travels throughout the world have impressed upon me our profession's awesome responsibility to a wide range of new stakeholders emerging in this global economy. These stakeholders have increasingly complex assurance needs.
They are seeking not merely traditional financial information but also accurate and objective information about a wide array of concerns, including how companies comply with standards of corporate responsibility.
We cannot know in what way the audit profession will need to reconfigure itself to ensure a continuing essential role as an objective trusted third party. What we do know is that a new era demands new thinking.
This rule-making process has broad implications for the global economy, and I'm confident that working together we're equal to the task of devising rules that will protect the public interest today and in the decades to come.
CHAIRMAN LEVITT: Thank you. Mr. Laskawy.
MR. LASKAWY: Mr. Chairman, Commissioners, I want to thank you for inviting me to appear before you today on this vitally important rule proposal.
As you know, Ernst & Young is one of the Big Five accounting firms in the United States. We have more than 23,000 partners and employees in the U.S., and increasingly we are a globally integrated firm with members of Ernst & Young International having offices in 689 cities around the world.
Integrity and independence are, of course, the cornerstones of the accounting profession. The SEC's independence rule release discusses this fact at some length and also discusses the unique and important role that the accounting profession plays in the nation's securities markets.
E&Y understands that role. We acknowledge that we have a unique relationship to public investors who rely on us as vital gatekeepers to the public security markets and who count on us to perform our audits well and effectively.
There is another relationship, another unique relationship, that was not discussed in the SEC's release, and it also warrants a few words. It is the relationship between the accounting profession and the Commission.
Unlike broker dealers, investment advisers, investment companies, stock exchanges or other central players in the capital markets, accounting firms are not entities over which the Commission has direct regulatory powers.
But in my view, we work more closely with the Commission and the staff in the development and application of rules and principles that are essential to the integrity of our nation's financial markets than does any other sector of the economy.
We do so through the FASB and other self-regulatory activities, through meetings with the staff to discuss difficult or unusual accounting issues through countless interchanges during the SEC staff review of our clients' SEC filings and through many other channels, both formal and informal.
This public/private sector relationship has had occasional rocky moments, but I believe it has worked very well for more than half a century, and it has worked well for one specific reason. Our primary goal and the Commission's primary goal is exactly the same.
Like the Commission, we want to make sure that our clients' financial statements are as accurate as possible in accordance with Generally Accepted Accounting Principles. And we want public investors to be completely certain of the integrity and independence of the accountants who audit those financial statements.
Thus, the appearance of independence is perhaps as important as is actual independence. In this regard, we have supported the SEC proposal on enhancing the POB. I believe that it is in the public's and the profession's best interests to have independence oversight over the profession.
For the same reason, I also support having a majority of public members on the Independence Standards Board. Both of these relationships, the one we have and the investing public and the one that we traditionally have had with the Commission, were the principal reasons for my firm's decision last May to express support for the concept of an SEC independence rule.
I've grown increasingly concerned during the past several years that the heightened scrutiny of auditor independence has had a negative impact in the marketplace. Increasingly, audit clients are troubled by the uncertainty surrounding the independence rules and questioning and denying our ability to offer a range of services that the SEC would agree do not -- do not -- present independence concerns.
I have, in other words, been concerned that the appearance that auditors lack independence could undermine our relationship with the investing public, and I was also hopeful that a rule could help us restore some civility between the relationship between the profession and the SEC.
It is unfortunate that the Commission's attempt to promulgate an independence rule has actually led less civility and has increased the tension between the profession and the Commission. I do not agree with the approach taken by others in the profession, including the AICPA, in making harsh attacks against the Commission and in trying to stonewall the Commission's efforts.
In fact, I am quite troubled that the AICPA, which has an obligation to represent all of its members, would take sides in a fashion that can only weaken public confidence in the accounting profession.
I have always believed that the profession can and should work to reach a reasonable solution with the Commission, one that would best serve the public interest.
Thus, although I do have concerns about certain aspects of the Commission's rule proposal and I have stated those concerns publicly, we decided several weeks ago to meet with the Commission staff to discuss these matters.
Together with the representatives from PricewaterhouseCoopers we have conveyed to the staff our conception of a rule that best furthers the public interest. The issues in this rule-making will affect millions of investors, tens of thousands of professional careers and thousands of public companies, and they are very, very complicated issues.
Accordingly, we wanted to make sure that the staff had a chance to listen carefully to our concernsMy colleagues and I at E&Y have been greatly impressed by the dedication and time commitment the staff has displayed throughout the comment period and have been particularly impressed at how seriously the staff has taken its commitment to the protection of public investors.
And the staff's receptiveness to our concerns is an example of precisely what I just discussed, the positive and productive relationships that has traditional existed between members of the accounting profession and the Commission.
In conveying our comments, we have told the staff that, in our view, an independence rule could accomplish three important objectives.
First, the rule might address an issue that has long needed attention, the financial relationship and investment restrictions governing the profession and audit clients. In many respects, the current rules are both outdated and irrational.
This is particularly true with respect to spousal employment and restrictions on the participation by spouses and employee stock compensation programs.
Second, a rule might clarify what is and what is not allowed with respect to non-audit services for SEC attest clients. In that regard, a rule might properly address the two activities that, obviously, have raised the most public concern; namely, information systems consulting a internal audit outsourcing.
Third, a rule could clarify certain relationships and affiliations that an audit firm can have. Increasingly, partnerships, joint ventures, minority investments, cross-licensing, customer alliances and other cooperative arrangements are key requirements for our clients' existence in the global marketplace, and it is important that we, too, be able to have such relationships not, of course, with audit clients but with entities that are not audit clients.
After discussing these matters with the staff, we and PWC have proposed our own independence rule. We have given an initial copy to the staff, which I understand has been placed in the public record, and we'll attach our final version in our comment letter.
We ask the Commission to consider our proposal carefully and ultimately to adopt our proposed modification to the final rule. Our approach would address most of the issues that were raised in the Commission's rule proposal, but, at the same time, it would protect our ability to serve the needs of our audit clients in a fast-changing and global marketplace.
I want to discuss two aspects of the proposal that have been at the heart of the independence controversy and have received the most attention during the Commission's recent public hearings; namely, information systems consulting and internal audit outsourcing. Our proposal would restrict the provision of both these services to audit clients.
First, information systems or management consulting. We recently sold our practice in this area. We did so for a variety of reasons, but one reason certainly was that although we did not believe independence was actually impaired by this service, we could understand that particularly with the large fees that sometimes are involved an appearance problem could be present.
I might note that now that we have sold this practice we have not discovered that we are somehow enfeebled, unable to perform effective audits or to maintain top-notch audit and tax practices.
In fact, we have found more the opposite to be true. Without a large consulting practice to manage we are now more targeted and more focused on our core audit and tax business, and our audit and tax partners feel as though they, and not the management consultants, are in the driver's seat at the firm.
Moreover, from our clients' perspective, there actually may be an advantage in not having such a practice. We have had a greater string of wins in obtaining new audit clients since we sold our management consulting practice than we had at any time in recent history, four new Fortune 500clients, including two Fortune 50 companies, just within the last six months.
Second, internal audit outsourcing. I personally believe that such work can actually improve the quality and efficiency of the audit and that independence is not affected.
In fact, not that long ago most companies did not have internal audit departments, and the audit firm performed more extensive audit procedures. However, I accept the fact that in the eyes of some, full-scope internal audit outsourcing raises an appearance problem.
I think it would be a mistake, however, for the Commission to prohibit all outsourcing, including small scale activities that have been performed for many years without raising an independence issue.
Providing outsourcing services in specific areas or locations, such as computer auditing or work at a company's foreign operation, should not be prohibited, and these less far-reaching activities clearly can improve the quality of the client's financial statements.
I also believe that if the SEC promulgates any proxy disclosure rule it should be essentially the same as the rule that has been in effect in the United Kingdom since 1991. That is a rule which discloses the total fees for audit services and the total fees for non-audit services.
This would mean that companies would make a general disclosure about non-audit services, but the specific independence related aspects of any services would be examined through the communications that are now required between auditors and the audit committee. We should give these new audit committee rules a chance to work.
These issues and many others are addressed in our suggested modification to the SEC's proposal. I sincerely hope that for the good of both the investing public and the profession, the Commission will adopt our proposal, that we can ensure public confidence in the accounting profession and also put these contentious issues behind us. Thank you very much.
CHAIRMAN LEVITT: Thank you very much. I'd like to comment on some aspects of your testimony, Mr. Laskawy in particular. This Commission has made as a major effort at the clarification of communication between ourselves and the public and between corporate America and the public.
We've talked frequently about going back to plain English. This effort has met some resistance from the legal community, which considers themselves a unique arbiter of certain arcane language and issues, but I think that we've prevailed in this regard.
So I am struck by your comments with respect to disclosure of fees, I don't know how my colleagues about thistthis, but I think that simplicity is terribly important; that investors be able to see that their company has paid $1 million for the audit and $20 million for consulting fees. That speaks for itself.
I don't know that you need the nits and grits of detail which might be confusing and might be costly to corporate America to provide that.
I am also -- I would commend both of you for your help in the first place in structuring the ISB and for your recognition of both the perceptual and practical difficulty in an equally balanced membership between the profession and the public.
I wonder why we have been so unsuccessful -- and you've commented on it, Mr. Laskawy -- so unsuccessful in getting trade organizations, which, in other industries, has provided a kind of balance wheel to embrace this notion. And I find it rather extraordinary that they should be siding with three of the firms rather than the whole industry.
I also would welcome your comments on the fact that even the small firms appear to be divided in terms of where the trade organization is coming out.
MR. SCHIRO: I think he was addressing you.
MR. LASKAWY: Okay. It would be my pleasure to answer that question, Mr. Chairman. As I stated in my remarks, that I have been disappointed in the Institute Institute takingon. They probably, through their own organizational process, have appropriately consulted with their board. But I do also agree with your concerns that I don't think a trade organization should take a position that doesn't embrace all its members' positions. And, as I pointed out to him, even though we are only two-fifths of the Big Five and there are many more CPAs who should be protected and listened to, I would say Ernst & Young -- PWC and Ernst & Young represent probably 50 percent, if not more, of the total size of the Big Five firms.
So it has been a disappointment, and I certainly would hope that moving forward there is a different approach on the part of the Institute.
MR. SCHIRO: I would agree, and I am extremely disappointed that a group that is to represent the members does not solicit the views of all the members before promulgating a position. I find that not representative of the interests of the people in my firm, who are active in supporting of that organization. I find that some of the actions of the leadership of that organization have not been representative, as Phil has just pointed out, of our two firms and did not engage us as they were adopting this position.
CHAIRMAN LEVITT: It seems to me that in an area such as both of you commented on, increasing public membership in the Independence Standards Board, that is such a logical way to reassure the public that I would hope that the AICPA would reconsider their opposition to that. And I would hope that -- I really don't know how the other firms feel about that issue, I do know that there has been resistance in the AICPA, but I hope that we could come to an agreement on that.
The other area that it seems to me is just makes so much sense, the Public Oversight Board was born as a result of the Metcalf-Waxman hearings on problems that existed in the profession going back into the '70s. And that board has certainly had a distinguished group of members. It is now headed by Charles Bowsher, the former controller general. And the tension that exists between the board and trying to get their charter established, again in a public forum, is the very worst kind of public image that can be conveyed. I would hope that the leading firms and the trade group would put aside the silly differences and use the POB as kind of an effective quasi-self-regulator because I think the consequences of not doing that, obviously, would suggest a different kind of regulatory structure over which all of us would have less control and maybe less confidence. And I would appreciate your comments on this.
MR. SCHIRO: I share your concern. I would share your hopes. I think that it is time for us to tone the rhetoric and time for us to work together. I think we have both expressed change is difficult. Change is always difficult. People tend to always resist change. I don't believe we have the window of time as the world is changing so much faster, as I have pointed out. I think if you look back during the agricultural revolution or if you look at the span that it took to mechanize the economies of the world during the Industrial Revolution, we don't have the luxury of that kind of time during this technological revolution.
The importance of protecting the interests of investors is critical during this time when changes are taking place so rapidly. So, to enter into a continuous dialogue and rhetoric over the issues, we really have to put that aside and we have to begin working together among representatives of the profession and the regulators on a global basis.
MR. LASKAWY: I would just add that this has been an unusual period of change and to some extent upheaval within the profession. I truly believe -- I am an optimist by nature -- I truly believe once we get through this process, we will have a much more harmonious relationship with the Commission, and we will have a much more harmonious relationship within the profession. And I think the ISB, the POB, all three-letter acronyms, and the SEC and the AICPA can hopefully go back to the way we used to live years ago where it was truly a partnership, and I believe that will happen again, actually. And I think this has been part of the process you have to go through to reach that.
CHAIRMAN LEVITT: I think that is very realistic and I appreciate not only your optimism, but I think your natural instincts are always to try to bring varying opinions and controversial issues into some sense of perspective and balance and that is invaluable in a process that tends to be as divisive as this.
Both of you have commented on the appearance of independence and both of you have suggested that this is vitally important to public confidence. Jim, I think you said that "the profession cannot ignore the growing perception of conflicts between auditing and consulting." Some in the profession have absolutely dismissed appearance as being a factor at all. Hasn't appearance always been important to the role of the accountant, to the way he sees himself, to the way he conveys himself?
MR. SCHIRO: Yes, I think there is no question but whether you make appearance be part of the rule-making process, I believe is subject to debate. But I think the state of mind, the quality of the people executing, how they handle themselves, the interpersonal skills are paramount to the importance of the perception in the marketplace.
I would like to comment as it relates to the conflict that I see. And I see that conflict more as an emerging conflict in the future because I think what we see, and I think if you looked at the O'Malley Commission and others, there is nothing that people who look back historically can say that there are issues relative to independence from a consulting standpoint. So, if you want to be someone who manages your business and your enterprise in the rearview mirror without looking ahead of the road in front of you, that is probably a good stand to take and say that there has never been anything in the past. But I think if you look at the way this economy is emerging and if you look at the way consulting practice is emerging and the alliances and the interrelationships that were extremely difficult, the motivation of the people in that business, there are clearly, clearly obstacles in the road ahead and those businesses cannot exist under one roof as we go forward, which is why my firm made a decision that we should separate those businesses.
That is the way you look at the future in this profession. I think that is critically important to that part of the business, that will have to protect the investors and the integrity of the financial statements.
CHAIRMAN LEVITT: There are dialogues in our society which take on a life of their own. This is one of those dialogues. It has gone on for a long, long time. And whether there are rules or not rules is diminished in terms of what the public perception is today as a result of the high profile that these issues have assumed; and I think that really calls for a coming together so that we can be united in terms of what has to be done to reassure the public. I sincerely hope that that occurs. You have both shown extraordinary leadership in standing apart from others in the industry and working with the SEC staff to make the rule better.
Do you think there is any way that your -- those that are not at the table with respect to the rule proposal and the process -- can understand the importance of an effort which is less adversarial and more in the public interest?
MR. LASKAWY: It is impossible for me to say how others feel, but I have great confidence in the three other CEOs of the other three Big Five firms. And I think they are balanced individuals, they have responsibilities to their firms and responsibilities to the public. And I would hope that when they do see, at least what I call the PWC E&Y proposal, that, hopefully, they can embrace it and not find it probably much more difficult on substance than something that they actually could embrace. However, I know some of them are appearing this afternoon and tomorrow, and you only can ask them for an answer. But I hope they will reach that conclusion.
MR. SCHIRO: I would share Phil's optimism there. I think there is a fundamental quality inherent in this profession of integrity, ethics, and ideals and we are all very client service-oriented. We put at the forefront the needs of our clients. We put at the forefront the needs of our people. I would hope that, and expect, having dealt with each of the leaders of those firms, that they would embrace what we have before us and enter into a dialogue. I think you create change by entering into a discussion and dialogue, and I think that is critically important.
CHAIRMAN LEVITT: Commissioner Hunt?
COMMISSIONER HUNT: First, I want to join the Chairman to thank both of you for appearing. There have been occasions of some contentious dialogue in discussing this rule. This is not one of those occasions, and I think we are all very fortunate for that. I have not seen your proposal yet, but I look forward to reading it. And I look forward to the staff and re-engagement of dialogue with you to see if between our proposal and yours, we can fashion something that most of the profession will be happy with. Of course, my only comment about the AICPA and the others in the Big Five is I'm struck by the difference in perceptions and I'll leave it at that because we can't solve that problem sitting here this morning.
One question I do have for the two you is in your view, would our rule or your proposal adversely affect those firms that deal with these small and medium size client firms -- adversely?
MR. LASKAWY: Actually, Ernst & Young, and Jim will speak for PWC, we also have many middle-sized and entrepreneurial and smaller clients, I actually think that the proposal that you will be seeing shortly will absolutely protect the medium-sized and small firms from many of the issues that I heard mentioned since I was here. I think it will actually resolve, I can't say all their problems, I don't know all their issues, but I would say a great many of them.
COMMISSIONER HUNT: Okay.
MR. SCHIRO: I share that. I think we each operate in different markets. I think the size of our firms spans a much broader spectrum. I would believe that these rules would enhance and move the profession forward into the next century and help aid the change and transformation that needs to take place across this profession in its entirety.
COMMISSIONER HUNT: One of you mentioned that, I think it was you, Mr. Schiro, we should be very careful in trying to establish global rules. Well I know you are a global firm, both of you, what we are trying to fashion, of course, is rules for the profession and this Commission in this country, in our market, without denying the globalization and integration of the markets in the profession. Do you see unintended consequences on your foreign affiliates from us adopting either our rule or yours?
MR. SCHIRO: I think that the point I was trying to make is it is hard in this environment today to say that rules do not transcend borders. We have to be sensitive to that. I think we have pointed out and have been working with the members of the staff in those areas where we think that there might be some. I think that we also have to recognize the fact that this country enjoys the most vibrant capital markets. People come to these markets to raise capital. And one of the reasons they come here and can with the safety that they can is because of reliable financial information. And we should not compromise and give that up. But at the same time, we have to make sure that we don't enter into extra-territorial rule-making.
COMMISSIONER HUNT: Well, I think we are very sensitive to that, because we have been working through our international organization to try to, as you know, develop a core standard of international accounting standards, particularly for use in cross-border offerings. So, I think this Commission is particularly sensitive to not trying to impose our rules on other markets and other societies.
But I appreciate your comment that we should be mindful of the unintended consequences, given the size andthe influence of our market and of your profession in our market and the combination of the two in the global economy, I think we have to be very sensitive to that.
MR. LASKAWY: Commissioner, can I just add?
COMMISSIONER HUNT: Yes, sir.
MR. LASKAWY: I will give you one specific example because it is one cause of consternation with Ernst & Young and I think the other firms, and that is the provision of legal services, which is not at the moment, for a whole host of reasons, allowed in the U.S. But in many, particularly continental European countries, the provision of legal services is embedded in accounting firms, and if allowed, in any rule that would deal with legal services that would impact what our affiliates overseas could have very dire consequences, actually.
COMMISSIONER HUNT: I am very aware of the practice on the continent of Europe, and I look forward to a reasonable dialogue from members of my profession on that issue with respect to how we practice here because I think, as you know, we are probably in the minority of the advanced countries in terms of keeping up this -- not even a serpentine wall but almost a solid wall except -- a straight wall except perhaps for tax services. And I think we have --my profession has to engage in a long dialogue so that we can see whether we are going down the right track or the other members -- the profession in other parts of the world.
But, anyway, thank you very much for appearing. We, obviously, all look forward to an improved relationship with all members of your profession, but I look forward to seeing your rule and trying to work with you to see if we can affect a satisfactory answer.
COMMISSIONER CAREY: Good morning, Mr. Laskawy and Mr. Schiro. I want to begin by applauding you both on being such fine examples of corporate citizenship and understanding that when you head an organization such as yours, you have a responsibility to the public interest, as well as your partners' interest.
The question I want to ask you both -- Jim, you did touch on -- is what do you think would be the impact or the risk in codification of the four guiding principles in the proposed rule?
MR. SCHIRO: I think, as I expressed, the concern I have of codification of the principles would lead to a narrowing and a lack of flexibility. I think when you see the proposed rule that we have laid out, the principles would be not part of the rule-making but a framework in which the rules would be laid out. Instead, we would have a listing of specific services so that we would have the flexibility of adapting this business and this profession to the changing needs of the profession.
MR. LASKAWY: Commissioner, I agree with Jim. I don't want to get into the details of those four principles but just on a personal level, I disagree with one and a half of them completely. But I would agree that moving them out of the rule and putting them into a preamble or some statement, I think would resolve the problem. But I think it would be very difficult if they were part of the rule and our joint effort would not include them in the rule.
COMMISSIONER CAREY: And, Mr. Laskawy, I just want to make sure I am clear on this, you share Mr. Schiro's view that one additional public member should be added to the ISB?
MR. LASKAWY: Yes, it is my --
COMMISSIONER CAREY: I'm sorry?
MR. LASKAWY: I actually have been saying that for a year before this was even an issue. I think before it was before the Commission, I was concerned that the perception, again, because I think Chairman Allen, when he testified early on, indicated that he had not seen any evidence where this 4-4 division caused any problem. And, by the way, again, we are both members. I just perceive the perception in retrospect is something that is a problem. And I don't think the votes in a sense will change, but I think it will make people more comfortable.
CHAIRMAN LEVITT: I think it is really terrific that the both of you were forthcoming with that. I mean that is where it should come from. When other SRO's have moved in this direction, it was their initiative and it is a smart thing to do. They shouldn't be dragged to the table. And, that obviously, was the spirit that you brought to this.
COMMISSIONER CAREY: Because it is a question we put to the AICPA last week but were disappointed in their response. Thank you both for being here.
MR. LASKAWY: Thank you.
MR. SCHIRO: Thank you.
COMMISSIONER UNGER: I just want to say I so appreciate your testimony here today, and I can't thank you enough for working with the staff -- with the staff and not us on the details.
COMMISSIONER UNGER: People have talked a lot in this dialogue that -- well, that we have begun to have now --in the course of hearing the testimony from the witnesses, they have talked about trust and respect, and I have always respected the accounting profession. I do think it is a noble and oftentimes thankless profession, perhaps not as much as lawyers these days. But respect I think always needs to be earned. And both of you earned my respect today in a very big way. I always believe there is a compromise to be had and if you have the dialogue, you can reach that compromise. And so I can't give you enough compliments on engaging in that dialogue and reaching that compromise with us. And from what I have heard, your proposal sounds eminently reasonable, and I look forward to looking at the details of that.
The one thing I thought I could maybe pick your brain on a little bit while you are here, is you both spun off your businesses, but there was a point where both of those, the auditing and the consulting co-existed at your firms. And so I just wanted to hear from you, perhaps firsthand if you don't mind, how that worked and what caused you to spin off the business?
MR. SCHIRO: I think Phil has already accomplished his, and we are in the process. As I said before, I think that what we had up to this point, that is when I used the analogy of looking in the rearview mirror, I think what we had involved -- and I often say there was a person named Luka Papioli who was the founder of the accounting profession, and he was the auditor, the generator of the bookkeeping work and there was no segregation of all of these activities. And as times changed, you had a segregation of those who kept the books and those who audited the books and things moved on. But there was a need for us to help companies devise systems, systems that would allow them to accurately keep books and records. And there were two groups. We were not having the people who were developing those systems auditing those books. There was a distinct -- listening to comment you had earlier in one of the testimonies, where somebody had mentioned that people were implementing the systems were also auditing the systems, I'm not sure --
COMMISSIONER UNGER: We heard that a couple of times.
MR. SCHIRO: I am not sure, I don't know how accurate that is, but I can say that in PricewaterhouseCoopers, I would say that in all of the large firms, that does not exist, to the best of my knowledge. That is not the way we built those businesses.
As I looked to the future of what was happening with the consulting business in our firm, it was happening as you looked out, as you were entering into partnerships to help implement large-scale systems. You couldn't do this alone and the economic relationship with the client in implementing those large-scale systems -- clients were expecting you to take different kinds of positions with them. Clients are potentially asking you to look for equity participation. Into the future, as I looked at how those businesses are developing, I don't see that those businesses can exist under the same roof. That was not the way these systems -- and the size of some of these projects -- in the past, on a relative fee basis from a perception standpoint, they were much smaller. And these jobs are getting much larger in terms of some of the jobs. I think Phil mentioned the same thing in his testimony as well.
COMMISSIONER UNGER: What was the breakdown in the revenues when you decided to spin off your business?
MR. LASKAWY: Approximately 40 percent consulting, 35 -- I want to add up to 100 percent -- 35 accounting and auditing and 25 tax would be approximately, give or take. Before I respond, and I'll try to be brief, can I give you my parents' phone number so you can call them?
COMMISSIONER UNGER: Absolutely.
COMMISSIONER CAREY: We'll send them flowers.
MR. LASKAWY: Oh, well, that's --
MR. LASKAWY: When we started building a consulting business -- and we all had consulting businesses, all the Big Five for 50, 60 years, some larger than others, but certainly Ernst & Young would have been a smaller consulting business, it was really to give the kind of advisory help in a very different environment -- I am talking 15 years ago before this big technology boom, and I think those kinds of services really would still be helpful to be given to clients. But suddenly there was this tremendous demand for consulting services that just grew and filling a void in the marketplace, in my opinion, is what happened. Some of it was good positioning and good planning, but a lot of it was theserendipity of the times and suddenly we had this enormous consulting business, at least Ernst & Young did, which was doing very, very well. We really don't believe, as you know, that we ever impaired our independence on an audit but that is not the issue.
But, actually, in the last couple of years, as this business has evolved and developed, it really, as Jim said in his prepared remarks, it really has become very, very separate and very distinct from the rest of our business. And it is nice to have a business that makes a lot of money and is profitable and is growing quickly but in my opinion, there was no longer any synergy with the business, and I also felt there was a need because of independence issues, capital-raising issues, that it was time -- it was a wonderful run and it was time to move on and go back to our roots. And, as I said in my remarks, I believe our partners -- certainly, they were rewarded with some financial benefit but they are very, very happy because they are back in doing what they do.
CHAIRMAN LEVITT: And that certainly would be responsive to those who argue that the consulting services are essential to performing a quality audit.
COMMISSIONER UNGER: And I am fairly certain that there was testimony to that effect, that the reason to keep them together --
MR. LASKAWY: Oh, yes, there is a need.
COMMISSIONER UNGER: Thank you. The reason to keep them together was that synergy and was the crossover, that you would have one of these experts -- or I forget what they called them, technology expert or something, consultant come over and help with the very technical part of the audit and then wouldn't it be so great for that person also to work on providing other types of services for that client.
MR. LASKAWY: There is a need and that is why in our discussions we have been having with the staff, there is a need for a certain level of capability because in the conduct of an audit, which is becoming a much more sophisticated challenge, you need an array of experts, not just auditors, to do an audit. And to be able to attract these experts, they like to do consulting and other things beyond just the audit. And I believe, and I think under even our no action letter with the Commission when we sold our consulting business, we still have the capability to have that array of experts. So, the argument that you have to have 30,000 consultants to do an audit is not real, it never was real, because, as somebody said earlier in the day, what percentage of clients are you doing consulting for and it is usually in the 20 to 30 percent range. So, the other 70 percent, I hope, are getting good audits.
On the other hand, to defend those who make that statement, there is a strong argument the more you know about your client, the more involved you are in all aspects of the business, the more likely and better opportunity there might be to find some deficiencies that might not occur otherwise in the audit process. So, there is a certain relevance or reality to that argument. But at the end of the day, I think it is overwhelmed by the other side of the issue.
MR. SCHIRO: Yes, I think the world has become increasingly complex. I think the challenges that you face as an auditor and the ability to help manage risks requires a much broader array of technical expertise. That does not mean that those people must be implementing in that area.
Now, you have to attract and retain quality people. And as Phil points out, I think we have allowed in the proposed rules that we have the flexibility to allow some of those people to meet those challenges so they can stay ahead of the curve. You don't want to be auditing in an environment where you know less or you have a knowledge level that is less than those who you are auditing. And I think that is the challenge that we face, and I think we can strike the right balance.
COMMISSIONER UNGER: We have that challenge, too.
MR. SCHIRO: So --
COMMISSIONER UNGER: I'm sorry, would there be any cross-over then, once your business is spun off, and do you have any now from those who are in the auditing -- consulting side, to assist in the audits?
MR. LASKAWY: Well, our goal would be to have and we believe -- that is why one of the issues in affiliations and alliances is such a big part of it and on the back burner probably in a lot of the public commentary from outside the profession, but it is such a big issue for us with respect to this rule. We need the ability to have affiliations and alliances with certain maybe consulting companies and maybe other companies so we can be sure we have the capability that we might not house in the LLP going forward.
COMMISSIONER UNGER: Would you ever contemplate using the same individuals for the consulting as advisors on an audit?
MR. SCHIRO: Not on an audit, be auditing their own work. I think what you have to say and look at is if you were to ask me these questions two years ago, my view, and the Chairman and Chief Accountant heard with me, I believe in the multi-disciplinary services, that you needed these skills. I think that what I see is the technological revolution that has crept up on us so rapidly where you have some of our clients who can close their books and records in one day, and it takes us a much longer period to audit those books and records.
We have to get to the point where we're investing in redefining this accounting and auditing profession so that we can conduct simultaneous contemporaneous audits of information -- not just financial information, because you can see the dramatic impact that information on the marketplace has on the markets.
It is not the historical information, it is the disclosure of a press release that is fictitious that wipes out half the market value of some companies or the supply chain in a company like E-Toys that basically someone says they are not going to be able to fulfill orders. That wipes out 50 percent of the market value in a single day. We have to be in a position where we have the technological expertise to audit in contemporaneous fashion, to help companies manage risk over the Internet because this world is collapsing very rapidly around us.
COMMISSIONER UNGER: I appreciate that. One of our former colleagues, Commissioner Wallman, wrote an article about the fact that eventually there will be real time financial reporting. And I do agree with that. The question is how soon. Will be ready for that? I am not sure.
So, do you think then that there is any way to protect against the conflict of having the same personnel work on an audit and a consultant at the same time?
MR. LASKAWY: Well, I am not sure, Commissioner, on exactly your point. I think the people who work in a consulting capacity on an audit client are not the people who are doing the audit. They are assisting the auditors in being able to conduct the audit. Now, at the same time, if they are asked to do some consulting on a particular area, for example, let's use financial derivatives. We have people who are experts on financial derivatives, I think absolutely they can help a client deal with a problem and at the same time be assisting our auditors in doing an audit of the derivatives or the transactions. Yes, I think that works fine. It has always been the way we have operated. This is not something new. It is just that there are more areas of expertise that are needed than had traditionally been needed.
COMMISSIONER UNGER: Well, again, I compliment both of you and your firms for working with us and for having a dialogue. I appreciate it.
MR. LASKAWY: Yes, thank you very much.
COMMISSIONER HUNT: Thank you.
Panel 6 (Morning)
CHAIRMAN LEVITT: The next panel is Mauricio Kohn, principal of Kohn Financial Consulting, representing the Association for Investment Management and Research; and Thomas M. Rowland, senior vice president of Capital Research and Management Company.
MR. KOHN: Thank you, Chairman Levitt. First of all, I would like to thank the Commission for the opportunity to be heard. My name is Mauricio Kohn, and I am a principal of Kohn Financial Consulting, which is located in Michigan. I am a chartered financial analyst. I am a certified management accountant and certified in financial management.
I am here with Georgina Black, to my left, of the Association for Investment Management and Research.
Specifically, we are here to present information, that we collected via surveys of members of AIMR regarding the issues that have been formally before you for the last several months.
For background information, the AIMR is a global nonprofit organization of over 43,000 professionals in 90 countries. Through its headquarters in Charlottesville, Virginia and more than 95 member societies and chapters throughout the world, AIMR strives to provide global leadership in investment education and development of professional standards. In that regard, AIMR has a Standing Advocacy Committee for the U.S., as well as other regions of the world. I am a member of the U.S. Advocacy Committee and serve on that committee's Audit Subcommittee. It is through this subcommittee that we conducted surveys of investment professionals for purposes of the SEC's proposed revisions on auditor independence. Our subcommittee focused on some of the same issues that are currently before you.
In addition, our committee has worked with the ISB where some of our members have served on task forces on these same issues. We have responded to ISB proposals and most recently responded to the O'Malley report, which has been referred to by several of the participants who have previously appeared before you.
Consistent with the AIMR's core principles of full and fair disclosure, our comment letters are posted on the AIMR Web-site. In addition to the subcommittee's findings, I have some personal observations from, as I would call it, "the battlefield," that echo some of the comments from some of the earlier presenters.
Before going into the results of the survey, let me say that AIMR believes that external auditors who are independent in fact and appearance and are objective play a crucial role -- or a critical role in maintaining the credibility of financial information disseminated by enterprises within the U.S. capital markets and by users of that information for investment decision-making purposes.
Our prepared remarks contain a summary of the findings from three surveys that we did this past summer. Ms. Black and I are available to discuss some of those findings in more detail during the question and answer period.
In answer to some of the concerns voiced by the presenters that sought to know whether the issue of auditor independence is as large as currently made by this Commission, let me say that we sent out approximately 27,000 surveys in total and received approximately 3,000 responses from investment professionals around the world. Our survey results are broken down by U.S. respondents and international respondents.
We submit that the results of these surveys of investment professionals answer the questions as to whether or not the concerns relating to auditor independence are as large as what the Commission -- what some people argue the Commission is saying.
Our surveys were broken down into three topics. One dealing with non-audit services. The second questioning whether financial interest would impair auditor independence. And the third was the employment relationships.
As I said, we surveyed approximately 30,000 or 27,000 respondents or survey participants, and we had a response rate of approximately 11 percent, having almost 3,000 respondents. Of the 3,000 respondents, they are pretty much evenly distributed among the three surveys, so the results were broadly the same based upon the number of respondents.
Without taking time to go through all of the details in the prepared text, let me just summarize some of the key positions that AIMR found and was supported by the surveys that we did.
First, an audit firm itself should be prohibited from having any ownership interest in an audit client and vice versa. The same is true for partners of the firm involved in the audit. Over 85 percent of the respondents to this survey indicated that that was their position, confirming our belief. Any ownership in an audit client should be held by an independent trustee or mutual fund or blind trust.
Two, non-audit services, such as appraisal and evaluation services, outsourcing and legal services should be prohibited or severely limited in scope. Survey results support this position as well with approximately two-thirds between 61 and 65 percent, respectively for those three types of services, indicated that they believe it would impair auditor independence. Our prepared remarks contain additional survey results for 12 different types of audit services outlining the surveys that we conducted.
As for the mandatory cooling off period that prohibits clients from hiring audit firm professionals, we believe that is too restrictive and could adversely affect U.S. companies competing for talent in a competitive marketplace. However, 62 1/3 percent of the respondents to our survey agreed with the disclosure provision for key positions in either the form 10-K or 8-K.
Fourth, full and fair disclosure of these potential conflicts of interest and our independence issues is a must.
Advocacy -- AIMR advocates that investor's analysts should be provided with all relevant information to make informed decisions. Personally, it is my own independent opinion that, as it relates to disclosure, the decision should be towards inclusion rather than omission. After all, one person's judgment about relevance may not be the same as another. Furthermore, it is my opinion that disclosure should not include not only the fees earned but more importantly the potential fees that could be earned in the next year based upon the work that is currently being sought by the audit CPA firm for non-audit services. After all, the question of independence can be impacted not only by work done but by the prospects of receiving additional work.
Another question that you should ask relating to the issue of auditor independence is if the investing public is equally divided on the issue of non-audit services affecting auditor independence, then it is a question as to whether analogy can be drawn to a clock that isn't working properly versus a clock that is set to the wrong time. What good is a clock that doesn't tell you what time it is or how much time is past to know how long I have been speaking as opposed to a clock that is set to the wrong time but accurately tells how much time is past?
Some in the accounting profession have questioned whether the need for reform is needed since no empirical data supports this. We believe that our complete survey results provide insights into what the public perceives and ultimately it is perception that drives the market.
In closing, on behalf of the AIMR, Georgina and I want to thank you for having this opportunity to present results of our surveys we conducted of investment professionals, the users of financial statements, and to help you decide this very difficult issue before you. We welcome the opportunity to be further involved and are available for questions.
CHAIRMAN LEVITT: Thank you. Mr. Rowland?
MR. ROWLAND: Yes, thank you very much, Chairman Levitt. And, again, I appreciate the opportunity to come before the Commission and express my views. As you mentioned, I am currently a senior vice president of Capital Research and Management Fund Business Management Group and in that responsibility -- I oversee the financial accounting of the American Mutual Funds, which is the third-largest mutual fund complex in the United States. Prior to joining Capital Research, I was an audit partner with over 20 years with one of the Big Five accounting firms.
My comments today are not a representation of Capital Research or my former partners and associates in the accounting profession.
I would very much like to commend the Commission for taking up the issue of auditor independence. I think it is an extremely timely and important matter to be considered. I think the changes in the accounting profession during the last five or 10 years have much out-paced the change in the oversight and rule-making with respect to auditor independence.
Rather than read from my prepared comments, I would like to just focus on a few areas that are particularly important to me and which I believe I can contribute to the work of the Commission. These areas are financial relationships, quality control standards and, of course, scope of services.
With respect to financial relationships, I think we all agree that mutual funds have become an extremely popular investment vehicle in the United States. The Institute believes that approximately 50 percent of the households in the United States own mutual funds. I think it has also been a very popular medium for investment with people within the accounting profession, particularly in the mode of retirements. So I think that clarification of the rules with respect to investing in mutual funds is appropriate for the Commission at this time.
And I think the mutual fund industry is unique from other operating industries for a number of reasons. Number one, the regulatory oversight provided to the industry, the extensive regulations with respect to the industry, the strong oversight from the independent directors and the independent directors that serve on the audit committees.
Let me focus first on the issue of direct investments. The proposed rule by the Commission would preclude direct investments from the firm, covered persons in the firms and family members in the firm from investing in audit clients. I very much support this view.
What the rule also allows, however, is that other members of the firms not associated with an audit have the ability to invest in an audit client of the firm. This is where I have some concerns. First, I think it is very essential that the firms have strong methods and effective controls over the investment activities of their professionals. I think we need to avoid the situations of inadvertent violations.
I was personally a little embarrassed to see the number of exceptions in direct investments that occurred recently among one of the Big Five firms.
Secondly, I think the firms may need to take a little more restrictive view with respect to non-covered people investing in mutual funds or in client's mutual funds in particular. And the reason for this is, as we all know in the profession, there is a fair degree of turnover in the profession. And we, as a consumer of audit services, expect the firms to provide the best and the brightest to our accounts. We would not like to find ourselves in the position of the firms being unable to provide these resources to us because of independence conflict by people who are not currently serving on the engagement. This could also be extrapolated to people who provide ad hoc advice during the process of an audit. Frequently, we ask our audit firms for advice on technical matters. We would not want to be precluded from these resources because of an independence conflict.
Indirect investments is a little more difficult to describe. Here the proposed rules would allow an audit person -- a person from an audit firm to have an indirect investment in an audit company. And in this particular situation, what we are talking about are the body of the profession which are a lot more limited than the broad group. We are talking about the people who are actually involved in the audit.
I think that there are significant differences, as I mentioned, between operating companies and mutual funds, which I would recommend the Commission study before finally issuing its regulations. As I mentioned, mutual funds are highly regulated. They are operated much by way of contract. In addition, the investments by mutual fund are more of a passive investment rather than soliciting an influence over control of management. And because of this passive investment, there are different accounting rules applied to mutual funds than there are operating companies.
There are two scenarios that are covered in this proposed rule. And the first is where the auditor invests in a company that owns an audit client. The second is a situation in which the auditor's client owns a company that is also owned by the auditor.
I would suggest that there need not be a restriction on indirect investments in mutual funds. In the situation in which the auditor invests in a mutual fund which owns a company which is audited by that mutual fund, there are very few, if any, conflicts of independence. The accounting rules for mutual funds are very clear and that the valuation of securities in a portfolio mutual fund are governed by market values, not by the underlying financial statements of the company.
With respect to operating companies, the rules governing accounting are much different. Depending upon the control of ownership, which is often measured by percentage ownership, the company could be accounted for on a consolidated basis or on the equity method of accounting. So, in this situation we could have potentially a situation in which the auditor, its investment in a company includes the financial results of the company that the auditor has an investment in. Therefore, I would propose with respect to the rules that there should be no -- the rule should not allow a small investment by an auditor through an indirect method. I think it is reasonable and feasible. We are talking about a relatively small number of professionals in the firm in which this would be applicable to and the propensity for auditors to invest in companies other than mutual funds, I think would be a less prevailing case.
COMMISSIONER HUNT: Mr. Rowland, could you sum up? We are running out of time.
MR. ROWLAND: Sure, okay. The next section which I would like to talk about is the scope of services. I particularly appreciate the opportunity to share my views here in the area of non-audit services. And I would remind you that these are my views. They are not motivated by an economic relationship with my prior firm, as I have none. They are, however, based on my many years of experience as an auditor.
I believe that the Commission has been presented with a number of sincere views from many distinguished and experienced individuals on this topic. Although they differ in the elements of the proposal, I believe they all support the intended outcome of such proposal. That is the integrity of financial recording as critical to the success of the capital markets and expected by the users of financial information. Any efforts that can assure such integrity should be undertaken.
I believe the proposal of the Commission and the support given to the profession over the years should be commended. There have been a number of advancements over the years which have actually helped the auditor with respect to the independence issue. To name a couple, one would be the notification to the Commission of auditor changes, efforts on behalf of the Commission to preclude opinion shopping among companies. I particularly applaud the work.
COMMISSIONER HUNT: You have got to give us your summary on this issue so we can move ahead.
MR. ROWLAND: Okay.
COMMISSIONER UNGER: I think that your written testimony will be part of the record but in fairness to the other witnesses, you really need to stick to the five minute rule.
MR. ROWLAND: Okay.
COMMISSIONER UNGER: More than five minutes. Good, thanks.
MR. ROWLAND: I would say that it is hard to refute the logic that has been presented with respect to non-audit services, but what I would ask the Commission to look to with respect to audit failures is the role of management, not to allude that there are a lot of management out there that do not have integrity but the headlines seem to focus on the auditors. And I would say that you might find a high correlation of inappropriate behavior on the part of management in these situations as well. I reflect back 15 or 20 years ago in the defense industry, there were a number of issues with defense contracts and improper charging to contracts. This was addressed by ethics measures by the companies. And I would recommend that the Commission focus also on measures that could be taken with respect to this debate.
COMMISSIONER HUNT: Thank you very much, Mr. Rowland. I think your experience in the investment company business industry is interesting, and I think we will think some about -- given your written statement, the applicability of these rules perhaps to the investment company industry might require some further thought on our part. So, I appreciate your comments in that regard very much.
As you agree, as everybody would have to agree, this is a huge and very important industry in American society now, and we do need to give some careful thought to whether the same rules need apply to auditing in that industry as opposed to I traditional operating industries. So, I thank you for that comment.
Mr. Kohn, your survey, will it be a part of our record?
MR. KOHN: Yes, we just closed at the beginning of September, and we are compiling all the statistics at this point.
COMMISSIONER HUNT: And, essentially, the respondents about 11 percent essentially agreed with the Commission's point of view with respect to the scope of services issue?
MR. KOHN: We have a breakdown specifically by different types of services, but we had a survey response of 11 percent of the survey of the people we surveyed responded to the surveys. As it relates to all classes, I think the breakdown was approximately equal, 44 or 45 percent were in favor or felt that it would impair versus would not impair auditor independence across all -- as a general proposition.
But as it specifically relates -- and Georgina has the specifics and I will let her go into the specifics.
COMMISSIONER UNGER: What about that 10 percent?
MS. BLACK: They were uncertain about how to respond either yes or no that it would impair independence. What Mauricio is alluding to is the question that was asked actually on all three surveys, that asked, "Do you believe an audit firm's independence or objectivity would be impaired if they provided -- if they advocate or lobbied on behalf of their audit clients in front of a legislator or a standard setter, accounting standard setter. And that is where we had kind of a 50/50 split in the 3,000 respondents was 44 percent said, "Yes, it would impair." Forty-five said, "No, it would not." And the rest were uncertain how to answer that question.
COMMISSIONER UNGER: How much longer before you compile the results because our comment period is closing rapidly?
MS. BLACK: Well, we have the statistics as far as the data itself but actually looking at questions and the responses to make sure there is no conflicting viewpoints that are based on maybe how the question was posed to those responding, and plus we got a lot of narrative responses as well that we have to kind of weed through and see if there is a common theme in some of those responses and what that may be.
COMMISSIONER UNGER: Okay. I appreciate the fact that you did the survey and that you are willing to include it in the record. And I appreciate both of your testimony.
But I would like to pick up where you left off, Mr. Rowland, which is the independent directors and what you both mentioned in your testimony, which is the Audit Committee and the role that they play in I guess ferreting out potential conflicts and making the determination for the company, the audit client as to whether or not the relationship with the auditor is something that has potential conflicts embedded in it, I guess. We have heard varying testimony on this particular issue and the ability of the Audit Committee really to get that information and to make the determination needed to truly protect the independence or preserve the independence. Can you comment on that a little bit?
MR. ROWLAND: Yes, here again, I would very much commend the Commission on their efforts to have financially literate Audit Committee members. I think it is extremely important that they are able to ask the right questions.
With respect to the non-audit services, the one thing that maybe could be done differently is typically the work that the accountants have done is brought to the Audit Committee after the fact. And maybe an improvement would be for the scope of services to be brought before the Audit Committee prior to engaging in those services so that the Audit Committee would have an opportunity to ask the questions of the consultants, auditors, and the company to arrive at an informed decision.
COMMISSIONER UNGER: But is that realistic -- it sounds good but is that realistic given how quickly things move and what the prior panel said in terms of probably this not-so-distant future trend of more real time financial reporting. Will the Audit Committee be able to assemble and consider and get back in time for it to be a relevant consideration in terms of the engagement?
MR. ROWLAND: I would say that under most circumstances firms go out for competitive bids with respect to consulting services, and they do not happen that quickly. It is a period of weeks, months, in requesting the proposals, analyzing the proposals, so I don't think it would be a particular burden to ask the Audit Committee people to look at them.
COMMISSIONER UNGER: How frequently do the Audit Committees meet? Upon demand?
MR. ROWLAND: Well, they certainly are available on demand if issues come up that they should be dealing with. And I think that is integral in the relationship between the auditor and the Audit Committee. In our complex, the Audit Committees meet twice a year but we do have phone meetings with them and provide them with information on a monthly basis.
COMMISSIONER UNGER: And what do you think their reaction would be if they were to have to take upon this new role?
MR. ROWLAND: I can't answer for them, but I would say that they are very diligent, they are professional people, they are interested in the well-being of financialreporting, so I believe that they would embrace it.
COMMISSIONER UNGER: Mr. Kohn?
MR. KOHN: I think I would agree with Mr. Rowland, from my own personal viewpoint, I am not speaking for the Association for Investment Management and Research. The idea of being proactive in terms of the evaluating the scope of work to be done or the issues to be uncovered or the concerns to be raised would be helped by being proactive with the Audit Committee as opposed to reactive to information that was provided to them after the fact.
COMMISSIONER UNGER: But will the Audit Committee be able to sufficiently protect against potential conflict so that there isn't a question of auditor independence, such as we are looking at today?
MR. KOHN: It goes to the -- again, I don't believe our survey had questions on this particular issue, but from my experience in the consulting arena of privately-held businesses, the question, and as I understand from the issues here today, it depends upon the scope of work that is being provided as to whether or not they would be able to safeguard the issue of auditor independence and the perceptions of it.
The problem you run into is that if you are auditing your own work or if the public perceives that there is a lack of independence or conflict of interest in the opinions that the auditors are expressing, how can the market not assess that there is a greater degree of risk and therefore the return requirement has to be higher, making the capital markets less efficient. So, if we have the ability -- if a CPA firm or an audit firm has the ability to provide services which the public perceives puts them in conflict, it has to create an ultimate inefficiency in the marketplace.
COMMISSIONER UNGER: Do you think the public perceives that there is a conflict today?
MR. KOHN: Well, I think that the fact that the discussions are going on and based upon our survey results that we did, the investment community perceives that there is a risk of that occurring. I think that the conflict is more evidenced when there are problems in the companies, major blow-ups and so forth.
But I believe, as several of the panelists have commented before, that the issue of auditor independence is a state of mind. And when I serve as an arbitrator for the American Arbitration Association or the NASD, the mandate we have to serve as an arbitrator is to be neutral, is to be free from any bias, any conflict, and even the perception of a bias or a conflict at a minimum should be disclosed. And it is in that regard that I believe the auditor should have the requirement to be independent from the work and not be subjected to the possibility of being questioned on whether or not they issued the audit because of a possible lucrative consulting contract that was in the wings to be awarded or because of the way that the consulting arm versus the audit arm -- it is ultimately that issue that has to have some impact.
The Journal of Accountancy in 1978 had an issue of the politicalization of information. And the parallel that they draw in that article was the issue of whether or not if your weather reporter, who is trying to provide you information about the weather, owned an interest or had a perception that you had been planning a picnic for the weekend and wanted to ensure that you had a nice time, so told you it was going to be sunny when in fact he knew it was going to be -- that the storm clouds were looming, he wouldn't be doing you a service. And, similarly, if he had a interest in an umbrella store and projected it was going to be raining, it wouldn't do you service to predict that there is going to be rain in the future. So those types of issues create the possibility and the eventual erosion of reliance on that information.
In addition, the work that I have done overseas in emerging markets suggests that the markets over there are very inefficient because there is no reliance on the financial information that is compiled and reported. So, to the extent that several of the panelists have talked about the possibility of that trend occurring, it is a slippery slope I don't think -- we don't want to even come close to going down.
COMMISSIONER UNGER: Do you see any evidence now that people are looking for a higher rate of return in response to the possible conflict issue?
MR. KOHN: In my personal business, I specialize in valuing closely held businesses -- or privately held businesses, and I am involved in a fair amount of litigation quantifying damages and lawsuits. I have seen instances in the empirical studies relating to rates of return compiled by numerous sources to support the fact that smaller firms, or the lack of information or concern relating to the quality of information, to require or impose a higher degree of return.
As far as it relates to auditor independence issues, I don't think there has been an empirical study to that single effect. But the issue clearly has a direct relationship to the quality of information.
COMMISSIONER UNGER: Thank you very much. Mr. Rowland, did you want to add anything to that?
MR. ROWLAND: Yes, I would say, being an audit partner and being in the profession for 35 years, I can tell you that at no time during my career did I feel pressure from other partners in the firm, either audit partners, tax or consulting partners, not to do the right thing. The view I believe rightfully was is that the risk associated with doing the wrong thing far outweigh any benefit that could come from other relationships that you might have. I can understand how people might believe from a perception that it is a problem. In my career, I personally did not experience it. And I have had to deal with some tough client situations and in every instance, I felt the firm was completely behind me, whether it meant keeping or rotating the client.
COMMISSIONER UNGER: Did your firm ever use the loss leader discount on audit services?
MR. ROWLAND: I would say that there certainly is that -- that goes on in the industry. The industry has become very competitive from the fee perspective. I personally believe that that is wrong and that I think my partners and I would have liked to have a situation in which that didn't occur. I would say that we have many clients that didn't produce the return that others did. Never, however, was there any pressure on us not to do what we thought was right. There was no second guessing about what you did or how much time you spent. The focus was on doing the quality job. If you didn't make a profit on it, that was a secondary decision that was dealt with after the fact, whether in fact you wanted to retain the business.
I think, interestingly, I have been to hundreds of Audit Committee meetings, and I would say that sometimes I think the Audit Committee kind of lose a little bit of track of the relationship with the auditor in that I have seen situations where Audit Committees have encouraged management to go out for bid for audit services and condone that. I would say that the Audit Committees would be better served asking the question if the auditors didn't get enough, encourage the auditors, in particular the senior members of the audit staff to spend more time on engagements and make sure that it was economically viable for them to do it.
COMMISSIONER UNGER: So, I guess your answer is yes?
MR. ROWLAND: Yes.
COMMISSIONER UNGER: Thank you very much. I appreciate your testimony and the whole panel.
MR. ROWLAND: Thank you.
MR. KOHN: Thank you.
(Off the record.)
* * *
Panel 1 (Afternoon)
CHAIRMAN LEVITT: The next panel will include Clarence E. Lockett, corporate controller for Johnson & Johnson, James W. Barge, Controller for Time Warner, and Robert Ryan, Chief Financial Officer of Medtronic, Inc.
MR. RYAN: Thank you. I appreciate the opportunity to participate in today's hearings on the revision of the Commission's auditor independence requirements. I have six points I'd like to discuss related to the proposed rule changes. As you'll see, we agree with the Commission's objectives but would realize them in a different manner than proposed in some cases.
For the sake of time I'll just refer to my written statement that's in the record for the first two. The first one relates to employment relationships with audit clients; the second relates to financial relationships with audit clients. And I'll just say here that our view is that this is much more focused. We think they're logical, less bureaucratic, and we're completely in agreement.
Our third point relates to the four principles by which to measure an auditor's independence outlined in the Commission's rule changes. We concur that an auditor is not independent if he or she has a mutual or conflicting interest with the client or audits his or her own work or functions as management or employee of a client or acts as an advocate of the audit client. We are in complete agreement with these four guiding principles.
Our fourth -- the application of these four principles is our fourth discussion point. The Commission has specifically added financial information system design and implementation and internal audit outsourcing to a list of services considered to impair independence.
As each situation is unique, we contend that the Commission should avoid defining specific activities that canor cannot be performed by the auditors and instead focus on the four guiding principles mentioned above.
For example, we agree that if an accounting firm designs and implements an audit client's financial information system or any related system, independence would be impaired. This would create a significant mutual interest between the client and the auditor and would result in the auditors' reviewing their own work.
On the other hand, if an internal audit function reports directly to the Audit Committee and does not perform any bookkeeping functions, we do not feel independence, whether real or perceived, is impaired.
The Commission states that the auditor would be relying on a system he or she helped establish and maintain or that management and the external auditor may become partners in creating an internal control system and share the risk of loss if that system proves to be deficient.
We contend that external auditors already have a stake in the maintenance and establishment of internal controls through the testing they perform and the improvements they recommend; as a result they already share in the risk of loss should the system fail.
In addition, external auditors must satisfy themselves as to the soundness of their client's internal control systems, which they will do regardless of who performs the internal audit work.
The bottom line in this scenario is that the outsourcing of internal audit could be viewed as an extension of the external auditor's existing role, and should not be treated differently when evaluating independence. However, of the internal auditors regularly performed monthly account reconciliations or similar tasks, we would agree that independence would be impaired, since the auditors would review their own work -- a violation of one of the four governing principles.
Each situation and the circumstances surrounding it is unique. Thus we do not believe that specific activities should be excluded from the activities performed by a company's auditors. Each situation, we believe, should be evaluated based on the four guiding principles proposed by the Commission.
Our fifth point relates to the role of the audit committee. Ensuring auditor independence has long been an objective of corporate audit committees. At Medtronic, our audit committee is actively involved in assessing our auditor's independence. I can tell you that they take this responsibility very seriously.
In the past year, requirements and responsibilities of audit committees have been enhanced, creating more engaged and active committee members. We believe that we should continue to require our audit committees, who are in the best position to evaluate independence, to play an active role in this assessment process as the proposed rule changes outline.
Our last point relates to the proposed rule changes on disclosure requirements for non-audit services. An important consideration in evaluating independence is the magnitude of the fee of the non-audit service provided both in absolute dollars and compared to the audit fee.
It's fair to say that the larger the fee for the consulting service, the more likely independence, actual or perceived, will be impaired. However, determining the appropriate threshold is a matter of judgment, and each situation and service is likely to be viewed differently.
In our opinion, non-audit service fees would be considered significant if they exceed the greater of 25 percent of the audit fee or $50,000. These parameters are slightly different than the Commission's proposed guidelines of 10 percent or $50,000.
Full disclosure of the non-audit services exceeding these thresholds in the proxy statement, we believe, is appropriate. The disclosure should include the nature and amount of the non-audit service. I discussed earlier the importance of the role of the audit committee in assessing independence. We feel that it's equally important to disclose in a proxy statement that the audit committee has has considerede impact of non-audit services on independence, both actual and perceived, and has concluded that independence is not impaired by the auditors performing these services.
The disclosures proposed would require companies to perform their own independence sensitivity analysis which may serve as a wake-up call and should assure independence is achieved. Thus, we are in agreement with the proposed changes related to disclosure, with the exception of the magnitude of the non-audit service requiring disclosure.
So in closing, I'd just like to summarize the six points I've just mentioned. We are in agreement with the proposed changes related to employment relationships, we're in agreement with the proposed changes relating to financial relationships with audit clients, we agree fully with the four guiding principles used to measure auditor independence. We believe it is not practical to have rules that cover every non-audit service which can or cannot be provided by a company's auditors. Instead, we propose that the Commission should rely on the four guiding principles to act as the governing authority by which all non-audit services are evaluated. This philosophy acknowledges that each situation and its surrounding circumstances is unique.
The role of the audit committee is critical in evaluating and monitoring independence. Given the significance of this responsibility, audit committees should be held accountable.
And last, disclosure is a powerful tool in assuring that independence, both real and perceived, is achieved.
I'll make two comments that are not in my written statement. One is that I am responsible to Medtronic's audit committee but serve on two others. And I really thank the Commission for the approach taken; it's very thought-provoking and it's one that I will actively be raising and discussing on all three of the audit committees.
The second point that I'd mention is that I had occasion last week to talk to the CFO of Novartis, who has quite an interesting approach. Novartis, though they're not an American company, limits the non-audit work in dollar magnitude to 50 percent of the audit fees. So that at no time can they -- can more than a third of the dollars that they spend be for non-audit work, thus ensuring -- this is, again, something I will be discussing with each of the three audit committees.
CHAIRMAN LEVITT: Thank you very much, Mr. Ryan. I think you're illustrating a point that's really true in matters of public policy, particularly divisive issues such as this, where the very airing of the controversy creates changes in behavior, and I think more and more audit committees throughout the country are aware of the public interest implications of what we're talking about.
MR. BARGE: Thank you. I'm here as the Vice President and Controller at Time Warner, and I'd first like to thank my colleagues at Time Warner who helped me prepare for this testimony, including Steve Swann, who you know or will recognize as the former deputy here at the Commission. And I would also like to express my appreciation to the staff, having been a former member of the staff here at the Commission myself. I know how much work and effort goes into these rule proposals. And my hat's off as well as I appreciate the opportunity to be here to speak to the full Commission. And I thank you for that and I appreciate the role that you're perusing in terms of pursuing the public interest, and after all, that's all of our interest. Including previous people who've testified this morning and engaging in the issues in pursuit of real dialogue and in pursuit of, hopefully, very meaningful resolutions. So that's the spirit in which we are here.
I -- as noted in my testimony, we generally support the broad principles that have been expressed in the proposal. I am here to share specifically my views with regards to our experience at Time Warner with regards for our internal audit outsourcing.
In that regard, as you may know, we out source part of our internal audit function to our external auditors, we did this in 1998 and we did it as part of an overall massive, significant cost savings program throughout all of Time Warner.
I am here because I'm concerned that the proposed rule would put limitations into a service -- or on a service that we found very beneficial of Time Warner, beneficial for us as well as beneficial for the investors at Time Warner.
This is also a concern that has been expressed by our audit committee. We believe that all internal audit outsourcing is not created equal. By that we believe that if it is properly designed, the internal outsourcing function does not impair independence.
We think for purposes of evaluating independence, you basically have to look at the internal audit function as being two meaningful functions. First is the management function, okay? Here you develop a plan, you oversee the execution, you evaluate the results of the internal audit plan, and you communicate the significant findings to both the operating management as well as the audit committee.
And separate and distinct from that is what we consider to be the procedural function. This is where you perform the work necessary to execute the predetermined internal audit plan. And the procedural function represents selective testing and reviews of what is already an effective system of internal controls.
We agree that outsourcing of the management function would impair independence. However, the outsourcing of the procedural function does not impair independence. The very nature of this work is a test in nature. It's the same type of procedures that are carried out every day throughout the year as part of the external audit services.
In fact, we believe that the external auditors are in a unique position to carry out these services in the most efficient and effective manner.
Outsourcing the procedural function is no different than either (1) expanding the types of services being performed under the external audit or providing agreed-upon procedures at the direction of management. Both of these functions are carried out on a regular basis, these types of services, by the external auditors, with no perceived or actual impairment of their independence.
It seems awkward to us to preclude these services provided as a part of the procedural function of internal audit, which is under the direction of management and the audit committee, and to preclude services when they're essentially the same as the services that are permitted to be provided as part of the external audit and as part of agreed-upon procedures work.
I want to give you an example. We have a fulfillment center in Florida. We use this to fulfill customer fulfillment services with regards to various Time Warner subsidiaries, such as some of our magazines, et cetera. We also provide fulfillment out of that center for third parties. We might engage in agreed-upon procedures to the extent that the third parties wish to know and have some comfort that the systems within this fulfillment center are functioning as we intended. In such a case we might engage the external auditor in agreed-upon procedures work and they would issue a report to us which we would then make available to third parties, which basically indicated the type of procedures at management direction and basically what their findings were. A very standard part of the work that's carried on day in and day out.
Alternatively, if management just wanted general comfort that the systems there are proceeding along the path that we think they should be, we might go to our external auditor and say, "Hey, while you're there we'd like you to expand the type of work you're doing. And expand your external audit procedures." Again, nothing wrong with that, no independence issues whatsoever. We find it ironic that the proposed release would prohibit such a review to be done by the external auditors if it happened to be done and performed under the banner of an internal audit outsourcing engagement. That doesn't make sense to us.
We think there's another practical issue. We note that the Commission -- and appropriately so -- requires an adequate system of internal controls. However, an internal audit function is not required in order to have an adequate system of internal controls. Notwithstanding that, I think that we would all agree that best practices endorse comprehensive testing of the internal control system, including the establishment of an internal audit function.
We think the Commission should be encouraging best practices, whether achieved through outsourcing or otherwise, rather than placing restrictive limitations over the pursuit of such practices. Everyone, all of us, benefits from extensive testing, whether performed by internal or external auditors. We think that outsourcing with the external auditors actually provides for the most efficient and effective audit coverage. You have seamless coordination between internal and external audit functions. You have increased and more efficient use of the knowledge of the company.
You also have no competitive posturing between two firms. And importantly you have a consistent audit process and methodology. And as you're probably aware, I don't think any of the firms have the same process or methodology when it comes down to their audit approaches. Not only that, they frequently change -- or often change -- their audit approach and methodologies. And not only that, within the same firms you will find that oftentimes internationally, from country to country, that those processes and methodologies will differ.
We think that the benefits and strengths of internal audit outsourcing actually carry over to the external audit service, making it more effective. It increases the external auditors' understanding of the company, it increases the likelihood that the external auditor will detect errors, and it improves the suggestions for improving internal controls that comes out of the combined audit function.
If we were precluded from outsourcing to our external auditors, we believe that we would incur significantly higher external audit fees and that we would incur significantly more management time in trying to coordinate these efforts between two firms. And in fact, when we out sourced this in 1998, I believe that if we were precluded from outsourcing this to our external auditors, that we may have chosen to not outsource at all -- on the basis of the difficulty in trying to coordinate two firms across the world with regard to the provision of services. Our proposal is basically that we recommend permitting the outsourcing of the procedural function of internal audit. We also, in addition to that, believe that the audit committee should be involved in all the decisions, all the decisions to outsource internal audit. We also believe that investors should be informed through disclosure of the non-audit service fees with specific disclosure of the internal audit outsourcing fees.
In summary, this approach, we believe, results in seamless coordination of internal and external audit procedures. It results in better-informed auditors, and it's more efficient for management. It also avoids artificial distinctions between services provided by the external auditors, whether they're provided as a part of the external audit services, agreed-upon procedures, or internal audit outsourcing. It also encourages more extensive testing rather than placing restrictive limitations over the pursuit of best practices.
In conclusion, we believe that properly designed internal audit outsourcing, with audit committee involvement, with appropriate disclosure, will provide for more efficient and effective audit coverage, leaves governance in the hands of management and the audit committee, and results in more fully and better informed investors. Thank you.
CHAIRMAN LEVITT: Thank you. Mr. Lockett?
MR. LOCKETT: Mr. Chairman, Commissioners, good afternoon. I'm pleased and honored to be here representing Johnson & Johnson in its views on auditor independence requirements.
We believe that the auditor independence requirements need to be modified and amended based on many of the reasons that you already heard, the changing in the marketplace, globalization, increased investors, information technology, its impact on how business is done, the fact that auditing firms themselves are increasing their capabilities as far as advisory services or concern representing significant portions of the revenue of the firm.
But despite these significant changes, we believe that the accounting profession should set the rules for independence. In fact you, yourselves, indicated that you'd look to the Independence Standards Board to provide leadership in providing auditor independence and to establish and maintain a body of independent standards applicable to auditors of public companies.
We agree with this position and believe that the ISB should set such rules.
We recognize that investor confidence in financial statements is key and that management of public corporations is responsible for the accuracy and the quality of financial statements.
The independent auditors provide the public with assurance that these financial statements can be relied upon. It is, therefore, imperative that the auditors are truly independent from those that issue financial statements and that the public perceives them as such.
We agree in large with the proposed general standard for auditor independence and the four governing principles for determining when an auditor is not independent. However, we do not believe the four governing principles should be stated as firm rules. They should be part of the framework and serve guiding principles.
For example, we believe and hope all of you would agree, that high quality and transparent financial information is in the interest of corporations as well as their auditors. This could be described as a mutual interest. If the first principle listed -- no mutual or conflicting interest -- is read as a rule, one could argue that the example just stated is an undesirable and prohibited situation. We believe it is not.
In regard to financial and employee relationships, the proposed rule states that an accountant is not independent if the accountant has direct or certain of indirect financial interest in or an employee relationship with the audit client. These interests and relationships also extend to certain relatives of the accountant.
We believe the financial interest rule should apply to any member of the accounting firm who is part of the chain of engagement -- which would include the whole engagement team as well as those in the national offices or those rendering specific or ad hoc advice to the client.
As far as employee relationships are concerned, we suggest you consider the concept of "key positions" as the determining factor. Functions such as the Vice President of Human Resources or the Vice President of Quality Assurance or the Vice President of Operations who can make key decisions that can have a significant business and financial impact.
With respect to non-audit services, the proposed rule lists services would raise independence concerns if provided by the accounting firm to the audit client. We believe that, given the increasing complexity of business systems and business processes and the environments in which we must do business, knowledgeable individuals are required to consult on them.
Accountants and auditors certainly have such knowledge, and coupled with the knowledge they have about their client, they are a powerful source of business advice.
Therefore, we do not believe that auditors should be prohibited from rendering other services to their clients.
We believe it is in the economic interest of the investors that services be rendered by those who are most qualified to do so. Accountants and auditors are in a unique position to give sound business advice to their clients. However, the nature of those activities should not be such that it could lead to impairment of objectivity.
Further, we believe that a sound system of internal control, oversight by the audit committee, and proper disclosure are key in monitoring independence. For example, at Johnson & Johnson, purchasing of services is independent of audit relationships. Competitive bidding is used and has led to the selection of service providers other than our independent accountants. Additionally, all fees and services are reviewed with the audit committee. We believe this represents an adequate framework of ensuring we obtain the best services for the best price while monitoring auditor independence.
Please note that one of the proposed excluded activities deals with financial information systems. We would like to point out that corporations are more and more using integrated business systems, of which the financial system represents a module. And there is a need to ensure that proper controls are built into all systems. The prohibition of auditors to consult on financial information systems may therefore imply that consulting on any part of such integrated business systems will no longer be allowed or that consulting on controls over these systems would be prohibited.
We suggest you consider the situation and ensure that any proposed restriction is not so broad as to preclude corporations from taking advantage of the expertise of their audit firm.
On the topic of outsourcing of internal auditing, we believe that at times there is a need to use outside services for highly specialized areas or unique international situations. The logical choice for this type of activity is often our independent auditors, since they understand our business, policies, and concerns. The ability to draw on their resources enhances the control environment.
We also believe that broader outsourcing activities in the internal auditing area should not be prohibited since in many cases they can improve the total audit process. We do not believe such outsourcing should be prohibited when conducted under the supervision of the corporation's management.
On the matter of disclosure, the proposed rule recommends a proxy disclosure, which would require companies to describe specifically each professional service provided by its auditor and indicate whether the company's audit committee approved the service and considered the effect that the provision of each disclosed service could have on the auditor's independence.
Disclosure requirements on auditor independence were addressed by the Blue Ribbon Committee in their report on audit committees improving effectiveness. And in that report, which was adopted, they included a provision that the audit committee must attest in the proxy statement to the fact that they have reviewed independence with the independent auditors, received from them a letter identifying the independence in accordance with Provision Number 1 of the independent -- from the Independence Standards Board.
CHAIRMAN LEVITT: Mr. Lockett, may I ask you to summarize, please?
MR. LOCKETT: Yes. I'm sorry I'm so winded. Okay. Okay. I'll just give you the last line.
Multinational corporations like Johnson & Johnson manage numerous affiliates around the world, and it's not beneficial to describe specifically all of the activities in a proxy statement to the audit committee. However, we would agree with some amendment to the disclosure currently being required by the audit committee but suggest that it be reasonable, such as defining what extent of the fees paid to the audit firm go for auditing, what percentage may go for other types of services. Thank you.
CHAIRMAN LEVITT: Thank you. Supposing we had a proposal similar to that which is used in the U.K., where investors would be made aware of the fact that X dollars went for the audit and Y dollars went for consulting? Would that meet your test?
MR. LOCKETT: I'm not so sure. Even though we use a reasonable person's standard, I believe that just presenting numbers, even reasonable people might disagree in terms of what that means.
CHAIRMAN LEVITT: So you would be more detailed than that?
MR. LOCKETT: I would try not to be more detailed, but I think I would try to be more qualitative in terms of the description of those services.
CHAIRMAN LEVITT: But you do support the notion of disclosure?
MR. LOCKETT: Yes.
CHAIRMAN LEVITT: Now you mentioned the ISB. I think it fair to point out to you that the ISB is presently equally divided between members of the profession and a group of very distinguished public members.
Those public members and their chair unanimously requested the SEC to deal with this issue. They felt that they were unable to deal with it in the time frame that would be reasonable.
Do you believe, as some have -- as the head of Ernst & Young and Price Waterhouse testified -- that the balance of the ISB should be changed to obtain a majority of public members?
MR. LOCKETT: Mr. Chairman, I believe that that would certainly go a long way in establishing that body in giving the appearance of greater independence from the profession of that body and its role in establishing independence. I would agree with that.
CHAIRMAN LEVITT: And I assume from your testimony that you also agree that in the interest of the public investor, perception is an important characteristic that has to be observed?
MR. LOCKETT: That is correct. Perception is.
CHAIRMAN LEVITT: And I would agree with you in terms of a blanket prohibition against the outsourcing of all internal audit functions. But I would hope you would respect and understand the testimony of the Controller of the Currency, former Chairman of the Fed Paul Volker, and one of the present Governors of the Fed, in pointing out -- and that's just an example of one industry, it could be others --the conflict that certain kinds of outsourcing of the internal audit would represent in terms of the auditor thereby in effect commenting on his or her own work.
MR. LOCKETT: Yes. I believe that that would be a conflict. Any auditor that would audit his or her own work - that on its face is a conflict.
However, I do believe that, as ably stated by my colleague to my right with Time Warner, with management's oversight and management's involvement, independence can be maintained and internal auditing outsourced.
CHAIRMAN LEVITT: Well, I think it's -- I hope you agree it's a question of degree and kind. I think the audit committees of America as a result of a lot of the work of the Commission are focusing more on these issues than ever before but we can't be certain that every audit committee has reached those standards.
But I get your point, and I would turn to Mr. Barge and ask how you can be so enthusiastic about your support with the four principles and yet you feel that it might be alright for an auditor to review its own work by allowing him to be both the internal and external auditor?
MR. BARGE: I don't believe that it's a part of the procedural function of outsourcing internal audit that the auditor will, in fact, be reviewing their own work. In fact, I would not duplicate the level of work in an outsourcing arrangement like that. It doesn't sound very efficient to me.
I'm enthusiastic for it because we've done this for three years and have seen significant benefits not only financially but also in terms of the quality of the work and the candor with which our firm is, you know, proceeding to do the work both in the external and the internal arena.
CHAIRMAN LEVITT: Does Time Warner use their auditor for consulting services?
MR. BARGE: Occasionally we do. We also use other firms as well.
CHAIRMAN LEVITT: Is this a consideration of your Audit Committee? Do you think carefully about that?
MR. BARGE: Absolutely. We review the level of services with our audit committee in terms of where we're engaging the external firms both with regards to consulting as well as we consulted with them significantly with regards to our outsourcing of the internal audit function.
CHAIRMAN LEVITT: Would you agree with any additional limitations on internal audit outsourcing other than the one that you proposed such as a cap on the percentage of the internal audit the external auditor could provide?
MR. BARGE: Well, I would not propose a cap on the degree of services. I think more important than a specific percentage is the nature of the work being carried out. I think that's absolutely critical.
I think that oftentimes the perception, if you will, could be potentially misunderstood. And that we wouldn't want to try to regulate misunderstood perceptions or misinformed perceptions and that if one really looks at the kind of service being performed and realizes that in a procedural nature, say a cash disbursements test, whether it's being performed under the banner of an internal audit outsourcing function or an external audit service, which it often times is, or agreed-upon procedures, which it oftentimes is, it's hard to believe that that type of work could create an independence issue even by perception, if you really understand the nature of the work, when it doesn't, if it's external, or if it's agreed-upon procedures.
So I would focus not on a cap or a percentage of fees. I would preclude any type of outsourcing beyond the procedural attestation function, even if it was 1 percent or 2 percent, for example.
CHAIRMAN LEVITT: So you certainly recognize outsourcing as a legitimate area of attention for the Commission to --
MR. BARGE: Absolutely.
CHAIRMAN LEVITT: -- consider?
Mr. Ryan, could you tell us something about the independence controls that your audit committee, which I consider to be one of the best in America, employs to assure independence?
MR. RYAN: If you take, for example, internal audit, one of the things that we do -- well, let me first tell you that Medtronic does not outsource internal audit. Though we think that depending on what you outsource that really the nature of what you outsource is very important. But having said that, we do use them for consulting services, though it is by far a very small percent of our total audit fees.
But for each engagement we review with the audit committee exactly what it is that we are, in fact, asking our auditors to do. We then actually look at the criteria. I'll give you an example.
For example, we could ask our outside auditors to do work for us on data warehousing, which we think is quite acceptable, but we would not allow them to do work as it relates to developing a financial system, because they, in effect, would then be auditing a system that they developed. So those are the kinds of controls.
So every year we look at every dollar paid to our external auditors and we look at what it is paid for.
CHAIRMAN LEVITT: Again, does your audit committee consider carefully both the real and the perceived threats to independence?
MR. RYAN: Yes, they do. I will plead guilty to being the one that brought up the issue of a cap. Let me just tell you this is something that I am going to raise with our Audit Committee when we meet next week as well as the other two audit committees that I'm affiliated with.
And I would argue that you -- again, as Mr. Barge just said, you have to look at the substance of everything you ask your auditors to do. But in addition to that I think the perception can be guided by what the dollars say. If,for example, you pay $1,000 to your auditor for external services and you pay them $100 for audit services, that can be a perception issue.
So I think there's some substance to what Novartis does in terms of looking at it and capping it at half or, a third, of total expenditures. Again, our audit committee, I haven't talked with them about that. They haven't approved it, but it's something that I think is worth debating.
CHAIRMAN LEVITT: Well you've said it better than I could. This is an issue of some debate between those who say that perceptions are meaningless. I think in terms of public confidence perception represents the ultimate reality.
MR. RYAN: I would say that perception to me relates to the comfort level that people who have -- reading the financial statements, how comfortable are they with the statements. And if, in fact, they see that auditors are a very small percentage of what the firm has paid, to my mind that says something about their comfort level.
Now I would also say that to my mind one of the most sacred things in the whole audit process is judgment. And I think you can't take judgment out of those issues. I mean, there is so much judgment that goes into a financial statement and I want to feel that if I'm sitting across from a partner, across from me at the table, that audit is the primary thing that they are looking at Medtronic for.
CHAIRMAN LEVITT: Again, that's so important. You put your finger on something that's critical. There are so many opportunities for the auditor to make a judgment call and no one can say whether it's absolutely right or absolutely wrong. But the investors should know that if the amount of money going to that auditor is ten times as much for consulting as the audit where is that judgment call likely to go?
COMMISSIONER HUNT: I want to thank the members of this panel for appearing before us. I have some different views than all of you in terms of what we should do about the scope of services.
Mr. Barge, I think I at the present time have a different view than you have on the outsourcing of the internal audit function, but I think I agree with you about the procedural line of demarcation and maybe that presents less of a conflict than if you outsource the whole internal audit. I can understand how people can have that point of view.
I will think about what you said, Mr. Lockett, about the chain of command and the employee that should be prohibited from holding, any holdings, in the audit client. You are not the first one to indicate that the four principles should not be embodied in the rules, but maybe should be in a preamble or be part of a guiding framework. And I appreciate that point of view as well and I will take that into consideration.
And Mr. Ryan, you may be right. It may be impossible to fashion a rule or rules governing every specific of an auditor providing non-audit services to a client, you know. Whenever we create a new set of rules, within the next week and a half somebody has figured out a way to get around those rules, either a smart accountant or a dumb lawyer or somebody.
So I'll think about what you said, think about what all of you, the comments of all three gentlemen and we will take them into consideration in terms of how we try to fashion a rule that will be satisfactory to most of the industry, most of the accounting profession and, hopefully, most of the Commission. So thank you very much for appearing before us. I really appreciate it.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: I just wanted to follow up on your notion, Mr. Ryan, about disclosing the amount of compensation received, as it were, and sort of pick up on what the Chairman was saying.
If you have an investor that was reading that disclosure, just how would that impact the dynamics of the financial reporting system as a whole? Does that mean every time an investor wants to read a financial statement, first they have to go to the section where it says, "Well, how much did you get in consulting fees and how much did you get in auditing fees? "Well, gee, you got a lot in consulting fees so I'm going to discount the credibility of these financial statements by that amount."
You know, I don't see how you could keep that from creeping into the whole financial reporting system and the integrity and credibility of financial reporting.
MR. RYAN: I would make a couple of comments. One of my other responsibilities at Medtronic is for investor relations. And I will tell you, investors are never loath to call the company and to ask those kinds of questions.
But, again, I think it's information that they need to have. I think it can be made very simple. I think it can be just a few lines. I think it should give them a sense so that they know -- it gives them a sense of where the auditor's motivations may or may not be. They won't be definitive, but it's another piece of information that I think they can have.
I would also say I went a step farther, and that is I really think we should put squarely on the backs of the audit committee the responsibility for looking at every individual thing that you ask your external auditors to do and to be sure that there's not a conflict and to basically certify that in the financial statements.
COMMISSIONER UNGER: Let's talk about that a little bit more and engage the rest of the panel.
To the extent that that happens now, which I assume it must, how many times have you --
MR. RYAN: I would argue that I think it's happening more now than it did and I think in part because of the rules that the Commission has put forward.
I mean, for example, I have been moved on one company from the compensation committee to the audit committee and I certainly contribute more to the audit committee, but I enjoyed the compensation committee. So, yeah, I think there's more expertise focused on the correct issue.
COMMISSIONER UNGER: Well, I think that's right, that there is -- we have focused our attention on the audit committee. But how can we say that that's not happening now, yet this very issue that we find important enough to have four full days or -- almost four full days of hearings about and to have everyone focused on can just be handed off to the audit committee, who's never done this before, and we assume that (a) they can handle the burden; and (b) they can do it correctly.
MR. RYAN: To me the issue isn't whether they have done it before, the issue really is can they do it? Are they qualified to do it? And I think we're putting more qualified people on audit committees and I think --
COMMISSIONER UNGER: Well, that's what I mean by can they do it.
MR. RYAN: Right. And I think they can. And I think there's nothing like them knowing and being charged and being responsible for doing that.
COMMISSIONER UNGER: But what about the practical implementation of something like that? Is that really something that can be done in a timely manner which I asked one of the other panels? I don't know how voluminous that would be in terms of time commitment and how many times you'd have to go to your audit committee and say, "Well, we want our external auditor to do this. What do you think of that? What do you think of this?" And does that really work?
MR. RYAN: I think it -- I clearly think it can work. I don't think it's all that time-consuming. If you've got good finance staff that can pull that together and you've got good people on your audit committee, I think that that is quite doable.
COMMISSIONER UNGER: That's a lot of ifs, but --
MR. LOCKETT: Well, if I might add, for years we presented to our audit committee the details behind the investments that we have made with our public accountants.
One of my concerns, however, with the say numerical disclosure just in itself -- and this happened to Johnson & Johnson -- when Price Waterhouse and Coopers & Lybrand decided to merge we had significant consulting business with Price Waterhouse and very little consulting business with Coopers and Lybrand.
When they were merged, and if you were to look at the combination now of audit fees versus consulting fees you will find a significant shift. So if an investor were to look at the financial statement of Johnson & Johnson today with that disclosure versus three years ago the perception might be that independence is impaired because of the investment.
Price Waterhouse was certainly working in areas where they had significant expertise in manufacturing systems and we certainly were not willing to disengage them because their firms had made a decision to come together. So then our challenge was how do we manage and ensure that independence is not impaired.
And I go back to my original statement; that for years even before we started we were committed to keeping our audit committee informed. They recognize their responsibility for ensuring that there was and that there is auditor, okay, independence and that data is presented to them and they challenge it and sometimes we have to come back with additional information to give them the comfort that independence has not been compromised.
COMMISSIONER UNGER: Have they ever found an occasion where independence would have been compromised and told you not to do it?
MR. LOCKETT: We manage well enough that we avoid those situations.
COMMISSIONER HUNT: Mr. Barge
MR. BARGE: I might just add to that slightly. I think, first of all, we were hopefully emerging from this process with some clearer and more workable rules on independence that I would like to think will perhaps remove some of the areas where independence might be more of a debatable issue.
I think you have to keep in mind in terms of trying to seek advance approval from the audit committee I think in all cases without any threshold with regards to dollar amount, with regards to the significance of the issue, would not be something that would be beneficial in the broad scheme of things.
I think in terms of hindsight and discussing everything with them in terms of the total fees, et cetera, it is absolutely necessary it takes place.
Then I think with regard to certain other areas where you may see fit to proceed, if you will, with the services being able to be provided, such as perhaps outsourcing of the internal audit function related to procedural work that you could, we would support that in all cases where you did that that it be discussed in advance with the audit committee.
We did engage our audit committee in those discussions and we had extensive and very thorough discussions. And I would also add with regards to the Blue Ribbon Committee and the proposals and the work that the Commission has done we've had improving and excellent candor with regards to our disclosures and discussions with regards to the audit committee, which is great.
I do think that the only thing I would add to that is let's keep in mind that the audit committee doesn't bear all the responsibility here. This is management's responsibility, and we are equally interested, as are the auditors, obviously, in maintaining independence, both in fact and in appearance. That's very important. We are the first and second line of defense before going to the audit committee.
COMMISSIONER UNGER: So in hearing this conversation I can't help but think, Mr. Ryan, maybe you should go back on compensation to raise the amount that you paid the audit committee for all this new working --
MR. RYAN: Well, I felt like I didn't give you as good an answer as I could have, but I don't want to give short shrift to disclosure. If you are disclosing too much it can be as bad as not disclosing anything.
But I think the reader has a right to know what possible motivations a person might have. For example, if I can read a first call report on Medtronic, and the banker will always note what other business they may do with the company, so that the reader can understand that there could possibly be a --
COMMISSIONER UNGER: I know and I'm a big believer in disclosure but -- as you said, the right kind and the meaningful kind. But I guess my concern in talking about disclosure is can you really disclose away the conflict and what it does generally to the financial reports of public companies? I just don't know.
If people are so focused on conflict and they see that there is that relationship and whether or not the disclosure of the dollar amounts is really going to cure the concern that people have about it.
MR. RYAN: Well, I don't think the dollar amounts alone would cure it. I think the dollar amounts are a good start.
I mean if, for example, you look at it and you pay $100 for audit and you pay $1 for consulting then that tells you that there's no issue. So it gives you an order, a sense of magnitude. Then if you want to go a step farther you can actually talk about what is done. If you want to do that.
Then I think we need to have the audit committee certify that they have looked at it and it's not only the audit committee but, as Mr. Barge says, management's got a real role here even before it gets to the audit committee.
COMMISSIONER UNGER: I just wanted to ask one last quick question. Do each of you use your auditor for consulting services? And if so, what's the percentage?
MR. RYAN: I don't know the exact -- we do use them. I don't know the exact percent. I can tell you I'm sure it's less than 25 percent of the total.
COMMISSIONER UNGER: Do you use other consultants as well?
MR. RYAN: Oh, on the tax side, for example, we have found that every firm has a very narrow specialty in a given area, and tend to go with that specialty.
COMMISSIONER UNGER: Mr. Barge?
MR. BARGE: We do use our external auditors in certain consulting arrangements. We also use other consultants. I don't know the precise percentage but if you aggregated the consulting work that our external auditors do it would be less than the overall fees that they earn on the external audit.
COMMISSIONER UNGER: So less than 50 percent?
MR. BARGE: Less than the dollar amount paid on the external.
COMMISSIONER UNGER: Okay.
MR. BARGE: I don't know if it's 25 percent or 75 percent.
COMMISSIONER UNGER: So we can figure it out.
MR. BARGE: Year to year, it can vary.
COMMISSIONER UNGER: Mr. Lockett?
MR. LOCKETT: Yes. If we limited it to just Price Waterhouse Coopers, then we would have something like a 60/40 split, non-audit to audit.
If you looked at it in the total of all consulting it would probably -- because we have consulting with so many other firms, that the auditing piece would be very small. So, again, that's the issue I have with this disclosure of a numeric, that you have to define what it is that should be disclosed, or it can be terribly misleading. I would tell you that maybe it was 25 percent consulting before the merger.
COMMISSIONER UNGER: Thank you very much.
MR. LOCKETT: You're welcome.
COMMISSIONER HUNT: Mr. Lockett, if I may, does your audit committee make the decision or is it fully informed of the decision when you do hire -- I guess it's now PricewaterhouseCoopers for a non-audit consulting service? Do they make that decision?
MR. LOCKETT: No, they do not.
COMMISSIONER HUNT: Who makes that decision?
MR. LOCKETT: We bid, and our individual operating company or the unit that is -- that has the need for the service would make that determination.
COMMISSIONER HUNT: Is the audit committee informed?
MR. LOCKETT: The audit committee is informed and reviewed, but it's after.
COMMISSIONER HUNT: Yeah, do they -- is there an annual review of the extent to which there has been-
MR. LOCKETT: Yes there-
COMMISSIONER HUNT: -consulting business given to your outside auditors?
MR. LOCKETT: That is correct. A very detailed report is provided to them covering those services.
COMMISSIONER HUNT: I have one other comment. I'm struck by the amount of consulting that all of these companies are engaging in in this business climate. Maybe it's better to be a consultant than a lawyer or accountant these days. I don't know.
COMMISSIONER UNGER: That's what I'm wondering.
COMMISSIONER HUNT: Or a commissioner, but anyway,thank you very much.
MR. LOCKETT: Thank you.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Thank you, gentleman.
Panel 2 (Afternoon)
The next panel is John J. Costello, Senior Director of Litigation for Gursey, Schneider & Co., and Stuart M. Grant, Director of Grant & Eisenhofer. Gentlemen, we are falling a little bit behind schedule, so I'd ask you to stay right on target if you could.
MR. COSTELLO: Thank you, Commissioner. It's a pleasure to appear before you and the other commissioners to express my views on your proposed audit rules for auditors' independence.
First, let me tell you a little bit about myself. I've been a CPA for over 35 years. My practice was for the first 33 years with one of the Big Five accounting firms, where I served as an audit partner and I had many clients that were large and small companies including registrants with the Commission.
In addition, I have conducted peer reviews of other CPAs and I have consulted on at least 50 matters involving accounting failures, including some audit failures.
I generally support the rules that are being proposed by the Commission. My comments indicate that I totally support standards two and three.
Standard 1, I think there could be some further definition as to the "mutual interest" that is proposed. And standard 4, I believe, covers the advocacy role of the independent accountant. I think the traditional role of the independent accountant serving as an advocate before the IRS or various regulatory agencies does not create an independence problem. I think there are some advocate services which do, such as serving as an expert witness for the client or providing any service such as would require the payment of a contingent fee.
I think that disclosure of the services performed other than audit services would be a valuable tool to stemming the concern for independence. My belief is the more disclosure there is, the better served the public is. I was an auditor when the rules for the Commission came in that required the disclosure of reasons why the auditor was fired. As a practicing auditor in those days, it made my job a lot easier.
As far as internal audit outsourcing goes, which there's been a great deal of discussion about, I agree that blanket internal audit outsourcing is probably not a very good idea. However, I think that in certain instances if there's internal audit outsourcing to the independent CPA firm, as long as the independent CPA firm reports to the audit committee, not the person being audited, I think you've solved a lot of your problems.
I believe as far as the out -- internal audit outsourcing goes, and other work that the audit firm does, it's been my experience the more the auditor learns, the less likelihood there is to be an audit failure.
I support the addition of one additional public member to the ISB.
As far as need for a specialist goes, in the auditing firms, in my experience over the years, many times have we had to go and get an independent consultant that was not part of the firm, whether it was for computer auditing in the early days, real estate evaluations, financial, different types of transactions now such as the straddles and spreads that we've been having over the years, or getting an independent engineer to evaluate a construction project. It is not something that's new. It's been there for a long time and could be done again.
In summary, I believe your rules on balance should be adopted.
CHAIRMAN LEVITT: Thank you very much.
MR. GRANT: Good afternoon. My firm primarily represents institutional investors, many of whom are members of the Council of Institutional Investors, and I was asked by the Council of Institutional Investors to share some of our experiences and observations with you. However, my testimony is my own personal view and is not an official position of the Council of Institutional Investors of Grant & Eisenhofer.
As those who have testified before you -- I guess for the balance of today and over the three days previous, we will tell you that they support the goal of the Commission. I am assuming that most of them will find full support for the actual proposed rules on auditor independence. For most constituencies, self-interest is to leave the current rules as is. I recognize there may be some wide-spread support for some smaller portion of the rules, such as the example that has been given about the non-auditor spouse owning stock in his or her 401(k). However, that is not the crux of these rules.
So we look a little bit at the various constituencies.
The current rules give the corporations the most flexibility. Those who want auditors without any potential conflicts, who want independence without reproach, can simply refuse to hire their auditors for any consulting work. Those who choose to have a cozier relationship with their auditors, either because they foresee some benefit of having the auditor provide consulting work or because they want an additional incentive for the auditor to be cooperative, will hire the auditor for consulting assignments. The proposed rule has no effect on the former category and a negative effect on the latter.
Of course, what is left out of most people's testimony from the corporations who have come here is that the rule does not prevent the hiring of another firm to take on necessary consulting. It just prevents the auditor.
The accountants. The accountants, no matter how they sugar coat it with the public interest, see these rules as a threat to their economic well-being. The proposed rules will eliminate them from the high margin consulting business for the clients with whom they have the closest relationship.
Again, of course, the proposed rules don't prevent the accountants from offering these same services to non-audit clients.
The plaintiffs' bar who brings the securities actions. The traditional plaintiffs' bar supports the current rules that allow accountants to reap large consulting fees from their audit clients because it provides the best indication of scienter that the plaintiffs' bar can find supporting their securities fraud lawsuits. With the courts raising the standards by which the plaintiffs must prove scienter, the accounting industry's own greed in obtaining large consulting fees from audit clients provide this necessary element.
The investor. The only group that is likely to support the proposed auditor independence rules is the investor and more likely the institutional investor. Institutional investors read and rely on the audited financial statements of issuers. Institutional investors feel comfort in this reliance primarily because of the existence of an independent watchdog, the auditor, rather than the threat of some securities fraud litigation after the fact.
If this watchdog turns out to be nothing more than a little Chihuahua with a little yap which no one listens to, the entire confidence in the financial reporting system is shaken. Thus, my clients, the institutional investors, need an important and independent loud barking watchdog who is not distracted from its job by sticking its face in the food bowl.
Some of our recent experiences. It is unlikely that an auditor will ever concede that the reason it took a certain accounting position was to protect its consulting business. Similarly, it's unlikely that a case will ever go to trial in which a specific finding through a jury interrogatory is made in which an auditor is found to have breached its duty in order to obtain or retain consulting business. Therefore, one can really only look at anecdotal evidence to see if there is a problem with auditors taking on consulting assignments.
In one case, we came across an auditor who found problems with the company's accounting system. The auditor was lax for at least two years and did not hold the company accountable for these system failures. In year three, the company's computer accounting system was sufficiently poor that the auditor called it to senior management's attention. However, rather than raising this with the audit committee, the auditor asked for and received from senior management the opportunity to bid on the consulting assignment to fix the financial systems.
While it is certainly a good thing for the accounting systems to be fixed, one must wonder whether the auditor would have been more aggressive or called these problems to the attention of the audit committee, if it had not been interested in obtaining a consulting contract to fix the accounting system.
In another case, we came across an accounting firm whose billings for audit and consulting work were in the eight figures. For at least three years, and in many cases five years, the audit firm had warned the company that its accounting positions were too aggressive and that specific and substantial corrective measures had to be taken. The company agreed to make the changes, but every year the same problems arose.
The auditors continued to give clean audit opinions at the same time that they were highly critical, internally and to a lesser extent to the company, of the company's accounting positions.
One again wonders if the client was not generating such substantial revenue for the auditor in both consulting and audit fees whether the auditor would have been more likely to go public with its concern or refuse to issue clean audit opinions. The auditor was sued in that case and eventually settled for an amount in the high eight figures.
I should tell you that I think the investigation by the Securities and Exchange Commission into that auditor is well into its third year.
A final example is the auditor of a company who had a catastrophic failure of its accounting system such that it was unable to accurately determine its accounts payable or accounts receivable. Nevertheless, the company continued to put out financial statements that were either reviewed quarterly or audited annually by its accounting firm.
The public remained deceived until such time as state regulators did an audit and discovered the company's problem. Once this was disclosed, the company's stock deconsultants whoht by 60 percent.
In this case, the auditors were not the consultantswho had provided the accounting systems, nor were the auditors the ones who discovered the problems at the company. However, if the auditors were the ones who set up the computer system, what is the likelihood that the audit would have been discovered or the problems would have been disclosed.
In that example, it is not only the financial pressures that challenge the integrity of the auditor, but also the difficulty of being a watchdog over one's own colleagues.
Just based on human nature, there is a temptation in the example that I just gave not to test the systems, but rather to have a level of comfort that the systems are fine because one's colleague down the hall did the installation.
Whether auditor independence is truly compromised by taking on various business activities that are proscribed by the proposed rules, to me, is not the central question. The central question is simply is there a reasonable debate over the question of auditor independence. If the answer is yes, and I believe that the answer is yes, the potential for a lack of confidence among investors, financial institutions, lenders and the like are enough for me to counsel in favor of the proposed rules, for if the confidence in the financial reporting system that exists in the markets today is ever undermined, the consequences to our country's economy will be disastrous.
CHAIRMAN LEVITT: Mr. Grant, could you summarize, please? We are running out of time.
MR. GRANT: Yes. We support the proposed rules and applaud the Commission for taking on this needed yet unpopular change, but we think it does not even go far enough. A strong argument can be made for a rule that prohibits auditors from any other work for the client other than audit and tax. Many companies and institutional investors voluntarily do this practice. I think until we get there, there will always be an element of doubt as to whether there is pressure on the auditors other than their pure audit relationship.
CHAIRMAN LEVITT: Mr. Grant, as someone who has had extensive litigation experience, why do you think there is so rarely a smoking gun?
MR. GRANT: I think it is because of the way that accounting fraud and restatements take place. In large part that there's -- and I think there's a consensus building that companies don't start off saying we're going to commit accounting fraud, let's go do it. They start off because of a pressure, usually in the quarterly earnings estimates, and so they ship some -- do a few little tweaks here and there that they don't think is really wrong. Then when they have the next quarter, they have to build on that and the next quarter and the next quarter and before they know it, they are in over their heads. And I think that the pressure with the top management's attitude that that will not be tolerated causes a type of environment like that.
The auditors, when they come in, I think, if they're independent, can speak out against that type of environment that allows that kind of fraud. I think when they lose their independence, that's when we see fraud happen. And there is no smoking gun, again, because I don't think there is a specific incident where someone says, okay, let's commit fraud. I think it's a step by step in which not only are more and more people inside the company coopted, but the auditors and a larger portion of the auditors are coopted by just being sucked into that whole system.
CHAIRMAN LEVITT: Do you think it's appropriate to base our rule-making on the kind of anecdotal evidence that you've provided us with?
MR. GRANT: I think that there is better evidence to be provided, but for that I think the Commission has to look internally, not externally. I think the problem with the things that we find are, number one, we don't have the same investigative powers as you do; number two, many of these cases are settled, particularly where there is serious wrongdoing; and, number three, many of them have confidentiality agreements that prohibits the more specific examples that we'd like to give and the naming of names that we would like to give.
I think that your staff does have the subpoena power and does do investigation and that in your Enforcement Division there is, at least in my belief, more evidence than you will find from outside and I stress that the Commission should push the staff to turn that over.
I know that there are some cases where these investigations wind up taking three years and then there's a settlement and we never really see what comes out of there, but you have the information within the Commission.
CHAIRMAN LEVITT: You know, I think all regulators would suggest to you that it's very difficult to, and probably wrongheaded to move toward a regulatory scheme which is universally opposed by those that are regulated. In almost all of the many controversial issues that the Commission has dealt with over the past eight years, there has been a process of reaching out and arriving at a consensus that probably would not satisfy partisans on both sides of the issue.
This particular debate has defied that kind of consensus. The industry has been divided. Their trade association has sided with one group against another, and a debate which had better been aired in less confrontational circumstances and terms simply hasn't developed.
I note that most of the institutional investors that have come before us up to now have opted toward a more Draconian approach than the Commission has put forward in terms of banning all consulting services.
Why do you think that's the case?
MR. GRANT: I think that it's the only way that we can have a bright line in which the lynch pin of the trust of the system is the independent auditor. Absent that independent auditor, there is nothing that really prevents financial statements from being fiction. And the amount of restatements that the institutional investors have seen and the Commission has seen over the last three years and the catastrophic result to the institutions of seeing tens of millions of dollars or hundreds of millions of dollars of losses individually and billions of dollars of losses in the aggregate between a single restatement, I think is very troubling to them.
And I believe they feel that the only way to prevent that from happening is to have an independent auditor who really has -- I think the institutions would prefer if the relationship was not so much "let us assist you with your business," but was a little bit more adversarial between the auditor and the company, and the auditor saying show me, prove to me.
Let the auditor be one who challenges things, not one who says let's walk arm and arm and let me guide you, but really presents a challenge to internal audit and the company to say I want you to be able to prove your financial statements to my satisfaction.
And as long as you have other business relationships, you are really not going to establish that, more of an antagonistic relationship, which I think in this case is extremely healthy.
CHAIRMAN LEVITT: Well, I'm not sure that I agree with that. I'm not sure that antagonism is what we should strive for here. We really have very little in our society which represents total purity. The auditor, after all, is paid by the company that it's auditing, which is certainly a compromise of pure independence. The Commission tries to reach for a balance wherever it can.
I'd like now to turn to Mr. Costello, if I might, and ask you how difficult do you think it is to prove that an auditor's independence was compromised by consulting fees.
MR. COSTELLO: I think the total amount of money that the auditor gets has a direct bearing on how independent they're going to be. I've been in the business a long time and I can remember when there were no consulting fees and I had a lot of problems with some difficult clients that threatened to fire me as an auditor. And I pointed out earlier in my presentation that the rules to disclose in an 8-K why you were fired was very helpful to me.
I think the consulting fees when they get $10,000 of audit fees and a million dollars in consulting fees probably do bear upon the auditor's independence, but I think that consulting fees on a stand-alone basis don't make any difference whether it's all audit fees or a small part.
CHAIRMAN LEVITT: What role have audit committees in your experience played in the many cases that you've been involved in?
Some have said, hey, stand back from this, let the audit committees of America decide.
Some audit committees that have testified before us have testified that they simply have a rule that does not allow for consulting by their auditor.
I don't know that that represents the majority of audit committees, but I'm curious to know about your own experience.
MR. COSTELLO: Well, my own experience has been as time has passed, the audit committees today are a lot more involved than they were 20 years ago.
Twenty years ago, the audit committees in many companies, public companies that were small or over-the-counter type companies, may have been just friends of the president or friends of the CEO and they were very accommodating to whatever the company wanted.
Today, with the additional burdens that the Commission has put on the audit committees, like, for instance, having a real accountant on the audit committee or somebody that understands accounting, I think has gone a long way. I think the more responsibility that the audit committee has, the more likely they are to take their job seriously.
And I see as time has passed they have taken that a lot more seriously. They are a lot more effective today than they were ten or more years ago.
CHAIRMAN LEVITT: Commissioner Hunt?
COMMISSIONER HUNT: Thank you both for appearing today.
Mr. Costello, I think in your oral statement you indicated that you didn't think that the outside auditors should be engaged in any advocacy for the audit client?
MR. COSTELLO: Well, I think it depends on the type of advocacy. I think that the advocacy of where you go out and you do an appraisal of a business that's about to be acquired and then you do your own auditing of that appraisal, I think is improper.
I think if they are serving as an expert witness in a lawsuit is improper.
I think if they're doing deals where there's a contingent fee involved to the audit or that's improper.
On the other hand, the traditional explaining matters to the regulatory commission is not improper.
COMMISSIONER HUNT: Suppose the company had been sued by the IRS for a tax matter.
MR. COSTELLO: Oh, I don't think -- if the auditor's prepared the tax return, I think he's right in the same place that the company is and I don't know how the auditor can avoid that.
My experience of what's happened in the financial situation that my colleague has described in many cases is what I call the baby alligator theory.
A baby alligator is the size of your hand. I've had audit clients that said, well, I want to do it, but it's only a little white lie.
But I've generally said, no way, because a year from now when you come back, the alligator is going to own the whole process.
And that's how my experience with seeing these accounting firms get into trouble is it's an inch the first year, a yard the second year, and then it's five miles, and then it's a restatement.
COMMISSIONER HUNT: Yes. I understand. I think that both of you -- I think I've seen some cases where the accountant failures have been so -- on the face of the matter very simplistic that I've sort of wondered how in the world did the auditing firm get into this position of letting this go through.
MR. COSTELLO: That's one way. The other is if it's too good to be true, it usually is. And we have some cases in Southern California like the Jay David case where a guaranteed 25 percent return to investors and if you didn't belong to the right social circle in Newport Beach you couldn't get in. It was too good to be true.
COMMISSIONER HUNT: I think people who believe that kind of return are the people who we should be disciplining as much as the people who make those promises.
MR. COSTELLO: And the auditor that went along with it was.
COMMISSIONER HUNT: Yes. Yes. Thank you both.
I am struck by what the Chairman said, that, Mr. Grant, the kinds of clients you represent really want us to go much further than we are going at the present time.
MR. GRANT: I should tell you that my clients are very appreciative of the bold steps that the Commission is taking and just because they advocate that you should step even further does not mean that they don't have tremendous and sincere appreciation for all the work you have done on this issue and other issues to make the markets a better place for the institutional investor. Thank you for that.
COMMISSIONER HUNT: Thank you. Thank you for those kind words. Thank you for both appearing.
Panel 3 (Afternoon)
CHAIRMAN LEVITT: Douglas Scrivner of Andersen Consulting, General Counsel.
MR. SCRIVNER: Mr. Chairman, Commissioner Hunt, thank you for the opportunity to appear here today. I will present a condensed version of my remarks and be happy to take any questions.
I have spent over 20 years as a lawyer in and around the auditing and consulting professions as a partner at Arthur Andersen and the last five years as a partner with Andersen Consulting. My interest in appearing today is to give you our observations on the audit profession and the interaction between auditing and consulting based on my years of experience with both professions.
I want to state up front that Andersen Consulting supports the SEC's proposed rule. The rule is necessary to assure the independence and quality of audits on which the integrity of our capital markets rely.
Our support is based on our observations of the industry for the last two decades. Some accounting firms have focused on management consulting and other high growth services to the detriment of the audit function. Consulting and other non-audit services are growing at a much faster rate and are regarded as more profitable than auditing; thus,investment dollars in those firms tend to flow to the non-audit services. This at a time when the need for investment in both audit related skills and the reinvention of the audit in response to the demands and opportunities of the new economy is critical.
The proposed rule will help redirect the focus of the relationship between the accounting firm and the audit client to the audit itself and away from the use of audits to develop other general consulting services.
These types of restrictions are commonly accepted by other professions to address real and perceived conflicts of interest. Practitioners in the medical and legal professions accept the principle that certain relationships by their very nature give rise to a lack of independence and objectivity and the public good is served by avoiding these relationships altogether.
While the auditors I have known are highly ethical and competent people, the goal should be to avoid putting these good people in untenable situations.
The fundamental question is whether the public interest is served by accounting firms becoming multi-disciplinary firms, offering a wide variety of services to their audit clients as new sources of revenue and profitability. Or is the public interest served by firms focusing on the audits as the unique franchise granted to them implies.
The accelerated proliferation of non-audit services performed by accounting firms has undermined in our view the accounting profession. The pressure to cross-sell is intense. It is common knowledge that accounting firms for years have low balled audit proposals in anticipation of continuing relationships and lucrative consulting assignments. Since the audit must be performed at such rates, there is pressure to cut corners, thereby potentially compromising the quality of the audit.
In cases where the audit firm provides both auditing and has consulting relationships with a particular client, there can be a strong economic incentive to retain the more lucrative consulting contract or other business relationships. This can lead to a willingness to compromise audits in order to keep the client happy.
There are numerous situations where audit firms have dropped an audit client where another relationship is more lucrative.
What does this say about the value of the audit to the accounting firm?
In many regards, the audit partner has become the client service partner, compensated and evaluated based on sales of all services to the client. The subtle pressure and criteria for advancement raises the obvious question of whether those with highly developed marketing skills are promoted over those with the best technical auditing skills.
In all of this, the common denominator is the commercial interests of the accounting firm, rather than what will sustain the confidence of investors in the integrity of the auditor's report.
Let me briefly discuss two of the arguments used by some of the accounting firms against the proposed rule.
First, will the proposed rule harm the accounting firm's ability to recruit highly skilled auditors?
The rule will prohibit accounting firms providing certain consulting services to audit clients. It is difficult to conclude that this prohibition will harm the recruitment of auditors, since in our experience there is no meaningful crossover in personnel between the audit divisions and those divisions providing other business consulting. The skills necessary to perform high quality audits are vastly different from those needed to perform consulting services of the type covered by the rule.
It is more likely that recruitment has been jeopardized by the actions of the accounting firms themselves. Some of the firms have diverted investment and resources out of the audit function and into non-audit services, thereby reducing the attractiveness of the audit function as a career path. They have created the very environment in which accounting majors look elsewhere and audit staff move over to the consulting side as quickly as they can.
A second question raised by some of the accounting firms is whether the provision of consulting services actually enhances the quality of audits.
It is important to note that audit firms do not provide consulting services to improve the quality of the audits, but rather for commercial considerations. A then CEO of one of the Big Five audit firms was quoted recently in Business Week saying, "If I had to trade an auditing account for other business, I would do it."
What better evidence is there of the commercial focus of that firm?
It is simply not necessary for auditors to provide many consulting services to enhance quality. There are many companies for which auditors currently do not provide consulting services. Would the auditors admit that their audits in these companies are of a lower quality than for others? Of course not.
What is necessary to maintain audit quality is a sustained focus and investment in the audit profession rather than in non-audit services in order to keep up with the complexity and sophistication of business in a rapidly changing environment.
In closing, we commend the SEC for taking this important step. The rule is necessary to ensure the long-term health and viability of the audit profession by restoring the audit as an end, not just as a means to develop other commercial business.
Thank you. I would be happy to take any questions.
CHAIRMAN LEVITT: Thank you very much.
A lot of commentators have said this should be the responsibility of the ISB rather than the Commission. I think I have mentioned a number of times that all the public members of the ISB have asked the Commission to undertake this.
Do you feel -- and two of the firms thus far have indicated that they feel the ISB should be increased to include a majority of public members. Do you share that feeling?
MR. SCRIVNER: As a firm, we have not really examined that. As a personal matter, I would agree with that. Yes, sir.
CHAIRMAN LEVITT: How effective do you think the Public Oversight Board can be in dealing with issues of this kind?
MR. SCRIVNER: Based on my experience, the POB at its best has been very effective and I think that what we need is a spirit of cooperation and working together between the self-regulatory bodies and the profession and, sadly, that appears not to be the case today.
CHAIRMAN LEVITT: That is an unhappy circumstance.
Do you think that the audit partner's job is made easier if we do establish bright lines about what is and what is not right with respect to independence?
MR. SCRIVNER: I think clarity of the rules, whether it's the bright line that is proposed or other just very clear rules that minimize the opportunity for clever lawyers or hungry auditors to find ways to work the creases, I think it's only to the benefit of the auditors. I think the ability to point to a clear rule makes their position in talking to their clients that much easier.
CHAIRMAN LEVITT: Do you think that accounting firms will have to divest their consulting practices if we adopt our rule or can they continue to thrive by providing consulting services to non-audit clients?
MR. SCRIVNER: I'm not sure my crystal ball, Mr. Chairman, is a lot better than yours. I believe that through structuring or other alternatives that divestiture is not the only way to deal with the issue. There is a lot of market opportunity out there beyond the audit clients, so I would certainly be hopeful that would be the case.
CHAIRMAN LEVITT: How prevalent do you think is the use of the audit as a loss leader?
MR. SCRIVNER: There is no question that the competitive pricing pressure for audits is extra ordinarily intense and whether you regard it as a loss leader for other services or a buy-in to a long-term relationship, I think that is the environment that's been created and it's unfortunate.
CHAIRMAN LEVITT: You mentioned something else which interested me and I don't really understand the implications of it, but you suggested that a change in the tone at the top is what's necessary to restore the stature of the audit process and its independence.
Through the years, I've known a number of the heads of your firm or your predecessor firm and I often speak about the legendary Leonard Spacek and sometimes even though he's more vital today than ever, I speak of the legendary Ray Groves or Russ Palmer or some of the other giants who talked about and really considered the public interest above all else.
Why did the tone at the top change, in your judgment?
MR. SCRIVNER: I think, Mr. Chairman, it's a product of just the competitive pressures, both externally and internally. The focus on size, the focus on the league tables, has made growth so essential in the competitive positioning of the firms that that has been a primary focus.
Internally, I think the competition, if you will, between the different components of the organizations and the efforts to grow and to be as profitable, to carry your weight, have focused the firms on the commercial realities as opposed to the professional imperatives and I don't know how you get it back. But I would agree with you that -- and I had the wonderful opportunity to work with Leonard Spacek early in my career and I think we need to find, the profession needs to find leaders who are so compellingly committed to the public interest and demonstrate that to their organizations.
CHAIRMAN LEVITT: Some would say that you have a strong economic interest in seeing to it that accounting firms don't perform consulting services. How would you respond to that?
MR. SCRIVNER: We make no bones about the fact that we are competitors. We deal with our competitors in the marketplace and that's where we beat them.
The credibility of our positions is up to you and others to assess. I don't believe that, frankly, the rule puts them out of the business in any event.
As I said earlier, there is plenty of market space for the accounting firms to perform competing services for non-audit clients, so, again, it's up to you to make that judgment, but you have to, I think, give us some credit for appearing and then judge for yourselves the credibility of our testimony.
CHAIRMAN LEVITT: You have discussed the draining away of resources from the audit process by the firms and if that's happening, I think that represents a serious problem.
Are there ways other than through this rule that we can encourage firms to redirect resources back to the audit process?
MR. SCRIVNER: I'm not sure I have a good answer for you on that, Mr. Chairman. I think it's about leadership. I think your efforts at speaking out publicly about these issues is helpful, but I'm not sure I do have a good answer for you.
I think the firms need to look at themselves, assess how they are performing against the mandates they have and I think there can be and should be a recognition that the audit business is not only a noble one but can be a very profitable one, and I think that's where they need to make their focus.
CHAIRMAN LEVITT: Commissioner Hunt.
COMMISSIONER HUNT: Thank you, Mr. Chairman.
Thank you for appearing before us today, Mr. Scrivner. Were you a partner in Arthur Andersen prior to being a partner in Andersen Consulting?
MR. SCRIVNER: I was actually part of Andersen World wide, which was the group that supported both of the business units, prior to a migration of those services out. I was a participating principal, a non-CPA partner, in Arthur Andersen, is what my legal status was. Yes.
COMMISSIONER HUNT: Did you see the attitude that you described between the auditing function and the consulting function while you were there?
I mean, you get money from the consulting and -- I won't say it's a loss leader, necessarily, but the auditing functions just didn't provide the income, the percentage or rate of return on investment that the consulting did and this led to a change in the attitude?
MR. SCRIVNER: Yes, sir.
COMMISSIONER HUNT: You know, I think we are struck at the end of the day, it's like the old proverb of two or three blind people touching an elephant in different places and coming up with different conclusions because the perceptions of some of the accounting profession could not be more different than the perceptions of other parts of the accounting profession and I have been trying to come to terms with that because the differences are just stark.
And I know reasonable people can disagree on something this contentious, but I am struck by the difference in perception between accountants. Relative to same size firms, some say consulting is our lifeblood, some say we shouldn't touch it. It's crazy. Or it's unusual.
Do you think in some instances a dialogue between the two functions could work? Or do you think the mind set, the attitude, of the auditors and of the consultants is so different that a fire wall won't work?
MR. SCRIVNER: I think it is possible that a fire wall approach could work. I would note that it is fundamentally inconsistent with the primary rationales that some of the accounting firms have used to contradict the thrust of the rule. You won't get the sharing of information, you won't get the movement of people if you really have the fire wall. Operations --
COMMISSIONER HUNT: They would say we ought be able to bring them over the wall in the instances when we need them because the audit is so unusual or so technical, then we'll shove them back.
MR. SCRIVNER: I think the answer there, Commissioner, is that the skills that are required for the most part to deal with those complex issues in the audit actually reside in the audit and business advisory side of the house today. They are not in the business consulting or the Andersen Consulting type of practice in any event.
In the rare case where you do have that skill set residing there and only there, I think it's so unusual you can buy it, as one of the earlier witnesses said. It's not uncommon in an audit to rely on an expert from outside the audit firm and in those unusual cases I think that's a perfectly appropriate way to deal with that issue.
COMMISSIONER HUNT: I'm not sure, do we have a copy of your written testimony? I think we do.
MR. SCRIVNER: Yes, sir.
COMMISSIONER HUNT: Okay. Well, yes, we do. Thank you. Along with the summary. Thank you very much for appearing before us.
I sincerely hope that working with the profession of which you are a part that we can fashion a satisfactory rule and get over this fairly, as I'm sure you appreciate, fairly hostile relationship here between the Commission and parts of the profession.
So thanks again for appearing.
CHAIRMAN LEVITT: Thank you, I'm sorry we have fallen behind.
Panel 4 (Afternoon)
We appreciate your presence here today. We have Joseph Berardino, a partner of Arthur Andersen, and James E. Copeland, CEO of Deloitte & Touche, and formerly the managing partner of Deloitte & Touche.
MR. BERARDINO: I guess I'll start.
Mr. Chairman and members of the Commission, thank you for this second opportunity to personally express Arthur Andersen's views on the coming proposal. We communicated our general thoughts in July and we will submit a detailed comment letter on Monday.
Before I get into matters on which we have submitted and which I will summarize in the interests of time, I just want to acknowledge that it's recently come to my attention that something has been floating around that I have frankly not yet seen that responds to some of the comments.
I just want to mention before I get into my testimony -
I forgot what I was going to say.
MR. BERARDINO: I just want to acknowledge a sensitive item that apparently there's been a piece of paper floating around with some comments that I have not seen that refer to this morning's testimony. From what I have heard, it does not express my views, and I hope you take my oral testimony today as my views on the issue in front of the house.
I want to focus on the central question presented by the Commission's proposal and that is will this proposal serve the public interests by improving the quality of auditing or is it more likely that audit quality will decline?
The Commission must know the answer to this question with complete confidence, it seems, before proceeding. At the end of the day, if you're not sure or if investors aren't sure or disagree with you, wouldn't it be better to chart a more modest course consistent with the principle first do no harm?
To that end, my testimony will highlight significant areas where audit quality is most threatened by the current proposal. I hope these comments in conjunction with others will lead you to conclude that the risks to audit quality are just too great to move forward with the rules as proposed.
Let's start with the objective we both share, producing the highest quality audits possible today and tomorrow. Auditor independence must be considered in light of a future that's nearly upon us. We are moving rapidly to a model where investors will require year-round instantaneous assurance for all kinds of information, financial and business, and all kinds of assets, tangible and intangible, in order to assess companies' value in the new economy.
More and more companies will literally close their books each day and investors will need a new assurance model. We are committed to delivering them. We will maintain standards of excellence in auditing, but it will require substantially increased competencies and process improvement in technology than exist today.
To deliver the highest quality auditing, we must have access to three essential ingredients: talent, knowledge and technology.
Talent, smart, highly skilled and highly motivated auditors and specialists, is what allows an engagement team to perform an audit's complex and multi-dimensional tasks.
Knowledge. Insight into the intricacies of the client's business and its risks is essential to assessing the relevance of reliability of the client's controls and financial reporting.
Technology and related tools and techniques is necessary to understand and audit the complex and rapidly evolving systems, processes and risks of clients in today's new economy environment.
If any one of these three ingredients is diminished, audit quality will suffer. The proposed rule, however, will devastate audit quality because it will erode the auditor's access to all three.
The scope of practice limits will ensure we know less about our clients, they will cut off our people from large segments of the market and deny us valuable insights that can only be gained by providing value added, problem solving services to varied segments of the marketplace.
The definition of accounting firm affiliate will turn every strategic or joint venture partner into the practical equivalent of an accounting firm with everything they do imputed to us and subject to all the independence rules.
The scope of practice limits and the affiliate definitions will limit our talent pool. Ask any professional to choose between an employer that allows them to sell their services to 100 percent of the market and one where their market as a result of government restrictions is closer to 60 percent, you will get the same answer and that is they'd rather have access to 100 percent of the market.
Strategic alliances and investments are an essential way we acquire technology, knowledge and talent necessary to perform high quality, cost efficient audits. In some cases, they allow us to leverage what we have in house; in other cases, they supplement what we have.
For example, we form alliances so our people can gain access to training and new technologies. Alliance partners market the fact that we are trained to help companies install and support these technologies. We use the knowledge gained to provide risk services and support audits. Both sides benefit, of course, but the biggest beneficiaries are investors who can be assured that our people understand fully the subtleties of these new and usually highly sophisticated technologies.
Targeted strategic investments are also critical. These investments almost always represent less than a 20 percent interest and pose no risk of significant influence over the investee.
The new rule would put accounting firms on a remote island where no meaningful relationships outside the island are allowed. Accounting firms could no longer access talent, knowledge and technology, all vital for audit quality in the 21st century through alliances with or investments in other companies.
We trust these consequences were unintended and that their destructive impact on the foundation on audit quality was not recognized. Time still allows you to reevaluate the proposal in light of what is best to protect investors.
Let me turn to the new restrictions on scope of services and some examples of how prohibitions would affect access to knowledge and undermine quality auditing. I'll start with internal audit outsourcing.
Some public companies have internal audit departments, others do not. As you know, the SEC does not require that companies maintain an internal audit function. In cases where internal auditors are employed, their role is to evaluate and monitor the company's internal control systems at management's direction.
There are many competent internal auditors. However, in this full employment economy we enjoy, even our country's largest companies are finding it difficult to attract and retain the number of internal auditors they desire. For years, the public accounting profession has assisted clients by extending its audit procedures to provide management with additional comfort that their controls are working as intended and to make suggestions for improvement. Audit quality is enhanced and investors are well served.
To this point I believe there is no disagreement on the appropriate role of the external auditor. However, in contention is the so-called outsourcing of internal audit work. In some instances, companies have no internal audit department or find themselves unable to attract or retain qualified internal auditors and have asked their external auditor to assist.
In all cases, the scope and nature of the internal audit work is directed by management and reported to the audit committee. These and other restrictions are summarized in detailed AICPA independence guidance issued several years ago with much input from the SEC staff and banking regulators.
When this internal auditing is performed by the same firm that is hired to audit the financial statements,that firm significantly enhances its knowledge.
Who benefits when the audit firm has this enhanced knowledge? I would suggest the investing public.
As a firm, then, we find that internal audit outsourcing increases our knowledge of the processes our clients employ to manage their business. These increased skills enable us to advise our clients and to provide year-round assurance to improve their processes and systems, reducing the cycle time in producing publicly available financial statements.
Some say that we are auditing our own numbers in doing what I just described. I disagree. What we feel we are doing is simply auditing more of the client's business.
In much the same way, prohibitions on IT consulting also would harm audit quality by limiting our access to talent, knowledge and technology. We need to have access to today's technology today. Otherwise, I am forced to play catch-up in a race I can't win.
Think of me racing Marion Jones in the 100 meters. I start out behind and the gap just widens.
Again, let's start with some facts. When we help companies design or implement IT systems, we gain a better understanding of the client's financial information and its technology systems, thereby also improving our ability to detect and assess risks that may impact the financial statements.
For example, if our specialists are involved in the design of IT systems relating to a client's e-business operations, we are better able to assist the process and technology risks relating to those operations. That gives us greater confidence in attesting to the reported assets of the business.
Moreover, implementing IT systems will often be the best means of implementing internal control and risk management controls as the rule expressly allows.
The better we understand our client's financial information systems, the more reliable our audit of the numbers generated from those systems. Beneficiaries of that enhanced reliability are the investing public.
And to be clear, at the end of this process, the IT systems are the company's, not the accounting firm's. The company owns and operates these systems, the accounting firm does not. As a result, whatever the theoretical loss in the appearance of independence, it is a minimal cost when compared to our improved ability to audit the client.
Adopting a rule that prohibits services related to client IT control systems will reduce audit effectiveness. We will do less IT consulting and our understanding of our clients' business risks will drop, particularly for those clients whose operations are predominantly information technology based, which means just about all clients in today's economy.
The combined impact of the scope of practice limits and affiliate restrictions will eliminate each Big Five firm from participating in at least 30 to 40 percent of the market.
Will that have revenue implications for us? Surely. But more importantly, it will have audit quality implications for our capital markets and very serious ones.
The reason? The brain drain from the accounting profession.
This proposal will make the war for talent unwinnable and the most significant casualty will be audit quality and those who depend on it.
Recently, I had the honor of meeting John Wooden, the legendary basketball coach at UCLA. Coach Wooden won more national championships than anyone will likely ever equal.
I had the opportunity to ask him, "In all your years of coaching, which coach did you fear most coaching against?"
His answer, "The coach who had better players."
The battle for talent has never been more intense. We just don't compete against McCulley, Jim Copeland, or others in the Big Five, we compete against dot com companies,investment banks, consulting firms, software companies, technology providers and businesses of all types.
The battle is fought in several different ways by attracting students into accounting programs rather than other business programs, by recruiting accounting majors from accounting firms, by recruiting technology whiz kids, et cetera.
Consider the basic element of what makes a career attractive: opportunities to learn and grow, task variety, complexity and interest of work.
In conclusion, the purpose of my testimony today was to highlight the most significant areas of the proposal that degrade the foundation of audit quality. Our comment letter will address these and other concerns. It will also make suggestions from a conceptual standpoint on a way forward.
All market participants need an independence framework that allows for informed judgment and a balancing of risks and benefits.
Mr. Chairman, you and your fellow commissioners are in effect faced with the same fundamental decision Congress had before it in 1933. Then, Congress had to decide whether to allow auditors to be paid by their clients, thereby raising perhaps the greatest threat to appearance of auditor independence, namely payment of auditors by the companies whose books they audit, or to create a cadre of government or appointed auditors, thereby ensuring absolute purity.
Congress weighed the risks and benefits and in its wisdom decided that audit quality would be better served by a market-based accounting profession, even though that decision guaranteed that every single audit of a public company would create the appearance of a lack of independence and that potential conflicts would always exist.
That decision necessarily accepted a tradeoff between absolute purity from any potential conflicts and enhanced audit quality.
You have the same decision before you now. I hope you exercise the same vision and leadership that was exercised in 1933 and don't for the sake of absolute purity jeopardize audit quality by diminishing our access to talent, knowledge and technology.
Independence can be preserved through transparency, recognized past practices, in thorough audit committee assessment and involvement.
Because of efforts led by the chairman and this Commission over the past two years, the infrastructure necessary to ensure vibrant audit committees, focus on auditor independence has never been stronger. We should give them a chance to work consistent with the tradition of our securities laws, which are based on disclosure, not proscription.
I would be remiss if I just didn't add one brief comment on the proposals put forward this morning. I think that's a constructive step forward. We will evaluate those comments very quickly and hope that it perhaps puts us in a new space to have a constructive dialogue with a mutually beneficial solution.
CHAIRMAN LEVITT: Mr. Copeland.
MR. COPELAND: Chairman Levitt, Commissioner Hunt, I welcome the opportunity to share with you my views on several key issues within the proposed rule on auditor independence.
The limited time we have here today will not permit me to go into great detail on the proposal, but we will be submitting additional detailed comments in the next few days. And I trust that those comments will also receive your careful attention.
For many years, the SEC and the accounting profession have shared the view that auditors and audit firms have a unique public interest role in our capital markets. We are both genuinely concerned with the quality and efficacy of audits of public companies and the need to constantly improve audit quality to maintain the public confidence in our financial reporting system.
That shared view has given us common ground and along history of working together effectively to make changes and improvements where they are needed.
In the case of this rules proposal, we also have some common ground. We agree that the existing financial interests and employment relationship roles are sorely out of date and need to be modernized. Our comment letter will provide what I believe are constructive recommendations in each of these areas.
Where we disagree on this rule proposal are the changes that would significantly limit the services that an audit firm may provide to its audit clients. While intended to serve the public interest, I firmly believe that the unintended consequences of this bright line limitation on services will be significant and far reaching, resulting in a lessening of audit quality and perhaps, ironically, independence.
My concern is that the Commission has not given adequate consideration to the consequences of the proposed rule and has rushed to the judgment that certain non-audit services should be prohibited.
In the next few minutes, I would like to cover three major topics.
First, the perception, which is the fundamental issue with respect to providing non-audit services.
Second, the de facto restructuring requirement of the rule, which is a devastating consequence for audit quality.
And global regulatory inconsistency, an inadequately considered implication of the proposed rule.
First, let me address what I see as the fundamental issue. The dialogue during these hearings has often led to a discussion of whether the perception issue exists. While there is no empirical evidence to support the assertion that an auditor's independence is impaired when it provides non-audit services to its audit clients, clearly some do perceive this as an issue and I believe the position that the perception issue exists.
Having said that, I believe that the more fundamental question is what is the most appropriate means of addressing the related risk?
I believe the concern over auditors providing non-audit services stems from three sources.
First is the premise that investors may have less confidence in audits from firms that also provide non-audit services to their audit clients.
Second is the fact that the level of revenue from consulting and advisory services today comprises more than 50 percent of total revenues of some firms.
Finally, the point has been made that providing non-audit services to an audit client creates economic pressure on the auditor and might influence the decisions that they make.
Taken together, these factors could be termed the perception issue.
The appropriate response to the perception issue is to determine whether the perception represents reality. I thought the panel on audit effectiveness did a credible job looking into this issue.
For the first time, the panel looked at actual audit engagements where substantial non-audit services were performed. The panel findings indicate that the reality does not bear out the perception. In fact, the results indicated no impairments of independence and in one in every four of the cases the results indicated that audit quality had in fact been enhanced.
The panel also suggested enhancement in the peer review process intended to address perceptions of problems with auditor independence.
The profession also has recognized this perception issue and, as a result, has created safeguards to ensure that the perceptions do not become a reality. My own firm completely reorganized itself in 1996 in response to these concerns.
Further, I believe that audit committees, acting as advocates for the shareholders, are in the best position to understand and monitor non-audit services. The recent changes under the Commission's leadership have resulted in new audit committee requirements that I believe over time will serve shareholders well and I can personally attest to the fact that audit committees are taking these responsibilities seriously.
Unfortunately, there has not yet been enough time to show that these safeguards will work. We should allow all of these new safeguards an opportunity to work before overriding them with drastic and dangerous prohibitions.
Let me comment on the economic pressure question, whether an auditor's judgment could be influenced because of consulting engagements with the audit client.
You are right to be concerned about any inappropriate influence on the use of judgment by auditors. While clients almost always want to do the right thing, every auditor eventually comes under client pressure while trying to do the right thing. That pressure exists whether or not we perform non-audit services.
Dealing with that pressure is fundamental to what it means to be an auditor and is at the very core of our responsibility to investors.
Our clients pay us and they can hire us and fire us, as consultants and as audreal concernle an audit partner does not want to see consulting relationships lost, his realconcern is with the audit relationship.
There are hundreds of situations every year where auditors say no to aggressive accounting treatments or the audit uncovers adjustments that are required to make the financial reporting conform more fully to GAAP. Although you don't see these situations because the client complies, they nevertheless occur. And sometimes we lose or resign from clients over these matters.
We take our public interest responsibility very seriously and consciously design and operate our audit practice to make sure that our auditors resist any pressure to get to the right answer.
We have extensive consultation networks, second partner reviews and other resources to provide support for the audit partner, dealing with difficult issues so that he or she knows that the firm backs them.
In addition, our reputational capital is at risk on every audit. There is no one client, no one audit fee, and one consulting engagement worth compromising the quality of an audit. Audits are dependent on the integrity, independence of mind and competence of our people. That doesn't change whether we perform consulting work or not.
We understand our responsibilities and do our best to act in the public interest each and every day.
I now want to address what I believe will be the defacto restructuring requirement as a result of the proposed rule.
Perhaps the worst unintended consequence of the proposed rule is the restructuring or dismantling of our accounting firms. This consequence is no longer debatable. We have all read accounts of the proposed sale of some or all of the consultancies of three Big Five firms.
While these decisions may be financially attractive, there is a question as to how the impact of these transactions will affect the quality of audits.
As one CEO of a firm planning to sell some of its consultancies recently said, "We genuinely are not sure how successful this new arrangement will be for the audit firm. It would, we believe, be a mistake for the Commission to require an even greater array of changes before it and the firms have had a reasonable period of time, perhaps as long as several years, to assess the impact of this change on a firm's ability to maintain a strong, vibrant audit practice that best services the interests of investors."
The consequences of this restructuring will be significant and I believe will have an adverse effect on the ability to perform high quality audits. This is because it will result in the loss of the competencies of our non-audit professionals.
These competencies are essential to high quality audits, particularly in the new economy, and must be readily available within the firm when needed to support the audit function. This is even more important now that timely quarterly reviews are required by rule.
The truth is the SEC recognizes that non-audit competencies are necessary to perform a GAAS audit. The panel on audit effectiveness did as well. The profession has learned firsthand that in today's environment, it is nearly impossible to audit complex organizations without specialists in information technology, actuarial science, mergers and acquisitions, and the like.
The question is, how in a restructured profession will these competencies be made available to the auditor?
One possibility is to in-source these competencies by purchasing them or leasing them, if you would, from an outside firm. But this raises questions about availability of the resources, quality control, and how the independence of the audit team will be maintained under that circumstance.
I believe retaining these competencies within the firm is the best approach. That way, they operate under our supervision, follow our quality control policies and are bound by our independence requirements.
While we prefer this approach, under the proposed rules, firms such as ours will be less attractive as a career choice. As to non-audit professionals, the best specialists are not willing to simply support audits. They also want to hone state-of-the-art skills in the marketplace.
As to our auditors, their career paths become more limited and therefore less attractive. Today, some of our brightest consultants have audit backgrounds. This is talent that I don't want to lose.
What about the talent pool for accounting students entertaining the audit profession? We're already experiencing a decline in the numbers and qualifications of students entering the accounting programs at the university level. Just this week, Business Week reported that the number of accounting graduates had declined about 20 percent between 1996 and 1999. That concerns me greatly.
We have historically been able to offer talented new entrants to our profession the opportunity to move to other areas of practice within our firms based on their interests and their capabilities. Those other areas include many significant services that are an adjunct to audit service, as well as the consulting practice. But narrowing the opportunities outside of audit will lessen the attractiveness of a career with our firm.
Let me digress slightly. In the debate around the impact of consulting -- 25 percent statistic has either been misused or misunderstood. This ratio represents the percentage of SEC audit clients that receive consulting services from their audit firm in any one year. So over a period of several years, most of the firm's clients avail themselves of the consulting services of their audit firms. This would be like saying a prohibition on selling automobiles would only affect 25 percent of the population because customers trade cars only every four years.
I have another problem with this statistic. The point has been made that since only 25 percent of audit clients currently receive non-audit services from their audit firm, providing non-audit services is not essential to the conduct of an audit.
Well we have never claimed that providing consulting services is essential to the performing of competent audits. The fact is that while we perform consulting or advisory work for a minority of our audit clients in any one year, we use these competencies to help us do a quality audit on almost all of our audit clients every year. I hope this clears up that apparent misunderstanding.
I would like to now turn to what I see as a global regulatory inconsistency. My concerns about the proposed rule are not limited to the effects within the United States. My responsibilities include being chief executive officer for Deloitte Touche Tomatsu, our global organization. In fact, I believe the proposed rule will have a substantial negative impact on the global capital markets. The potential impact of the rule is significant and far reaching.
By creating a standard for the appearance of independence that fails to recognize legitimate cross-cultural perceptions and traditions of auditor independence, which in many cases would directly conflict with the audit firm's statutory obligations in other countries, the proposed rule would significantly increase the barriers to cross-border capital formation.
In this area of increased emphasis on reducing trade barriers, the proposed rule would have the opposite effect, undermining global efforts to harmonize accounting and financial reporting standards.
The rule does not appear to reflect consultation by the Commission with its regulatory colleagues in other nations. This contradicts more than a decade of effort by the Commission to harmonize, not fragment, policies that might adversely affect cross-border capital flows. This is particularly surprising given the Commission's recent efforts as regards the adoption of the international disclosure standards, the concept release on international accounting standards and the restructuring of the International Accounting Standards Committee.
The proposed rule takes a completely divergent approach from the independence rules in some other countries, including recent proposals by the International Federation of Accountants and the European Commission.
Given the global nature in which audit firms and their clients operate and the globalization of the capital markets, including the recent significant increase in cross-border activity, the global implications of this rule should be carefully evaluated before any action is taken.
My firm and the entire accounting profession have a long history of responding positively and quickly to suggested improvements to audit quality and ethical behavior in order to better protect the public interest. There is no crisis that would indicate that action to limit scope of services is required at this moment in time.
Accordingly, I would urge the SEC to go forward with the modernization of financial interests and family relationship issues included in the proposed rule, but to set aside the portion of the rule dealing with scope of services.
Today, some firms have voluntarily chosen to divest themselves of what they are currently referred to as their consulting practices. Accordingly, the marketplace has presented the SEC with an opportunity to field test multiple firm models.
I would ask you to use the next two to three years to test the various models. The Commission has ample means to monitor the quality of audits and the relationship to non-audit services, as well as consider the many significant global implications. There is no reason why the harmonization of independent standards is not possible and it is clear that such harmonization, rather than a patchwork of conflicting standards, would better serve the investing public.
In the meantime, I think it goes without saying that your concerns have our full attention. I hope we will have the opportunity to work cooperatively with you to jointly propose improvements if and when they are needed. In the meantime, I thank you and I would be pleased to respond to any questions that you might have.
CHAIRMAN LEVITT: Thank you very much, both of you, for a very searching and detailed presentation.
As you know, I have said on a number of occasions that I had been hopeful that as in other difficult issues that the Commission has faced with different industries, we would prefer consensus solutions. We like to work very closely with participants and I think most industries would say that's been the experience with this Commission. Not so this industry.
This has been a difficult and a trying and a divisive and a contentious process and we may debate as to whose responsibility that is, but I think we would probably all agree that that's not a fortunate circumstance.
Have you made an arrangement with three of thefirms, Deloitte and Arthur Andersen and KPMG, to work collectively, that all of you would have to agree on a solution?
MR. COPELAND: I can only say that we have discussed a common position with respect to this issue. We do have a consensus on that position. We're all disturbed by the rule and I would say, that now appears to be true of all five firms based on what I understand was the testimony of PWC and E&Y.
CHAIRMAN LEVITT: Well, I think you're mistaken in that regard, Mr. Copeland. I would consider the testimony of those witnesses as being very constructive and very supportive. And if you like, I will quote from the testimony, saying that they are supportive of the process, they are of supportive of going ahead with the rule. I don't believe that --
MR. COPELAND: I honestly haven't read it. I was just told that the proposal was for significant changes in the rule. And if that's true --
CHAIRMAN LEVITT: In any rule, in any rule that the Commission considers, the Commission is obviously open to significant changes. But I would correct you in terms of your characterization. I suggest that you read their testimony before we carry that line of dialogue further.
A lot of commentators and in your own testimony have suggested the opportunity might be a more appropriate forum for considering this issues. Is that correct?
MR. COPELAND: My own thoughts would be that the Commission has initiated, at least three activities with respect auditor independence or bear on auditor independence. The ISB is one of those -- the Blue Ribbon Commission on Audit Committees is the second and the Panel on Audit Effectiveness is the third. In my view, that those should be allowed to function before we conclude that they're not going to be effective.
CHAIRMAN LEVITT: For the Commission to embrace ISB becomes difficult in light of Chairman Allen's testimony at our July hearing where that he said "the scope of services issues is different in-kind than a lot of other issues. And so it's not well suited for a board of our character. It's really a public policy choice that the government needs to make. And that's, I think, the view of us all."
And, indeed, that was the unanimous view of the public members of the ISB.
MR. COPELAND: I believe he also said he was agnostic about the proposal, however.
CHAIRMAN LEVITT: But in light of their unanimous recommendation that the Commission embrace this, I think you'd have to agree that for us to go back to them in the face of that, probably isn't very practical.
MR. COPELAND: I can't comment on its practicality. I haven't had the conversation with Chairman Allen.
CHAIRMAN LEVITT: Well, his testimony speaks for itself. Do you favor as the CEOs of Price Waterhouse and Ernst & Young a change in the balance of the structure of the ISB to include one more public member, making it five-four rather than the present 4 and 4 balance?
MR. COPELAND: My sense is that if it is to be a self-regulatory body, it needs to have important representation from the body that is supposed to be self-regulating. Whether that's four and five or five and four, I don't know if that's as important as the fact of substantive influence on the process itself by practitioners.
CHAIRMAN LEVITT: Most self-regulating organizations in our markets today have a majority of members from the public sector.
MR. COPELAND: Does that include the ABA and the --
CHAIRMAN LEVITT: I'm talking about the securities markets -- the NASD, the American Stock Exchange, the New York Stock Exchange. I'm just curious to know whether you think -- whether you share their view that we should move toward a majority of public members.
MR. COPELAND: I don't know that it's critical --that that's a critical issue in either direction. Again, as long as the input by practitioners is substantive and influential, whether they have a majority or a strong minority, I'm not sure is particularly important or would affect the outcome of the decisions.
CHAIRMAN LEVITT: So I gather you feel it is not essential.
MR. COPELAND: Not essential? Yeah, I would agree with that.
CHAIRMAN LEVITT: Not, desirable?
MR. COPELAND: No, not necessarily.
CHAIRMAN LEVITT: How about you, Mr. Berardino? How do you feel about that question?
MR. BERARDINO: Well, I'm a little confused only in the sense that the ISB was just recently set up and I thought we all had consensus on how it ought to operate. And happily, well, I think we all would've liked to see more forward momentum, but, happily, every conclusion they've reached has been a broad consensus, as it should be.
And I hesitate to think of any situation where one vote here or there would radically change the profession or its standards. So I -- this is not on my "A list," frankly, of things to focus on because I do think it's been working effectively. But I'm not -- this would also not be on my "A list" to lie across the railroad tracks and deny another member.
CHAIRMAN LEVITT: But do you think you would agree with those who favor moving toward a greater balance of public representation?
MR. COPELAND: I don't have a violent problem with that.
CHAIRMAN LEVITT: You don't? That's good to hear. You talked about purity. I agree with you. There absolutely is no such thing as absolute purity and no commission on the face of this earth would be foolish enough to try to strive for absolute purity. And both of you talked about reality. And if reality -- if perception doesn't have the reality to back it, it's not a perception. Would you care to correct that?
MR. COPELAND: I didn't say it wasn't a perception. It clearly is a perception. I said that I believe the appropriate action for the Commission to take is to determine that at the bottom of the perception there is a reality.
CHAIRMAN LEVITT: It has been my experience in life that perception usually is the ultimate reality. And enough witnesses have testified before this Commission on the issue of perception; that it's there. There certainly is a perception.
MR. COPELAND: I absolutely agree with that.
MR. BERARDINO: But I would encourage a broader view of who should assess the reality. The fact is, we're all in business to protect the shareholders and these relationships are complex between auditors and their clients. They're all different for different reasons. And I think what we're advocating is that the shareholders are at the table in evaluating these relationships, as they should be.
And we have no hesitation about any sunlight that is added in the way of disclosing what those relationships are.
MR. COPELAND: And I would just add to that the auditor --
CHAIRMAN LEVITT: Do you both agree that disclosure is a -- something you would be supportive of?
MR. BERARDINO: Yes.
MR. COPELAND: The right of kind of disclosure. Yes.
CHAIRMAN LEVITT: Could you amplify?
MR. COPELAND: It should be balanced. It should allow the reader to make an informed judgment about the implications of consulting fees, for example, on an audit firm. It should bear some description of the relative importance of those fees to the firm, itself, for example.
So I mean, disclosure itself is something that's hard for an auditor to disagree with. But the details of disclosure would be very important to me.
CHAIRMAN LEVITT: Would you be comfortable with the kind of disclosure which would allow a shareholder to know that his company had paid its auditor, for instance, a million dollars a year for the audit and $100 a year for consulting, period?
MR. COPELAND: I think that that should be put in a context because the flip side of that is, perhaps, the auditor was paid $100 and the consultant was paid $1 million and that might be relevant if it was a material sum to the firm.
CHAIRMAN LEVITT: The dilemma that you're proposal faces for us, is that many have called for detailed disclosure, line by line. We did this service. We did that consulting services. This Commission has strived and, I think, has been successful within limits in changing the way, both we communicate with the public and corporate America communicates with us and with the public, trying to move towards simplicity.
And I, personally, have great reservations about getting into the kind of detail that would be involved in going line by line and I would be more comfortable with a simpler kind of disclosure. I gather you would, too.
MR. BERARDINO: Well, I would just add just to complete the sentence and I think we're in mild agreement on this, is there is disclosure to the shareholders through the audit committee -- up front, after the fact -- audit committees can look the individual partners in their eyes --
CHAIRMAN LEVITT: We're going a step further. I'm asking you about whether you favor disclosure to the shareholders by the corporation?
MR. BERARDINO: Yes.
CHAIRMAN LEVITT: Okay. And Mr. Copeland does, too, although he would be certain to try to qualify the nature of that disclosure. Mr. Copeland said, and I don't think this was in your statement, that this rule would have a devastating impact on the quality of the audit.
MR. COPELAND: I hope it was in my statement. I intended for it to be, if it's not.
CHAIRMAN LEVITT: I didn't see the word "devastating" but I read it very quickly.
MR. COPELAND: I'd be happy to amend my statement.
CHAIRMAN LEVITT: Are you now suggesting then that the audit its performed by KPMG, and Ernst & Young and Price Waterhouse may be less good than the audits performed by your firm.
MR. COPELAND: One of the CEOs said in his submission, that there were uncertainties about the impact of this decision on the audit practice. And I believe that's absolutely true. I think that new methods will have to be found to provide access to the competencies that we would all agree, I believe, are required for a new economy audit.
And it's not clear to me, exactly, how you do that in a model where you do not have those internal to the firm, itself.
MR. BERARDINO: I'd like to just pile on that comment in the sense that Arthur Andersen really was the first that's lived through this movie. And that is, when we start drifting apart in terms of our sister firm, Andersen Consulting, and one of the primary drivers behind us rebuilding -- and we're still doing that -- a business consulting organization, is because we were missing those skills on our audits.
I think it's interesting to hear that two firms, one that just made their sale of the other, hasn't yet, and I agree with Copeland's testimony that you really have a unique situation in the sense that we're all in different places as to what the right answer is. And with all due respect to our competitors, I'm not convinced they've got the right answer.
I'm also not convinced, I'm all wise, I know I've got the right answer.
CHAIRMAN LEVITT: Nor am I convinced that we're on right, that we have all the right answers. But do you think a client of Ernst & Young will have a less good audit than your clients?
MR. BERARDINO: Let's find out.
CHAIRMAN LEVITT: The AICPA's own rules prohibit, among other things, appraisal and broker/dealer, investment brokers as impairing independence. And the Practice Section rules currently prohibit certain valuation, actuarial, and human resources services. Are you both comfortable with the prohibitions contained in the profession's own rules?
MR. BERARDINO: Yes, and I'd also add is guidelines, as I've mentioned in my testimony, on extended procedures which has been hashed over the years and which I would encourage us to revisit in this context.
MR. COPELAND: And also, our own firms, at least Deloitte & Touche, makes its own determinations about what services it will or will not provide on the basis of whether or not it believes that conflict -- or potential conflict --exists with auditor independence.
CHAIRMAN LEVITT: But if we revise certain of the proposed rules to more accurately reflect or even mirror those of your trade organization or the SECPS's own rules, would that move toward addressing your concerns?
MR. BERARDINO: I'd suggest we ought to consider why stop at so-called eight of 10. Why don't we do that with all 10?
MR. COPELAND: I guess I would say, yes, to your question in terms of would it move toward a more reasonable answer to this but I think another question would be, why put it in a rule if that prescription is working in its present form? Why create yet another regulation -- government regulation to be dealt with, when it seems to be working in a self-regulatory environment?
CHAIRMAN LEVITT: Well, if I understand your response, Mr. Copeland, you're saying that you would probably oppose to even parts of the proposal or just restate the current prohibitions?
MR. COPELAND: I would prefer the prohibitions be left in their current -- where they reside presently just because I would, generally, prefer self-regulatory versus government regulatory action. But you asked whether or not this was movement toward, an answer that was acceptable and I would say yeah, it's an improvement over what's in the proposed rule.
CHAIRMAN LEVITT: But it doesn't sound to me like you would approve the codification even using the precise the words of your own trade association.
MR. COPELAND: I don't think codification within government regulation is a good idea when they're working in the private sector.
CHAIRMAN LEVITT: All right. Your discussion about consultation with international regulators. I'd like to clarify that point. I have had extensive discussions with my counterparts in major markets throughout the world and next Monday, intend to have a similar discussion in Tokyo with them. And as best as I can tell, there's no -- well, let me leave it at that.
MR. COPELAND: That's fine. My comment was just that there's no evidence of that consultation in the proposed rule.
CHAIRMAN LEVITT: Do you have any empirical evidence that codifying and expanding existing restrictions on scope of services is going to adversely effect your recruiting efforts?
MR. COPELAND: I'm sorry. Would you repeat the question?
CHAIRMAN LEVITT: I wondered whether you had any empirical evidence that would indicate that addressing this issue of scope of services will impede or has impeded your recruiting efforts?
MR. COPELAND: There's no evidence that it has impeded our recruiting efforts, at this point, no.
CHAIRMAN LEVITT: Now the previous witness stated that those who provide audit services have different skills than those who provide consulting services in that there's little cross-over. Could you comment?
MR. BERARDINO: Well, I think the issue here is how do you attract different competencies. I absolutely agree there are different competencies. That's the whole point, isn't it? We need those different competencies, or we will be forced to outsource them to organizations that would not have our same culture, values, and independence in mind. There is cross-over. Absolutely, there is cross-over in many different forms in addition to assignment of some of those people on particularly complex audits.
We have things called "industry programs" where people with different competencies that specialize in an industry get together and talk about what are the key issues in that industry and it might be particularly the technology being employed that industry. Or packages of systems that are being put into those systems. So that's why we're so concerned about this issue is we absolutely have to be able to find as one of the firms said today, through some kind of an alliance.
MR. COPELAND: Yeah, I have no idea what the previous witness said but, virtually, in every engagement --audit engagement -- that we've performed, there is a multi-disciplinary team that performs that audit engagement. So I can't conceive of being able to do an audit in a complex environment without having IT specialists involved in the work. I can't conceive of doing audits today with the pension requirement without actuaries involved or tax specialists involved in the tax accrual. So it's a matter of policy, in our firm, that they must be involved in most engagements.
CHAIRMAN LEVITT: Well, I would agree with that. Certainly, the Commission's proposal does not eliminate all consulting services. Maybe the most encouraging parts of the testimony that I heard today, and again, you may have ad libbed that, Mr. Berardino, was your discussion about re-evaluating proposals and I certainly, if you're open to taking a look at alternatives, re-evaluating the proposals that this morning's witnesses brought forth, I think that would be very constructive. And we would really welcome an open dialogue. And I hope the both of you would take advantage of that.
MR. BERARDINO: Great.
MR. COPELAND: Absolutely. And we would -- and, of course, we, as you know, had very, very extensive dialogue preceding this rulemaking process and I would hope that the flexibility in those discussions would allow us to get to a point where we can propose something that would be in the best interest of investors in the capital market.
CHAIRMAN LEVITT: I certainly would be interested in seeing that. Let me turn to another area for a moment. We probably all would agree, now you spoke about the 33 and the 34 Act. I have a different a view as to what that said but, certainly, in '75 the Metcalf-Waxman Committee was pretty pointed about their recommendations and their view as to the problems that the industry endured. Now they came up with the Public Oversight Board. We may debate its relative effectiveness.
But, I think we'd all agree that that existence is better than not having its existence. And I'd like your comments on why have we been delaying, since last May, the acceptance of the POBs Charter under its distinguished leader and it's members. What in the name of good heaven has caused all of us to be participants in diminishing public confidence in the whole system by refusing to get together and iron out the kinds of issues that would enable the POB to go forward with the united support of their members, your trade association, your principals, and the SEC?
MR. COPELAND: I think the issue is that our self-regulatory organization and a number of the major firms in the SEC are all agree on very important components of that charter. But we all don't agree on the same components. I know you and I have had a discussion and, from what I can tell, I think you and I could probably reach an agreement on what that charter should look like.
But when you put the other players into the mix, I think that agreement begins to evaporate.
CHAIRMAN LEVITT: Don't you think that's unthinkable? Don't you see, as a consequence of all this --the failure to come to terms with this -- would be the structure of some other kind of self-regulating mechanism which, probably, none of us would prefer?
MR. COPELAND: It's a possible consequence. But it's also possible that the consequence could be a better self-regulatory --
CHAIRMAN LEVITT: Don't you think the perception of a six-month delay in approving the basic charter says something about the process?
MR. COPELAND: I do, indeed. And I think the process has not been a particularly good one.
MR. BERARDINO: I have nothing to add.
CHAIRMAN LEVITT: Commissioner Hunt.
COMMISSIONER HUNT: Thank you. First of all, again thank you for participating. I don't know whether you were in the room when I said that I'm struck by the different perceptions and various elements of the profession as to the validity or the need or the wisdom of these proposed rules. But I'm also struck by what you said with respect to trying to work together, maybe around the new proposal that was submitted this morning which, I think, none of us have had a chance to see. So I wouldn't really know what it says.
But we, as the Chairman said, we will certainly be looking at it to see if it presents things. We hope you will look at it to see if you think it presents things that you find acceptable. And, maybe, by working through that seeing if and how we should modify the proposal that's on the table. We can get over that, what some would see, including myself,have perceived as a fairly hostile climate between the SEC and parts of the profession.
Mr. Berardino, do you think that any significant changes are needed in the scope services rule in light of the rules were you talking about, Mr. Chairman, the two of you were talking about with the Chairman, which are in your own professional guidelines?
MR. BERARDINO: Well, I think, in trying to focus my presentation, there's clearly heavy some lifting to go in the extended audit procedure area or so-called "internal outsourcing" in the IT area. Those are very fundamental to us and so I think that's where there's most heavy lifting. I think in the other areas, we can look more closely at what the existence guidance is, but I would hope that would not be in the heavy lifting area.
But on your point about groping for elephants, but I've never tried to do that, so I'll take your word for it. Whatever the rule was and the reason you've got our attention, is we think the proposed rule has very significant consequences. We all agree on the public interest. We all agree on all the changes we're experiencing. Where we, frankly, don't agree and I think it's an honest disagreement. Give me the other debating card. I can take the other debate, and say it passionately.
But we pause and say, we're not trying to impose our model on everybody else or our view of the world on everybody else. And so let's make sure it is an elephant. And that may take a little while. But, in the meantime, we're not doing things that are illegal, done with subterfuge in some closet; everybody knows what we're doing, including the shareholders we're here to protect. So that's why you get such a strong reaction.
We think it's leadership to stand up when something's going in the wrong direction and say we're not convinced so please accept it for what it is.
COMMISSIONER HUNT: Let me say I think that nobody on this Commission doubts the bona-fides of your views, the strength with which they're held. I personally am very much willing to take them into consideration as we try to modify this rule. This is what a comment period is all about, this is what these gruesome days of public hearings are all about. We are trying to fashion a rule that will be satisfactory to the profession, satisfactory to the public, and, of course, satisfactory to the Commission. And I hope that you would work with us.
Mr. Copeland, I think that -- I believe the competitive pressure is there with or without the consulting side of the house. I think that's clearly given the way the audit business is divided now. What is it's clearly got to be, it's got to be true. I think that your point -- we have done some -- I will be doing more in the very near future. We do need to consider -- continue to consider the global level to our consequences. I know something about the climates in some of the other countries and this would not go over very well.
MR. COPELAND: Okay.
COMMISSIONER HUNT: It would be impossible even in some other markets, I think, but I hope we can work together. I hope this is the beginning of a serious dialogue and not the end because we're coming to the end of the formal comment period. I look forward to working with you and your partners and other elements in the profession. It's a difficult and complex issue. It's been around the profession and this Commission for a long time. I hope we can really work together to get something decent going.
And thank you, again, for your cooperation and actually the climate of your testimony today.
MR. COPELAND: Thank you.
MR. BERARDINO: Thank you.
CHAIRMAN LEVITT: Let me say that I think that your testimony has been very constructive. I think that we can agree that it's best to try understanding our different perspectives to try to reach a resolution of this rather than allow this issue to fester into the future. I think that all of our interests and, most importantly, the public interest,would best be served. And it's in that spirit, I hope you look seriously at changes that have been suggested by some of your colleagues and feel free to introduce your own changes and engage in a dialogue geared toward arriving at a solution that may not be everything we wish for, it may not be everything that you wish for, and admittedly none of us can really look ourselves in the mirror and say, we know absolutely certainly this result will occur.
That's really my idea of how this could work well and I commit my availability and the staff and my colleagues on the Commission to work with you toward that end.
MR. COPELAND: Absolutely, Mr. Chairman. And I would just ask also that the Commission and staff consider the consequences of either side being wrong. If I'm wrong and selling off these competencies or having them walk out the door because they can no longer be competitive in the market place. One way or the other, losing those competencies is a disaster for the profession. And it's not correctable.
If, on the other hand, I'm wrong and there are other models that produce just as good of an audit result, then there's a fairly easy and happy solution to that in that we all have a big financial payday and follow the lead of some of our other competitors. The consequences, the risks seem to me to be disproportionate on one alternative versus another.
CHAIRMAN LEVITT: Well, my experience has really been that there is no perfection. We've got to seek for some kind of balance and I believe that the market, ultimately, will be far more powerful in whatever we do or don't do from a regulatory point of view.
I believe that the public interest is at stake and I think our reaching a measure of agreement on this issue, albeit an imperfect measure of agreement, is in the public interest. And that's the goal that the Commission will try to strive for.
MR. COPELAND: I agree with that, although, it would be possible to reach agreement on a solution that was a bad solution.
CHAIRMAN LEVITT: Thank you very much. Harvey, are you still here?
MR. GOLUB: I'm still here, Arthur.
CHAIRMAN LEVITT: I thought I could keep this going so long you'd go home.
MR. GOLUB: I wanted to.
Panel 5 (Afternoon)
CHAIRMAN LEVITT: I am delighted to welcome the next witness, Harvey Golub. Although Harvey and I may disagree on some philosophic points, I feel perfectly comfortable in saying that he is one of America's finest executives, finest in the history of American business. He is someone who cares passionately about doing the right thing. I think his professional qualifications and credentials are not just extraordinary, but his track record is exemplary. If there was ever a set-up for a fall, that's it.
But Harvey, I respect you enormously, and I respect what your testimony may be even though it may differ in degree from my own thinking -- Please.
MR. GOLUB: Thank you a lot. Can I get a tape of that introduction --
CHAIRMAN LEVITT: Sure.
MR. GOLUB: -- so I can give it to my 15-year-old son the next time he challenges my wisdom, which is, as you know, I think, a nightly event.
I was going to greet a number of you but let me greet you Chairman Levitt. I'm pleased to respond to the invitation that you gave me to speak to you on the topic of auditor independence, and I'll try to do so from several perspectives and not from others.
First, my observation as the CEO of a large public company, a company that is a significant consumer of the professional services rendered by accounting firms and a company that is also a beneficiary of the size and quality of our capital markets which are in turn supported by a transparent financial reporting and a rigorous regulatory environment.
And second is to give you my personal views regarding the issue of auditor independence. I should disclose to you that American Express has a business interest on both sides of this issue. As I said, we are a large consumer of audit and consulting services. We engage Ernst & Young for independent audit and for some consulting assignments as well. In fact, 40 percent of the fees we had paid to them in 1999 were for consulting projects.
In terms of what we classify as consulting fees, however, those E&Y projects represent less than 10 percent of the amount we spend on items we classify as consulting.
However, American Express is also a provider of non-audit accounting and business advisory services through one of our subsidiaries, American Express Tax and Business Services. Those services generate revenues which in one sense is large and absolute in numbers but less than 3 percent of American Express' total revenue. And as a provider of accounting services, that subsidiary will separately report to the Commission -- respond to the Commission with its views on the independence proposals. So I will not be addressing those contents or those perspectives today.
Clearly, quality financial statements are one of the key reasons for investor confidence in our capital markets. And having access to complete and reliable financial information allows for the greatest degree of market liquidity. Auditor independence is rightfully an integral part of that model and that system.
At American Express, as you know, we rely on audited financial statements in two different ways. The first relates to our own statements. We view it as essential that investors in American Express have confidence in the reliability of our financial reports and in the integrity of our auditors.
Second, we rely on the audited financial statements of other companies in order to make investments on our own behalf and for the hundreds of thousands of investors in American Express mutual funds that aggregate hundreds of billions of dollars in total.
Independent audits and independent people conducting those audits represent an important element in the financial control system of a large company such as American Express. As CEO of that company, I must be ensured that the information I receive about the business is what I need to hear rather than what some people may think I would like to hear. That is why at American Express we have a strong internal audit function, a strict code of conduct strictly enforced, an employee person office that is a model for other companies. And that is why I personally reinforce the need for independence to our own financial staff first, to our own internal auditors second, and to our outside auditors as well.
That independence provides a degree of objectivity and completes the control cycle for shareholders and for management. Because of the importance of independent audits, some people, including the Commission, have questioned whether the expanded services offered by accounting firms have weakened the independence and the reliability of their audit opinions.
From what I can see and what I have read, there's apparently no empirical evidence that independence or audit quality have been impaired.
In fact, the opposite may well be the case. In considering the issue of auditor independence, there are five points briefly I'd like to make. First, at American Express, whenever we have engaged our auditors for consulting assignments, we have never seen anything to suggest other than total independence and objectivity in the delivery of both services.
Second, when we engage our auditors for consulting services, it is because we view them as best suited for the specific assignment at hand. Their basic knowledge of our business makes them better consultants to American Express on certain issues and can make the process more efficient and less costly for us.
In fact, we believe that because we are such a significant audit client, we can get better people, better oversight and better results on the consulting assignments than would otherwise be the case. I cannot prove that, but I believe that to be true.
I view the audit work as leverage to the consulting side for us, not the reverse. Third, I believe the far critical potential conflict for auditors exists in their having a paying customer relationship with the companies they audit in the first place. Auditors are selected, paid and re-engaged annually by their customers. The firms must be objective and independent of their clients while at the same time relying on those clients for their revenue. This presents potential inherent conflicts far greater than those arising from taking on consulting assignments.
And yet this is apparently not substantial issue because of the ethical standards and principles in place that guide an auditor's action. In that situation, those situations, ethics and principles, rather than rules and checklists, are what make the process work and the conflict manageable.
Fourth, I believe the quality of audits is ultimately linked to the competence and the personal integrity of the people conducting them. For this reason,accounting firms need to attract and retain the best and brightest people they can and to offer them leadership positions in dynamic, growing, profitable firms.
Accounting firms that combine audit practices with tax work and consulting services apparently make for a more interesting place to work. Any potential action that unduly restricts career opportunities with a firm or makes accounting firms less attractive employers will ultimately have a negative impact on the caliber of people they hire and, therefore, ultimately on the quality of the services they provide.
Fifth, and lastly, at American Express, as at most publicly traded companies, our audit committee can and does set parameters with regard to the appropriateness of retaining our auditors as consultants. They can and do review the ratio of audit to consulting work and also evaluate the nature of those consulting assignments. The members of our audit committee make informed decisions about the extent and nature of non-audit services and act as they should in the interest of the shareholders to avoid potential conflicts.
As I mentioned earlier, the issue of auditor independence is an important one, but I don't believe from what I can see that it is a problem in serious need of repair. The significant audit failures that occur, the ones I have read about in the papers, do not appear to be the result of independence lapses and cannot fairly be characterized as such. Rather, they appear to be failures of competence and quality control often combined with elaborate client frauds.
The assurance of financial statements and audit integrity I think cannot be addressed successfully by substituting legislation and rules for ethics and principles on the part of people. Competent professionals consistently adhering to standards and ethics far better for the public interest than dictated dos and don'ts.
Development of a reasonable conceptual framework, I believe, should precede any attempt to craft checklists or issue rules for a real or imagined potential conflict. This framework can then be interpreted and applied to specific situations through professional pronouncements, and where appropriating in enforcement proceedings.
As the manager of a business, I would always rather deal with high caliber objective auditors or guided by ethical standards than a less capable one following a rule book. As an investor, I would always rather rely on competent management working with an active independent board and supported by ethical, competent financial people inside the company in the audit firms. Thank you.
CHAIRMAN LEVITT: You know, I don't have any doubtthat American Express, under your leadership and with the caliber of board that you've assembled and your personnel, follows practices and procedures that should make any shareholder thoroughly comfortable. It really doesn't mean that every American public company adheres to those standards. And this industry, it's not the dress industry, it's not the -- it's really -- it has a franchise. It was given a franchise. Every public company must be audited. So they have some, in my judgment, unique responsibilities. And mindful of that, they've established their own code of conduct. They have their own rules which say you can't audit yourself, and you can't do appraisals and a whole host of things such as that. Would you have any problem in having the Commission embrace those very eight principles that they themselves have set forth.
MR. GOLUB: I'm not sure I understand the principles enough, Commissioner, to tell whether that --whether those would do it or not, and I'm not sure I understand the implications of codifying in regulation what is now in practice in a self-regulatory organization. And without fully understanding the implications of that, I'm not sure I would an opinion.
CHAIRMAN LEVITT: You know, so many of the issues that auditors deal with today are not questions of fraud or misdeeds of any kind. Ninety-nine and nine-tenths percent of the auditors that I know at least, and maybe all of them, are really good, honest, hard-working, underpaid professionals trying to do the best job they can. But there are issues such as -- you know, issues where judgment is required, how to determine the future cost of liability for cleaning up hazardous environmental sites. Judgment is needed to decide what reserves a company should record to cover potential damage awards against a company that faces litigation. Accountants must determine the useful life of assets. These are all judgment calls.
It seems to me that the disclosure of the amount that a firm is getting in consulting fees as well as the amount the firm is getting in audit fees could help an investor establish whether those judgment calls may lean more toward the company's interest or the share holders' interests.
MR. GOLUB: I'm not sure that I would have any difficulty in releasing data on the total numbers as you were talking about.
CHAIRMAN LEVITT: Yeah, in very simple form.
MR. GOLUB: But I think what that would do is inevitably lead to the next question of what were those for, on the part of some people, and there would be pressure to release that information. And for example, if we looked at 16 acquisitions in a certain field and had E&Y help us on that for whatever reason and we did none of them, that would obviously be information that we would prefer not to have in the public domain. So we would if we had to release the information, we would do it by not hiring E&Y even though they could do it better and hiring somebody else who may cost more and take longer.
CHAIRMAN LEVITT: But I don't think you'd have to reveal that information. There's lots of corporate information that's proprietary. And I think that in its simplest form, disclosure of the amount -- I mean you can trace anything to what it might lead to and then you'd do nothing, but I gather you wouldn't be uncomfortable with a disclosure then?
MR. GOLUB: No. No. I would not find it interesting information myself in reading about other firms.
CHAIRMAN LEVITT: Right.
MR. GOLUB: But I would be -- if the Commission said, you're going to report this we report it, we report lots of information that I don't find interesting and that would be another piece.
CHAIRMAN LEVITT: That's characteristically open-minded. Thank you very much.
MR. GOLUB: You're welcome. Thank you.
CHAIRMAN LEVITT: Who is the next -- don't go away, Harvey, I want to say hello.
This regimen has worn out my fellow commissioners -- my fellow younger commissioners, I might add.
Panel 6 (Afternoon)
CHAIRMAN LEVITT: State boards of accountancy, William Baker, Michael Daggett, Michael Conaway, Thomas J. Sadler, Ronald Nielsen, and Kathleen Chapman.
Thank you very much for bearing with us through a long day of testimony.
Let's start on the left.
MR. BAKER: Thank you, Mr. Chairman. My name is William Baker, and I am a practicing attorney in Phoenix, Arizona, and I have served for five years on the Arizona State Board of Accountancy and am presently its chairman.
The statement I have submitted in writing does not represent the views of the state board; they are my own views, as is today's discussion of the events that have taken place.
I will not presume to read the written comments that I have submitted because, since I wrote them, there have been a number of changes that have come to my attention concerning these efforts, not the least of which was your speech Monday to the National Association of State Boards of Accountancy and the reply to that by the incoming president of the AICPA and then just today hearing the two members of the Big Five and your discussion concerning, perhaps, some solutions to the proposed rules that they object to that we have not -- I have just picked up a copy of the other proposals. So I have not had an opportunity to study it.
I welcome that because I think that there has been an impasse. We also applaud the effort by the SEC to modernize its rules.
I firmly believe that actual versus appearance of independence is a big question. But unfortunately it is an objective standard versus a subjective standard and appearance is just not on an eye chart test. I heard this this morning, I thought it was very applicable -- that if you read down below 20/20 and you get down to 20/10 and you can't read the other lines, does that mean that you are not independent? Is it a bright line test?
I don't believe it is. I think you are still dealing with subjectivity. It is more of what sometimes us lawyers call the red-face test or the good smell test. If it doesn't smell good, you don't do it. If you're going to get the red face by doing it, you just don't do it. The problem is making an objective test out of the subjective test.
I really applauded your talk at the NASBA meeting; it was very impressive. As you well know, you received a standing ovation. However, as a result of that, I do have a few comments concerning that.
I agree with you that there is a franchise granted to the accountants, certified public accountants, and that franchise is very important. But that franchise is granted by the state boards of accountancy, not by anybody else. We grant the certificates. So it is up to the state boards who are responsible to protect the public in their states as to the performance by those people holding certificates.
And I think that your efforts to improve and modernize those rules are very -- probably long overdue. But I think we shouldn't rush to judgment. And I was happy to hear your comment with the two previous members of the Big Five because I see no need for haste. And if the rules are going to come out different from what they have been published, then I think there is another round of comment period that we would need to go through.
I don't think we need to rush to judgment. There are major changes occurring in the profession. But all of a sudden, this summer has been filled with deadlines that are somewhat unrealistic. The one on the self-regulating organization, we had approximately 30 days in which to respond to that. And now these independence rules, we've had 75 days. My board has not had a chance to really look at the whole impact of your rules.
We don't want the rules considered in a vacuum. We feel these rules will ultimately impact all firms and CPAs and therefore it is important that we take reasonable time in which to analyze their impact, especially if they are going to be changed. And I would applaud the change.
I think the dialogue, at least what I heard Monday, was pretty strident and I think that anything we can do to back away from that stridency would aid a solution.
My board would look forward to cooperating with the SEC in the look-back agreements and those kind of things. We appreciate your letter indicating your -- the Commission's cooperation in those areas. And in order for you to get a flavor for the impact of these rules on the small firms and on the individual accountants, I would invite you to come to Arizona and we will be happy to put on a program where you can listen to the small firms and to the individual CPAs and we will give you that flavor of that portion of the registration group that will be ultimately impacted by these rules.
And I apologize, Mr. Chairman. I have a plane to catch and I have a long flight home to Arizona. I would be happy to answer any questions before I leave.
CHAIRMAN LEVITT: All I would suggest to you --what 30-day period are you referring to about an SRO?
MR. BAKER: When the self-regulatory organization came out in June.
CHAIRMAN LEVITT: What self-regulatory organization?
MR. BAKER: There was -- help me, Michael.
MR. CONAWAY: -- to the reporting panel on audit --
MR. BAKER: Yes.
MR. CONAWAY: -- asked for comment.
CHAIRMAN LEVITT: That was the O'Malley Committee and they had their own timetable. I differ with you in one regard.
This issue has been before us for 25 years. It is not an issue just between the people sitting here and people sitting here. It is now a matter of public concern, great public concern. It has endured for a long time. We've got to make that decision and make it now. Our 75-day comment period supplemented by an unprecedented number of public hearings, a vast outpouring of public comment letters suggests that, like other difficult decisions, we will either get together and reach a consensus decision or the Commission will go ahead and move ahead with its proposal.
So the time is now, the time is not next year. The Commission does not intend to delay this and continue a dialogue which is so loud at this point that we wish to reduce by deliberations right now among the parties that know as much as they will ever know, where at least 50 percent of the industry in terms of size has a proposal that the Commission is looking seriously at, there is no reason why we can't move further.
MR. BAKER: Thank you, sir.
MR. TURNER: Mr. Baker, before you go, if I could ask a question?
MR. BAKER: Sure.
MR. TURNER: We've talked about the potential impact on the small firms. If we were to pass this regulation, would the Arizona State Board go through its own process of deciding what if any changes they would make to enter into their own set of independence regulations?
MR. BAKER: Mr. Chairman, Mr. Turner, we would probably -- in my opinion, whatever regulation the SEC adopts filters down in this way: If there is a registrant in Arizona who is disciplined by the Commission for violation of its own rules, by virtue of the fact that it -- say the practice -- has been restricted or limited or canceled before the SEC, that is a factor that our board considers in disciplinary action by the board.
MR. TURNER: For audit companies that are not covered, necessarily, do you even have the same rules that we have today?
MR. BAKER: We follow a much broader set of rules. We follow not only the AICPA code of ethics but also whatever other standards are out there.
MR. TURNER: Well, for private companies, isn't that basically the AICPA's rules? So, in fact, there are differences between our rules and AICPA rules today? So, in fact, isn't Arizona today a difference between the rules that you apply to independence for private companies versus the rules that we apply on public companies?
MR. BAKER: It's not that black and white in Arizona, I've been advised by our attorneys.
CHAIRMAN LEVITT: Mr. Daggett.
MR. DAGGETT: Thank you, Mr. Chairman. And I thank you for the opportunity to express my views here today as a regulator, a user of audited financial statements and a certified public accountant.
I am Michael Daggett, and I am a CPA practicing in Phoenix, Arizona, and have practiced in national and local CPA firms for over 25 years. My current practice provides a broad range of services for small and medium businesses and those businesses vary in types of industry and services.
While I do not perform services for public companies and I no longer perform auditing services, I am still subject to those independence rules and standards promulgated by the American Institute of Certified Public Accountants.
As you may note on my resume, I have served on the governing council of the American Institute of Certified Public Accountants, the American Institute's quality review executive committee, board of directors of Arizona Society of CPAs, the Arizona State Board of Accountancy, past president,and finally the Board of Directors of the National Association of State Boards of Accountancy.
I have significant experience serving my profession as well as the public from the perspective of the professional associations and the regulatory board and its association. My remarks, however, are personal to me and are not intended to reflect the position of any of those associations that I serve or have served.
As has been stated numerous times in one form or another, independence is a fundamental tenet of our professional conduct. To maintain our professional trust and integrity, it is extremely critical to live by the highest standards of independence. And this is particularly true with attestation services.
Our clients, as well as the public, do not always know us well and certainly not personally, and mostly extend that trust through their perception. In my past service for the professional associations, I might add, I continue to serve those professional associations in various roles. We fought the mandate by the Federal Trade Commission to allow for our profession to accept commissions.
The position of the professional associations, the American Institute of CPAs and the state professional societies was that the prohibition of CPAs accepting commissions protected the trust and integrity extended to our profession by the public. It was generally felt that the public perceived that we performed our services without the influences of monetary gain.
While the associations gallantly fought this change, it reluctantly conceded, allowing the acceptance of commissions on a limited basis. The arguments expressed at that time against commissions parallel the arguments at this time for maintaining the highest standards for independence.
Incidentally, one of the major limitations placed on our profession when accepting commissions is the continued prohibition of accepting commissions from clients for whom we provide attestation services.
Just as commissions threaten the objectivity of a CPA's judgment, so do the financial rewards received from services which also have a significant and material investment in the success of the company's performance.
I have an extremely high level of respect and admiration for the American Institute of Certified Public Accountants, its leadership and its staff and the prominent national and international CPA firms that are partners in the staff.
I as well as just about all CPAs look up to the leadership of the groups and reap professional benefits from their successes. We also suffer their failures.
I prefer to believe that the recent violations of independent rules by a certain national CPA firm were more the result of the firm's frustration with rules which have failed to keep pace with changing times, rather than blatant disregard of the standards. We can ill afford the development of a more relaxed and cavalier attitude towards those standards from which we have attained our professional prestige. It behooves these organizations to be sensitive to their impact on the profession as a whole and the credibility that has been attained by their leadership.
To be at such odds on such an important issue with these organizations makes me nervous, at least and, at worst, concerned about the direction of our profession. I have, as previously noted, considerable experience working with the leadership of our profession and have, without exception, observed a constant and unwavering dedication to maintaining high standards for our profession as well as a commitment to maintaining the public's trust.
I am a strong supporter of the profession's efforts to be self-regulatory but appreciate the need for the partnering with and accepting oversight by other organizations whose primary commitment is to protect the public. I would, however, like to caution this agency as I would any regulatory agency not to over reach or overreact, a tendency that I note in regulatory entities, be they a standard-setting committee of the American Institute of Certified Public Accountants or a government agency, the Arizona Board of Accountancy, I might add, is to micro-regulate.
This tendency becomes inflamed at times of crisis or controversy. And, try as we might to identify the nuts and bolts of independence, it is a mind set. As the Wall Street Journal quoted your chief accountant, Lynn Turner, you would have to get into the auditor's head.
Consequently, we can become so focused on our efforts to tighten the nuts and bolts of an auditor's behavior that we haven't allowed for the expansion and contraction or changing times and out-of-ordinary circumstances. Now, do the rules need to restrict a firm's ability to provide human resource services to a company because of the firm's interest in the success of the company's employees? It's important to remember, of course, auditors also have an interest in its clients success --already have an interest in the client's success.
I would suggest that such services would create relatively little risk and an unyielding prohibition would seem to me to be excessive. Clearly, designing an information system that sets controls and procedures which are integral to the reporting of the company's financial results is far more likely to impair an auditor's mind set than evaluating employee performance and compensation.
I would feel differently if the firm were then hired to audit its performance in connection with the human resource engagement. I might also feel differently if the magnitude of such an engagement exceeds a reasonable level of materiality. Granted, materiality can be as difficult to define as independence.
CHAIRMAN LEVITT: Could I ask you to summarize, because we're really running low on time.
MR. DAGGETT: In summary -- I'll go right to it, sir. In summary, independence in appearance is as critical as in fact. Public trust in our profession is a factor of how our behavior is perceived and is as critical today as it has ever been. This is especially true in the global and electronic environment in which our commerce is made.
And, finally, with respect to the significant changes in the standards, I hope that common sense will prevail when clarity of need does not.
I thank you for your time and I also again thank you, Mr. Chairman, for addressing the National Association of State Boards of Accountancy this past week.
CHAIRMAN LEVITT: Thank you.
MR. CONAWAY: Thank you, Mr. Levitt, Chairman Levitt. I am wearing two hats. Michael Conaway, CPA, from Midland, Texas. I chair or am the presiding officer of the state board and our board has presented to you our comments on the proposed rule-making.
To the extent that my personal -- my comments differ from or deviate from what is written, those are my personal comments and I'm responsible for those comments.
Let me give you a quick explanation of the process that we went through in determining our comment letter, we had a -- our rules committee struggled with these proposed rules. We had face-to-face meetings, we had conference calls. We had no shortage of the exchange of drafts. And the players on this committee, I believe, are a micro-version of this entire process. We had every jersey in the game at this table and what you have in our letter is a compromise among all of those people that was worked out throughout that process.
We had Big Five, we had Accountants Coalition representatives, we had academics, we had Wanda Lorenz who already testified earlier today. We had sole proprietors. We had members of industry and government all working around the same table to come up to a compromise in which no one got everything they wanted but no one lost everything as well.
I too heard your speech on Monday and I am very appreciative of those comments and they are generally in line with my own personal comments. However, I would ask that simply telling each other we're wrong in louder and louder voices rarely contributes to the overall solution that we all seek. And I would also ask the AICPA and its leadership to tone down their rhetoric as well, as I don't believe that is conducive to what we want to do in this arena.
I serve on two trade associations, one state wide in Texas and one national trade association. Each of us on those board of directors, as we speak, and it might be perceived that we are speaking on behalf of the members of those organizations, struggle with how we come to consensus on what is being said. Do we in fact represent the broad membership or do we simply represent our own personal views?
I would, as Mr. Baker said earlier, I would encourage you to seek out others in the AICPA, other members of the American Institute, because I'm not sure in this instance that the leadership is reflective of the broad, 300,000-plus members that are out there. So we, too, would welcome you to come to Texas to listen to firms that audit SEC clients. Not necessarily the Big Five, although they would be represented as well. But hear from them how these rules impact you.
Brief comments then on -- from our paper. The four principles, we would ask that perhaps those be better placed in a preamble or a guidance document. That some of the strict interpretation of the language would reach further than I think that the Commission would like to have happen.
CHAIRMAN LEVITT: I agree.
MR. CONAWAY: Thank you.
We would also ask that, on covered persons, the one comment that we made that is maybe an understatement is the implementation of these rules represent challenges. With respect to affiliates of accounting firms, we also think there that the reach would encompass certain relationships that we don't see as impacting auditor independence and we would want to look at those as well.
And the ban on non-audit services, our committee in long discussions could not conclude that an absolute ban on non-audit services would be appropriate in these instances without some evidence that the ban was needed. We would encourage you though, as you've already said earlier today, to perhaps codify those existing prohibitions and proscriptions. But with a clear understanding that the intent is not to expand them beyond what they currently cover.
With respect to the disclosure of fees, I think that movement down that line is appropriate. I also echo a concern that the raw data, in and of itself, may not be helpful in disclosures to shareholders. What do they in fact do with that information in terms of evaluating the auditors? But I don't know that we can get away from not disclosing at least the absolute number on those fees.
As a procedure matter, I too am a regulator, as you. I don't make as much money as you do. I am also responsible for the rule-making process that is not dissimilar to what you do. These are complicated rules. Many are calling for a simple slowdown or a delay or an extension of time. I don't believe that is necessary. But I do believe -- because each time that is called for, if I were in your position, I would try to evaluate what their motive was, is it because the process will be better or is it because they are trying to do an end run and get at the Commission in a different manner?
I would call for a second round of comments. You'll have heard four days of testimony -- and I compliment you on your stamina for being able to hang in here all day. You will have four days of testimony, numerous letters and plenty of comment for the Commission to chew on and give effect to and consideration to in the ultimate final rule. I would ask that, rather than delay for delay's sake, that you issue the rules perhaps in two pieces. One, where there was clear consensus among the group and set those in final form. The areas where we are struggling with and trying to understand the impact, that those would go a second round of drafts with another limited time of comment. Because, I agree with you, unless you set deadlines, we simply won't focus on the issue and we would call for that.
Thank you, sir, for your time.
CHAIRMAN LEVITT: Okay. Mr. Sadler.
MR. SADLER: Thank you, Chairman Levitt, for inviting me to appear here today. It's a privilege to speak on behalf of the State of Washington to the extent that I am able to do so. My comments were submitted written, echo some of the remarks of my colleagues in that these guidelines were prepared rather hastily and follow pretty much what we use for our regulatory efforts in the state of Washington. And therefore, I am allowed to speak on behalf of the state of Washington and, in certain cases, myself.
I compliment you on your stamina and your effort in this area. We have been undergoing these types of reviews in the state of Washington for at least the last two years and I understand fully the process.
Auditor independence is a foundation of the CPA profession. In addition to the SEC arena, it permeates through all of our work. Every activity in the accounting or reporting arena in addition to audits, SEC audits, reviewed statements, compilations, and attest services require independence and that has been one of my concerns with the issue here today as to how we will filter this through state regulation and what the impact will be on the smaller practitioners and small business.
Our rules would say that any attest service which includes audits, reviews, compilations, require that the accountant be independent and that standards of appropriate bodies be followed. Included in the appropriate bodies is the SEC. Of course, I want to highlight in that regard the consequence of amending these rules because I believe that it will follow on and will be significant.
Having said that, appearance in fact and appearance in fact of -- independence in fact and appearance has been a hallmark of the CPA practice and that which distinguishes us from all other professions as certified public accountants.
Through my practice of doing public accounting for over 30 years, I've had some large firm experience and most recently for the last 27 years in a local firm. So my experience in the large firms is somewhat dated now but independence and and mental attitude has always been the hallmark of the profession.
But we hear from the AICPA and other trade publications that the growth in audit fees is stagnant. Audit is a commodity. We should use our audits as a leverage to obtain more profitable work. In this kind of an environment, how can we be expected to maintain independence.
I have read your principles and I believe they could stand some clarification in that regard. And some of the problems that I've seen is that the independence for a professional or an auditor, not only is it a requirement for their relationship with their client but it appears to become a problem with their relationship with their own firm. As the firms get larger and their services expand, the necessity to maintain professional skepticism not necessarily is restricted now to your client relationship but it has become a problem with their firm with relationship.
We agree that this environment calls for modernized rules. I think whatever you decide and what degree that you move forward with these rules, there will be many details that will need to be worked out, many scenarios will be brought to you. That's what happens in the state of Washington. We think we have something very clear that we put it out in a regulatory format and we find that the devil's in the details.
So, therefore, we support a strong Independence Standards Board. I have a strong feeling that the SEC has not maintained confidence in that organization, is not happy with its progress. That's just the feeling I have.
If that's in fact the case, that process should be restructured and if possible a NASBA representative should be included from the state board or some other public representative from the state board of accountancy. It will be necessary to interpret future issues.
We believe that your general standards should include that a professional should not subordinate his or her judgment to others and maintain professional skepticism.
Many discussions I've heard here today have had to do with should the relationship and fees be disclosed? I believe that would be incomplete without some recognition of the realization rates or the proportionate profitability or the type of fee that was incurred.
CHAIRMAN LEVITT: I don't think the public would understand those very terms. The purpose of disclosure is to give the public some feel as to whether on the close calls, the subjective judgments that may be made, whether there may be a motive to come down on the side of management rather than the shareholder.
We've had all kinds of views about the nature of the disclosure. I have to say to you that some argue that every jot and tittle, every line of what consulting is should be put forth. I reject that personally as much as I do the words that you used because the public needs this in the simplest, easiest, most digestible way or they don't need it at all.
MR. SADLER: Well, if I could just be permitted one more comment on that, and that is the relationship of gross dollars to consulting is interesting but probably not as relevant as if a firm that has made $10 an hour doing the audit and makes $1,000 an hour doing consulting. That is the point of that comment.
If there could be some way that that could be introduced into the disclosure, I think it might be useful and also make that disclosure relevant.
CHAIRMAN LEVITT: Thank you very much. Mr. Neilsen?
MR. NEILSEN: Thank you, Chairman Levitt. We appreciate the opportunity to share our thoughts concerning the proposed rules on audit independence.
Accompanying me today is Kay Chapman, Administrator of the Division for Professional Licensing in the Iowa Department of Commerce. I am a member of the Iowa Accountancy Examining Board. We as a board have reviewed the information and the comments that we make today are my personal comments together with the comments that I've received from board members.
The accounting profession today faces great challenges. The types of services that are provided by CPA firms have expanded over the years. In fact, some of the new services today are core services. These additional services have been in response to wishes and demands of clients and the firms that have developed these services are using them as a means to develop staff, obviously increase profitability and attract diverse staff.
The independence of fact and appearance has been and still is the backbone of the accounting profession andthe main reason why accountants are still considered the most trusted professionals. The public places a great deal of reliance on audited financial statements and the importance of auditor independence has never been greater.
We support the Commission in its efforts with the AICPA to establish the Independent Standards Board and the work that's been taking place.
We do have some concerns that the work of the Independent Standards Board may be overshadowed by the implementation of these new rules. Our question is, is there a plan to reconcile these rules with the Independent Standards Board so that we can eliminate confusion that may result from these differences? We believe that this would be a very important step and would clarify many issues.
The recent actions taken by the Independent Standards Board and the commission to bring independence matters to the attention of audit committees is a very positive step. The participation of the audit committee in identifying and resolving any potential independence issues for non-audited services performed is a very important matter and obviously will bring greater scrutiny to this very important area.
With these new disclosures and the audit committee responsibilities in place, we also question whether or not some time should pass to see what impact these new rules will have.
With our limited time, we'd like to address two specific issues. One, as it relates to the financial interests of members of the audit firm. We do have some concern allowing adult children of covered persons to have financial interest in an audit client. We realize that adult children are not necessarily under the control of a parent; however, the appearance and the ties are too close and leave opportunity for impairment of independence.
The other issue that we would like to speak to are the nonaudit services. Everybody is -- almost everybody has spoken to the report by the panel on audit effectiveness. It indicated that there wasn't -- there weren't audit failures directly related to the performance of non-audit services.
The other issue related to nonaudit services that we would like to at least visit about is the term "advocate" which is used many times in the proposal. We think that in many instances a CPA can provide non-audit services for a client and not be considered an advocate. We also believe that it's possible that a firm can, in effect, be an advocate, especially in tax matters, and still be considered independent and not impair their independence.
We also believe that this illustration potentially parallels with the work as an expert witness. In most instances, an expert witness who has the slightest appearance of advocacy will impair the effectiveness of that expert.
We do think it's important to note, too, that in most instances the nonaudit services are provided by members who are not necessarily involved with the audit.
We thank you for the opportunity to share our comments.
CHAIRMAN LEVITT: I gather that both you and Ms. Chapman speak for the state of Iowa; is that right?
MR. NEILSEN: That's correct.
CHAIRMAN LEVITT: So it's not necessary to provide additional testimony, is that --
MS. CHAPMAN: There are two sentences which I would like to add.
CHAIRMAN LEVITT: Great.
MS. CHAPMAN: The commissioners on uniform state laws have recently promulgated a new administrative procedures act for the states. Iowa has enacted part of it. That, together with the direction from our Governor Vilsack, we are required to review and edit all of the rules for licensing and disciplining accountants within the next year. We would like to be able to do it accurately and completely.
My job is not to help the recruiting for any accounting firm. My job is to protect the public in the State of Iowa and to discipline accountants when necessary. The idea that the disciplinary rules should be kind of loose and easy bothers me as a lawyer because if you are going to be held to a standard which you can be punished for disobeying, that standard has to be easy to understand and complete, just like any criminal statute must be.
So I would ask that you get on with it and you give us our time to get our rules in order to complement you.
CHAIRMAN LEVITT: That's terrific. I wish I had started with you.
CHAIRMAN LEVITT: It's characteristic of my friends from Iowa that they are concise and direct and to the point.
Are you all affiliated in some way or other members of the AICPA?
MS. CHAPMAN: I'm not. I'm not even an accountant.
CHAIRMAN LEVITT: How about the others?
MR. NIELSEN: Yes, yes.
MR. SADLER: I am a member of the AICPA.
CHAIRMAN LEVITT: You know, I've asked them to be able to present my views at their council meeting in October. Do you think they should allow me to do that?
MS. CHAPMAN: I did hear your speech on Monday.
MR. NEILSEN: Yes. We would support that.
CHAIRMAN LEVITT: I wish you'd tell them that.
MR. NEILSEN: We will.
CHAIRMAN LEVITT: Because I really think it's important that -- you know, we may disagree but I will give them -- we were having a separate day's hearing for them and I think it says something in terms of the spirit of openness that we extend this courtesy to one another.
MR. DAGGETT: Well, we're not so influential that we control that. We will certainly put in our input and I will submit that and make sure I get a call in to them.
CHAIRMAN LEVITT: Thank you very, very much.
MR. TURNER: Mr. Neilsen?
MR. NEILSEN: Yes?
MR. TURNER: I have a couple questions. One is the O'Malley Panel report and the fact that it states that they didn't find any instances of a lack of independence. But the report does go on to say that even if they do --
MR. NEILSEN: I think that, yes, that is correct. And I certainly didn't want to take anything out of context. However, I think the report did indicate that they had not determined that there were audit failures.
MR. TURNER: But they go on to say that they couldn't find them.
Let me ask you another question about the O'Malley report. The O'Malley report goes on to later say that there's a number of services that are inconsistent with the provision of auditing services, including, legal, broker-dealer and underwriter type services. And they think think that removing them would improve auditor independence. Do you agree with them on that statement?
MR. NEILSEN: I would agree with them on that statement.
MR. TURNER: Thank you.
COMMISSIONER UNGER: I'll be happy to pick up where the Chairman left off. So I apologize, I had a prior commitment I could not get out of so I will read the transcript of your testimony and I have available here the actual written text. But I take it each of you have testified?
MR. SADLER: Yes. Yes, we have.
COMMISSIONER UNGER: And our able counsel has asked questions?
MR. BECKER: Well, I actually have a question or two I'd like to ask Mr. Conaway. I read in your statement that the Texas board has some reservation about the proposal. Am I right about that?
MR. CONAWAY: Yes, sir.
MR. BECKER: And regardless how the Commission comes out. In considering whether Texas should revise its rules, as a result of this rulemaking, that the Texas board or whoever writes the rules is going to exercise its independent judgment in deciding whether or not it will do that.
MR. CONAWAY: That's correct.
MR. BECKER: Who are the -- if you know, who are the principal users of financial statements of nonpublic companies?
MR. CONAWAY: Well, the standard banker, shareholders and potential purchasers of those companies are the normal users.
MR. BECKER: Are these, in your experience, generally folks who are more sophisticated than the average investor?
MR. CONAWAY: Mr. Becker, I don't have any empirical information on that, who the average investor would be. But to the extent a banker has better access to the client and to what's going on than some far distant shareholder would, certainly.
MR. BECKER: Well, I take it you agree with me that you would hope that a banker has more sophistication than the average shareholder; is that the way Texas operates?
MR. CONAWAY: I lived in Texas in the late '80s, Mr. Becker.
MR. BECKER: Fair enough. I won't go there.
MR. CONWAY: In all fairness, I was also in the banking industry at that time.
MR. BECKER: I take it then that for a state board to decide what it's independence standard should be, it does not have to take into account the same way we do concerns about maintaining investor confidence in the national securities markets?
MR. CONAWAY: I disagree. I think our role and responsibilities as a state board is to protect the public interest, just like yours. I don't see a difference.
There are a lot of SEC registered companies based in Texas. All of the big accounting firms are based in Texas. There are a lot of non-Big Five accounting firms who practice before the SEC. We regulate them as well.
The state boards regulate everybody, every CPA, whether all you do is a simple tax return or you sign off on the most complicated multi-national audit in the world, you come under our regulation. We're the ones who can take your license away from you. The AICPA can kick you out. You guys can say, you can't practice before us. But we can take their livelihood totally away from them.
So I believe our interests are parallel, no matter what the size of the entity. We want independent auditors performing good quality work with integrity and objectivity. I don't believe that's any different than yours.
As to what impact these proposed rules when issued in the final form would have in Texas, we're a bit provincial in that we believe -- we understand what ought to be going on in Texas and we will look at our rules. Our rules don't currently reflect everything in the AICPA's rules or your rules, but we have perhaps even more stringent rules.
Our general counsel advised us yesterday that, should we get into a fight with a particular CPA who may have been at odds with our own rules in Texas if they were more stringent than the SEC's rules, that we would be in for a fight as to which jurisdictional rules prevail. But, nevertheless, that is a fight we would make in defending our rules on independence or anything else.
MR. BECKER: Thank you very much.
COMMISSIONER UNGER: What's been the panels experience with respect to handling conflicts of interest in enforcement cases? Has that been something that you've been able to determine?
MR. CONAWAY: We have a very aggressive enforcement process in Texas. We have four lawyers on staff and we have a general counsel. Quite frankly, we have been unable to find empirical evidence that would say that the root cause of whatever the enforcement case was is a commonality of interest between the auditor and the client.
Generally, there are a lot of other reasons that could perhaps mask that root cause.
The issue is a rule of hearts and minds and you just can't hardly write those. We can write great rules as to how your tax return ought to be done or how your financial statements ought to look like but writing rules that govern the hearts and minds of those making those judgments are difficult at best at finding those violations.
COMMISSIONER UNGER: Anybody else? Are you the spokesperson for the panel?
MR. CONWAY: No ma'am, I'm not. I've just never seen a microphone I didn't like.
COMMISSIONER UNGER: Okay.
MR. SADLER: I can just speak in general to that issue and that is that we find auditor or accounting reporting compromised in the case where errors occurred during the course of engagement that the auditor believes to be the responsibility of their consulting work.
In other words, as long as they're consulting and doing everything fine and then they do a report, an audit, or whatever the case may be and there's nothing wrong with their work, then there's no conflict of interest and they go on.
The problem is when an error occurs in the side work, when they make a misjudgment in taxes or they somehow miss something during the course of their work. Then they're in a position of conflict.
COMMISSIONER UNGER: Something happens in the area of the consulting work?
MR. SADLER: On the consulting side perhaps or maybe some previous financial issue that happened. It could be either way.
COMMISSIONER UNGER: Okay. Anybody else?
MR. DAGGETT: We have experience with the suspicion that it was, in fact, a conflict of interest or perhaps a violation of independence. But, again, when there is a violation as has been suggested here that has been detected, it's much easier to prove that violation than it is the fact that it was caused by the lack of independence.
MS. CHAPMAN: Writing the rules is easy compared to finding the evidence.
COMMISSIONER UNGER: Well, I think it's difficult on any enforcement case involving an accounting failure from where I sit to determine exactly what the cause of it was. So it's hard not actually being there and conducting the audit to know what should have been done. It's easier to second-guess it than it is to get it right the first time.
But there was one thing that's come up in the course of hearings -- I'm going to get to the spokesperson because I heard it was a Texas rule. The loss leader that you had a rule in place that prohibited discounting and I'm just paraphrasing what I've been told -- limits the amount that a firm could discount their engagement, their audit engagement.
MR. CONAWAY: Yes. We have a rule in our books that prohibits you from bidding a job that lists in your direct labor costs and all-inclusive labor costs so that it costs you bore from it, it's going to cost you more to do that audit than what that fee is going to be, then we have a prohibition against that.
COMMISSIONER UNGER: Have you brought any cases for --
MR. CONAWAY: No, we have not.
COMMISSIONER UNGER: How long has that rule been in place?
MR. CONAWAY: I've been on the board for better than five years and it was there when I got there.
COMMISSIONER UNGER: No enforcement case in five years?
MR. CONAWAY: On that issue.
MR. SADLER: I have a quotation that you might find interesting on that issue out of the CPA Managing Partner Report. Alan D. -- I believe it would be pronounced Coulton says, representing the Practice Development Institute: If these rules take effect then, "It would make marketing almost cost prohibitive because firms wouldn't have the feeder of financial statements to lay the groundwork for cross selling financial services." That's the Managing Partner Report, September 2000.
COMMISSIONER UNGER: Could I trouble you to part with that and put it in the record? I'll get it from you after.
MR. SADLER: I'm happy to provide that.
COMMISSIONER UNGER: Thank you.
MR. CONAWAY: It's probably an illegal copy but that's okay.
MR. SADLER: If you'll take copyright responsibility, sure. Thank you.
COMMISSIONER UNGER: So did there -- is that type of arrangement what brought about the rule, do you know? The genesis of the rule?
MR. CONAWAY: It's my understanding what came about is that most rules have an anecdote associated with them but the worry that the big firms would predatory price their way into markets and through the system and, in effect, gain a competitive advantage over smaller firms that couldn't discount their work to the same extent. The idea was to at least put them on a footing that said you can't sell the work for a loss, knowing it on the front end.
You know, that's not to say that all of us have not been involved in audits where our fees are less than what we wind up having to charge because the work is more extensive than we had guessed on the front end. But that's a different issue. You just can't do it prospectively.
COMMISSIONER UNGER: The last -- do you have something --
MR. SADLER: That's another thing --
COMMISSIONER UNGER: Another great quote?
MR. SADLER: It's another paper you might find interesting, an AICPA publication entitled, "Making Audits Pay: Leveraging the Audit and the Consulting Services."
COMMISSIONER UNGER: Excellent. Chalk it up to the public interest.
MR. CONWAY: Another copyright violation.
The last question I'd like to ask you all was, we had had some small firms say that they were concerned not necessarily about the SEC proposals applying to them because they didn't have SEC audit clients, but that the states would adopt something similar to our proposals, were we to adopt them.
Is that the case? Do any of you have any sense of whether or not you would want to adopt those types of -- rules along the lines of ours?
MR. DAGGETT: I would just jump out in front here and say that I would suggest it would be a very high percentage of those rules would ultimately become the rules of most any state statutes.
MS. CHAPMAN: It would certainly be considered and then put into the mix for any new rules. High probability.
COMMISSIONER UNGER: It's a legitimate concern?
MS. CHAPMAN: Yeah.
MR. SADLER: And many rules may adopt them by reference, such as ours, which references the SEC rule as an appropriate rulemaking body that a professional in the state of Washington must follow.
COMMISSIONER UNGER: Okay.
MR. CONAWAY: I also believe that the one size fits all mentality sometimes gets criticized, but I believe there are those who worry about being considered second-class citizens within the profession when you have certain rules apply to them that don't others.
So it's a -- this is by anecdote. We changed our fee structure and didn't charge a fee to certain members in industry and government and we got some criticism for that because they didn't feel like they were getting to pay their fair share of the cost of the information and felt like they were being treated like second-class citizens.
COMMISSIONER UNGER: We just don't hear that enough here.
COMMISSIONER UNGER: Well, I thank you very much. I don't know if the Chairman had anything else he wanted to ask, but I think I've exhausted my questions.
COMMISSIONER LEVITT: Thank you all.
MS. CHAPMAN: He's had a long day.
COMMISSIONER UNGER: Thank you very much.
CHAIRMAN LEVITT: Maybe I'll see some of you in Las Vegas.
Panel 7 (Afternoon)
The next panel is Roderick M. Hills and Charles C. Cox. Let me say, as I introduce one of my worthy predecessors, that there is something about this job that transcends partisan politics. When I encounter a former chairman of this agency, I have a very, very special feeling for them, particularly one who is as distinguished for public service and doing the right thing, as Mr. Hills, and Mr. Cox as well, enjoys a superb reputation. And I am honored that you have come before us today, and I am sorry that you had to be delayed.
It has been a tiring experience. I don't know if you ever went through a similar series of public hearings --
MR. HILLS: It is uncommon.
CHAIRMAN LEVITT: Mr. Hills.
MR. HILLS: I have submitted written testimony and if I may just summarize it. Speaking from the past 30 years of experience, I must say that I firmly believe that the independence of accounting firms has been compromised far too often because the continuation of the audit relationship has become more important to some audit partners than the integrity of the financial statements.
In those 30 years, I have served on the boards of 12 publicly traded companies, on the audit committee of all of them and as chairman of the audit committee of seven of them. Five times, I had to write off more than $100 million of assets that should never have been recorded in the first place. Eight times we had to fire a chief executive officer for mismanagement. And on five occasions, we either replaced the audit firm or the entire audit team.
Each time we did that, we checked and found out the auditors had raised significant accounting issues with the management that they had not raised with the audit committee. And you have to ask why does that happen, and it happens for the simple and sad fact that the auditors are much more afraid of being fired by management than by an audit committee. And there are too many managers that are willing to use perhaps a subtle threat just to lose the audit assignment if the audit partner is reluctant to accept some kind of accounting irregularity. And there are too many auditors that are willing to yield to those threats.
And so if auditing firms are prohibited from providing some consulting services and discouraged from providing others, I don't think there is any doubt that there will be less likelihood that the integrity of the financial statements will be compromised.
Human nature being what it is, as several of the prior people have testified, the maintenance of the audit relationship itself will cause a yield to the integrity, sadly. I must say that all of my disappointing relationships with external auditors have occurred in companies where the non-audit fees were quite low.
For that reason, I would ask the Commission in addition to its proposals, that it seriously consider taking -- insisting that the independent directors, the members of the audit committee take stronger action to protect the external auditors from what I would think is too often undue management pressure. I strongly support the Commission's initiative. I do, however, suggest that the Commission's final rules on the question of auditor independence lean heavily toward the specific disclosure of non-audit services and somewhat less on the prohibition of those services.
If I may, I would like to use the issue of the internal audit function to illustrate my thoughts. There is a problem there, of course, because many companies still do not have an internal audit function, out-sourced or otherwise. And so I think the Commission should consider, either by regulation, by enforcement or just by some speeches, that they make it clear that the lack of an effective internal audit function can constitute a material weakness in the internal controls of the company.
I do agree with the Commission that, as a general proposition, the external auditors should not accept an assignment to do the internal audit. There are really several reasons for that. The establishment of the internal audit function is normally done with close assistance from the external auditors, who, by the way, are also required to disclose any material weaknesses in that system. It is at least strange to consider the possibility that the external audit partner will be asked to comment upon any weaknesses in the system that is being operated by its partner.
Second, the primary reason to have an internal function is really to allow management to maintain control over its own financial systems and its processes. If the external auditor and the internal auditor are the same organization, the company is going to lose some of that control. That doesn't have much to do with the independence of the auditors but it does have to do with the efficacy of the business.
Third, and maybe most important, the internal auditor works for the audit committee. If we ask for an investigation of an incident or if we ask to determine whether or not a given investment has been performing as expected, if we ask for opinions about a bookkeeping matter or about the quality of some financial official, we expect that internal auditor to do exactly what we ask him to do. If we were to ask the external auditor to give the same kind of opinion, most of them would tell me that they couldn't do that without harming their objectivity and their independence.
And so I fully support the Commission's effort, but I am skeptical about the efficacy of trying to draw a bright line between what kind of internal audit function can be permitted and what can be prohibited. I have listed in my written submission a number of incidents where I felt it was necessary, certainly appropriate, to use the employees of the external auditor on occasion. And so I respectfully suggest that the flexibility be left to the audit committee and management to determine whether or not in a given circumstance, the external auditors should be permitted to perform what most people would consider to be an internal audit function.
In my written submission, I urged that the same approach be taken to some of the other non-audit services that are offered by the external auditor, I must hasten to say, however, that disclosure certainly is not sufficient. The audit committees must police the use of the external auditors or the system won't work. They should ask the external audit partner, for example, whether his or her services -- his or her compensation is linked for the non-audit service that he or she may have originated for their firm. And the audit committee I think should discourage that practice. They should ask management to deal with a different partner whenever they want a service other than an audit service from the external auditor. I think also that the audit committee should not allow the non-audit fees to be larger than the audit fees except on occasion, where they may be some unusual circumstance. But certainly not year after year.
And the audit cannot be allowed to be, as it is often, the loss leader, the one to originate other services. Management is often callous in using the lure of other services to negotiate an audit fee lower. It is not uncommon for the chief financial officer to insist upon a lower fee, which, of course, is on his budget, knowing certainly the consulting fees which are part of somebody else's budget will be higher later on.
And, finally, the audit committees should be made to understand that they must take effective, affirmative action to protect the independence of the external auditor. Since 1977 when the New York Stock Exchange first required the existence of audit committees, there have been constructive comments by the Treadway Commission, the BlueRibbon Commission, about what independence means. However, the fact that members of an audit committee may seem to be objectively independent is not enough. Audit committees, in my view, need to be far more aggressive in protecting the independence of the external auditors and the internal audit function. They need to play a significant role in the engagement of the external auditor, in the selection and replacement of the partner in charge of the audit, and in fee negotiations themselves. The external auditor should know that the primary relationship is with audit committee and not with management. That is a view, I must say, Mr. Chairman --Commissioner, that would require a change, a significant change in the relationship between the audit committee, the auditors, and management.
I respectfully suggest to you that the Commission over the years, is at its best when it requires and enforces disclosure rules -- when in the past there have been calls for regulation -- the Commission has leaned toward more disclosure. You may know that back in the '70s, when we had those 410-some American companies that were embarrassed by having made a questionable payment overseas, that disclosure was much more effective. And that is, of course, when the audit committee requirement came about.
I believe that by prohibiting some functions where a clear conflict exists, and by discouraging others, by requiring disclosure and meaningful oversight by the Audit Committee, the Commission will achieve its objectives.
Thank you very much for the opportunity.
CHAIRMAN LEVITT: Mr. Cox.
MR. COX: Thank you, Chairman Levitt, and Commissioner Unger. Lexecon, the firm where I work now, is a consulting firm that specializes in the application of economics to a variety of legal and regulatory issues. In that regard, I have been asked by Arthur Andersen, Deloitte & Touche, KPMG, and the AICPA to comment on the rule provisions that would restrict non-audit services that can be provided to an audit client. I have focused mainly on the costs of those provisions. I will try to summarize my testimony very briefly.
In my opinion, the Commission has failed to analyze the costs and benefits of that proposal. And the best analysis possible under the time constraints that have been imposed by the Commission's comment period failed to support that proposal. It is also my opinion that the Commission could adopt a less intrusive regulation that would address concerns about auditor independence while allowing the marketplace to determine the appropriate degree of separation between auditing and consulting services.
In reviewing the proposal, I first found that the proposal provided no evidence of a problem or of benefits from the proposed rule. In fact, it didn't cite a single case of concrete evidence that a problem exists. Instead, the proposal relied on appeal to common sense and claims that -- I am taking from the proposal, "There can be little question about the effects of impairments from the provision of non-audit services on investor confidence." It went on to claim that "gradual decreases in investor confidence may not be measurable but their cumulative economic impact could not be more palpable." I disagree, in that common sense doesn't support such a sweeping regulatory change. To me, there may be problems in the U.S. securities markets currently but they don't suffer from a lack of investor confidence. I think what we have seen is a period of participation in equities by individuals, both directly and through mutual funds, has reached new heights and where U.S. companies have raised unparalleled amounts of new capital through the equities markets. And I see no indication of a loss of confidence in these markets.
Next, I noted that there is no reliable evidence put forth in the proposal that consulting by accounting firms or their affiliates inhibits the financial reporting by public companies or effective audits by accountants. Also, in my review I found that the experience of other countries fails to support the Commission's claims.
Turning to costs. The Commission does not even attempt to measure the cost of its proposal, but I believe that those costs should be measured because they may be substantial. Accounting firms have consistently built large and profitable consulting businesses but that kind of economic success doesn't occur at random. It follows from low costs and economic efficiencies. And companies that have spun off parts of their consulting operations have typically kept substantial pieces of the consulting business and have continued to act as incubators for new consulting services. With the restriction rule, the economic advantages of these efficiencies would be eliminated or substantially reduced by the proposal.
In addition, the proposal could reduce the number of effective competitors providing audit services to companies that employ multiple consultants. Another area of costs that isn't measured is that the proposal would create an ambiguous and open-ended regulatory framework that would be costly to resolve.
Finally, unintended consequences of well-intentioned rules are a well-documented source of costs of regulation, but I believe that those should be considered and measured in this instance. Although I have not had time in the available comment period to estimate the likely costs, I suggest that the magnitudes could be substantial. For example, if audit clients are forced to switch consultants bythe proposed amendments, they will have to turn to either higher cost or lower quality consultants. Now, suppose that this reshuffling increases consulting costs that are influenced by 1 or 2 percent as a result. Taking the number put forth in the proposal of $3 billion of overlapping consulting costs, that would suggest a cost of $30 to $60 million per year as of 1999. Now, what would be involved going forward in the future years would obviously depend on spin-offs and the development in the industry. On the other side, suppose that the proposed amendments raise the costs of audits by 1 or 2 percent, again taking the figures put forth in the proposal, that would suggest a figure in the range of $90 to $180 million per year. And some portion or all of those costs would be borne by shareholders.
So, in conclusion, I think that the Commission has not made a case for why any change with the scope of auditing services is necessary. And I would note particularly in light of recent enhancements in the environment of corporate audit committees in safeguarding auditor independence. But I think that from what I have seen that the Commission has plainly failed to demonstrate the need to go any further than a disclosure approach, which would be a less costly approach and that would involve some type of disclosure about amounts spent to purchase consulting services but would not prohibit such purchases. That would rely on the fundamental premise of disclosure and letting investors make the decisions based on that, and I can see no justification for the prohibitions that are suggested in the regulation.
CHAIRMAN LEVITT: Mr. Cox, did I understand you to say that you were being retained professionally by Arthur Andersen, KPMG, and Deloitte & Touche?
MR. COX: Yes, and the AICPA.
CHAIRMAN LEVITT: The ones who have banded together to oppose this recommendation. Were you on the -- refresh my recollection, were you on the Commission that dealt with this issue of disclosure? I know at one time there was a disclosure requirement and then I know that Bevis Longstreth told me that he was on a Commission that we looked at. Were you on that Commission with Mr. Longstreth?
MR. COX: That was before my time at the Commission, Chairman.
CHAIRMAN LEVITT: But you are comfortable with disclosure?
MR. COX: Again, it would depend on the particular disclosure. I found that it is usually very hard to disagree with the idea of disclosure -- disclosure is good but it has costs. I would qualify my support to say it would depend on just what kind of a disclosure rule.
CHAIRMAN LEVITT: Well, let me be more specific. In the UK, they have a rule which says that the shareholder is entitled to know how much the company had paid for the audit function and how much they paid for consulting services. Would you be comfortable with such a rule?
MR. COX: That is the kind that I had in mind. I hesitate to say "comfortable" because I haven't really analyzed it in any great detail as far as the costs of the rule but that is the kind I would investigate certainly.
CHAIRMAN LEVITT: Well, your clients asked you to ask the question of the costs of the rule, and I wonder whether they asked you to identify any benefits to the rule as well?
MR. COX: I looked for the benefits, and I didn't see any in the proposal that, again, as I said, --
CHAIRMAN LEVITT: You saw absolutely none, no benefit?
MR. COX: I didn't see any. I was surprised that there wasn't some kind of a section of benefits, with evidence about the benefits. But when I didn't see any evidence that related auditor services to payment of consulting fees and instead saw an appeal to the common sense analysis that I referred to, I didn't find any.
CHAIRMAN LEVITT: Well, think back to your days when you were a distinguished commissioner and acting chairman. Surely, you must have promulgated some rules whosebenefits were obvious but not quantifiable. Isn't the protection of investor confidence a benefit even if you can't put a number on it?
MR. COX: Well, I would say that there are ways to put numbers in -- I have never maintained that you can quantify every cost and benefit of a proposed rule. The thrust of my comments was that I don't think that there has been any effort. I didn't see anything in the rule proposal that I thought ah this looks like some analysis from the Office of Economic Analysis.
CHAIRMAN LEVITT: Are you familiar with the existing conflict check systems in audit firms and the improvements being made to those systems in the wake of the problems endured by PricewaterhouseCoopers independence violations? It seems to me that the cost of such systems could be diminished by an exclusionary ban on investments and non-audit services. And, yet, I assume that would be an efficiency that your clients would wish to avoid?
MR. COX: I am not familiar with those. It is not within my area of expertise.
CHAIRMAN LEVITT: But if the economic efficiencies provided by an audit firm's consulting services is the factor that you suggest and you take it to its logical extreme, would you eliminate the requirement that a company's financial statements could then have to be verified by an outside auditor since it might be more efficient to just have the chief financial officer provide that verification?
MR. COX: I am not suggesting that, Chairman Levitt. I am not suggesting a repeal of the requirement that financial statements be audited independently.
CHAIRMAN LEVITT: And when you comment on the lack of concern among the public on this issue, you know, we may be getting bleary-eyed after three arduous days of public hearings, but there have been an array of witnesses, TIAA-CREF, Calpers, a variety of state funds, all of whom have testified that this is a matter of enormous concern to investors. And I think all of us who have served on the Commission recognize the importance of preserving public confidence. You can't put a number on that. That is a very fragile kind of entity. And if that concern is out there, if pension funds are speaking about it, if analysts are talking about this issue, we can't turn away from it and say, "We can't put a cost on it, therefore it doesn't exist."
MR. COX: Well, with all due respect, Chairman, I think my response here said that in the proposal it suggests that -- something about a palpable loss of investor confidence and I was saying that I believe that I don't see that, the markets are booming, confidence is high.
CHAIRMAN LEVITT: Should we neglect the testimony of the largest pension funds in America today?
MR. COX: I am not asking you to neglect any testimony. What I am asking for is given that I didn't see this decrease in investor confidence that was mentioned in the proposal, I then look for what is the evidence of the problem, the problem of non-audit consulting services compromising an audit. And I think it would be a good thing to start with some evidence about reality. I am not saying to disregard the --
CHAIRMAN LEVITT: But why do you think they are clamoring for it? What is their motive? What is the motive of the controller of the currency, the former chairman of the Federal Reserve Board, a present governor of the Federal Reserve Board asking for restrictions on some services?
MR. COX: I don't know motives, Mr. Chairman, but I do know that I didn't see any evidence of the problem.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: I hate to interject, but I am struck by your testimony in comparison with the testimony that we had earlier from E&Y and PWC in which they both articulated, both Laskawy and Schiro the fact that it was the change in the dynamics of the business and the industry generally, which has brought it to our attention, I think. So, coming about it from a different angle than I think you are talking about. But how that caused them to make the business decision that they couldn't have competing businesses under the same roof and that one was to assure the outcome of the client be a certain way and the other was to have a completely independent audit of their financial statements.
And I should find the exact quote from the testimony, but I am sure you will be locate it. It is one of those two. I think it was Laskawy. But I was struck by the fact that the point was, of that particular portion was that they couldn't coexist and that was why it was spun off. Yet, in your testimony, you talk a little bit about lost efficiencies as being one of the main three categories of potential cost. And, again, I was struck when you said that and in looking at your testimony, how those executives said that it was not the practice of those two firms to have the crossover in the auditing personnel -- or I don't know what you call the experts -- with the consulting group. And so there are no efficiencies for some of the firms and yet there might be some for others. And I don't know if that factors into why they have a different position from the three firms and the AICPA, but perhaps you could shed some light on that?
MR. COX: I will respond, yes. I heard the testimony, too, and was interested when I heard it. I think it is too early to tell. These spin-offs, the proposed spin-off and the actual spin-off of those two gentlemen haven't been around very long, and I certainly wouldn't advocate some kind of a requirement that any accounting firm provide non-audit services that it doesn't want to provide. But from my study of this issue, I found that even with spin-offs, there seems to be some consulting left in the firms. It isn't as though it was completely gone. And, as I recall the testimony from earlier this morning, it was particular kinds of services that were spun off. So, that would be part of my answer.
And, again, I would advocate a system of regulation where these kinds of changes could take place and take place regularly. That any accounting firm that didn't want to provide audit services or adopted a business model saying this is our vision of the future and we think things have changed, that is fine. The market will determine that.
COMMISSIONER UNGER: Well, I think the evidence that you were looking for came as a result of some very large enforcement actions involving investments by people working at the firms and it brought into question their independence. And then when you took a closer look, you saw the change in the dynamics of the business and that sort of put into further question other independence issues, should we be looking at that. The chairman might have a different view on that. I think that is part of what brought us here today was, gee, we should be looking at this before there is a big problem because if there is a big problem, it is going to be hard to undue.
CHAIRMAN LEVITT: I think Commissioner Unger puts it quite well, and I think that you will recall during your days at the Commission that an isolated event gave rise to the Commission's concerns that prior to that, it may not have occurred to you. That certainly was the history of insider trading or any of the great matters that concern the Commission, the focus on several firms' internal control problems with respect to investments furthered the Commission's concern.
COMMISSIONER UNGER: Mr. Hills, I didn't want to leave you out of this, but Ralph Whitworth testified last week, and I didn't make the connection at the time but he said he and Rod Hills hired 1,200 auditors to come in and deal with management.
MR. HILLS: It was only for a couple of months.
COMMISSIONER UNGER: I thought that was incredibly impressive. And I thought if I ever, A, have money and, B, am allowed to invest in the market, I want to make sure that whatever I invest in, the audit committee is run by you and Ralph Whitworth because I thought that was really above and beyond. But I have to say I don't think I have that confidence in all of the audit committees of the 16,000 public companies. And so I am wondering if we really can shift a significant amount of this responsibility for determining whether there are conflicts or the extent to which the auditing and the consulting can co-exist to the Audit Committee without having something more in terms of a check?
MR. HILLS: You have to keep in mind the audit committee is a fairly new creation. It can to be effectively not until 1977, '78 I think its' made a lot of progress. I think it has become a very important factor in corporate governance. I think the Blue Ribbon Commission pushed it farther. I think that there is increasing awareness that the responsibilities of being on these committees creates not only a public responsibility but a potential personal liability, and I think more and more people understand that. I think it's not hard to find people willing to step forward and take responsibility.
So I guess the answer is, I would agree with Mr. Cox a little bit in saying that it is a better choice right now, trying to prohibit things that are difficult to define. The difficulty with any rule is its ambiguity, because no matter how you do it, it is ambiguous. What is a legal service? Nobody really knows. What is an internal audit function? Nobody really knows.
The distinction between external audit function and internal audit function is minuscule. In fact, if you look at the management letter that the internal auditor gives you,it looks identical to the management letter that the external auditor gives you.
I think the thing I tried to say, in my written submission and didn't repeat, is that regardless of economic analysis -- and I -- and, Mr. Chairman, I take responsibility for creating the office of Economic Analysis for whatever harm it does us, or good it does, and I'm glad I did of course. The problem is a diversion of effort, a shift of focus away from the integrity and the majesty, if you will, of the accounting profession, to the consulting profession. It's an erosion that's occurred over a long period of time. It's occurred for a lot of reasons.
It's occurred partly because too many management negotiators have tried to force the fees too low. Too many times I've witnessed a chief financial officer who thought it was terrific that he got the company to lose a little bit --the firm to lose a little money on the audit and said, "What the hell. I'm going to make it up on the consulting fees."
As a result over a period of time, a young man that comes into the professional naturally puts himself over on the consulting side. It gets more prestige. It gets more effort. I think it makes more money. It is a fact that many auditors have a loss on the audit. Now the firm may overall say, that's not so, but I've seen too many times and too many audit partners who have told me, as chairman of the audit committee, yeah, they lost money on it, and they would have given it up if they haven't gotten a consulting fee.
If you change the focus, if your incentive in any organization is to do something other than the thing for which the organization was created, you have a problem. It's going to take a sustained and determined effort to get the purpose back.
I must say I have a lot of confidence in some of the management of the audit firms now. We certainly saw it over the last three years in terms that they're trying to put the focus back on the audit, and I think that the effort to subcontract -- excuse me -- to parse off much of the consultant operation is a sign of that. But bringing the dignity and the authority to the audit and to the audit partner, as distinguished from the consulting partner, is really what I think you're about and what I think that the initiative that you've been is well begun.
COMMISSIONER UNGER: So as chairman of the audit committee, how do you respond when someone tells you that the firm lost money on the audit and that they were going to make it up on the consult business? Is that acceptable?
MR. HILLS: We respond very forcefully and say, let's go back and renegotiate and find out why we overpaid for the consultant fees.
COMMISSIONER UNGER: That's not the answer I was expecting.
MR. HILLS: It's interesting. One of the -- I was chairman of an audit committee with a very distinguished chief financial officer, a person I admire and respect a lot. And the audit partner came one day and said that for three years in a row, my respected friend had told him that if he didn't lower his fees, he was going to put it up for bid. Well, the notion that the chief financial officer thinks that he can put the audit out for bid without talking to the chairman of the audit committee, is, to me, a strange notion.
So I think as people talk -- and let's say if some of the speeches is going to move toward the question of the internal audit function and the responsibility -- if the chairman should happened to have a footnote sometime that says that the chairman of the audit committee is responsible to see that the audit is well paid for, is supportive of itself, then I think the world will change. And I think it is changing.
COMMISSIONER UNGER: And what about a prohibition against something like that, for example, the Texas rule?
MR. HILLS: Well, there's no doubt that there's some things that should be prohibited. I mean there are clear conflicts of interest. But if you put it in the 10-K that the audit fees were a million dollars and the consulting fees, five million dollars, it takes a pretty tough chairman of the audit committee to accept that. You know that something is wrong. And it may be -- as you said, we have thousands of auditors because we had a problem.
So it could happen in any one year that the costs could skyrocket for a legitimate reason. In that case, however, the external costs, the so-called extra consulting fees, were managed by the audit committee itself. I was the chairman of the audit committee and I managed it.
But if those fees are too high, too long -- and I don't know whether -- I mean I don't know what rule -- I would never accept the notion that the consulting fees should be larger than the audit fees, period.
Now there's always an exception in one given year for some good reason, but except for that, just as a practical matter, I think that would be a bad practice. I think that if you would ask most audit partners, they would accept what I just said.
COMMISSIONER UNGER: Thank you. That was very helpful.
COMMISSIONER CAREY: Mr. Cox, your client, the trade association for the industry, AICPA, has, as I understand it, a number of accepted prohibitions on various kinds of activities that firms can engage in. If the Commission were to adopt language that mirrored those prohibitions, would you be comfortable with that?
MR. COX: I'd have to look at the prohibitions and consider the language. I really can't say on as vague a proposal as that.
CHAIRMAN LEVITT: I believe our chief counsel has a question.
MR. BECKER: Mr. Cox, I have substantial experience and respect for Lexecon and when I was in the private sector I used them for a variety of cases. I'm surprised to hear you say that you haven't had time to estimate the cost of the proposal. What would you have done if you had time that you can't do because of the lack of time?
MR. COX: I think that I would have started by seeing what data are available in designing a way to get at these categories that I talked about. But this is a complex question and it's not something of which I'm aware of, of publicly available data that allowed me to start out the way I do a lot of projects that I work on. So I think that the very first thing I would have to do is explore the availability of data and then, with that kind of understanding, think of what could be estimated and what couldn't.
MR. BECKER: Well, are you saying that you haven't had time to explore the availability of data?
MR. COX: Yes.
MR. BECKER: So you don't know what data is available and what is not available?
MR. COX: That's correct.
MR. BECKER: And you haven't done that because of the 75 days in the comment period haven't given you time to explore the availability of data; is that right?
MR. COX: That's correct. I don't think 75 days was enough to do a worthwhile analysis of the question that I put in my testimony.
MR. BECKER: But just to make clear, the analysis would have started -- any analysis would start with exploring what's available, and you're saying you don't know what's available?
MR. COX: I don't know. I don't have data and I had no belief that I could do a data-based analysis within the period that I had to work with.
MR. BECKER: Did you look for data?
MR. COX: No, I didn't set out to do that kind of analysis because of the time constraints.
MR. BECKER: So you just knew, without knowing what data were available, you knew you wouldn't have time to do the analysis; is that right?
MR. COX: I knew that I couldn't collect data and do an empirical analysis of these questions within the comment period, the 75 days, and I didn't have 75 days.
COMMISSIONER UNGER: So what David is saying is, if there was no data available, you actually would have had enough time.
MR. COX: I'd have to see what the -- if there were no data available, but I would have to explore that, Commissioner.
MR. BECKER: What else would you have done if you had more time that you haven't done?
MR. COX: As I said, I would see the data and attempt to get at some notion of the costs, rather than the kind of example I gave in this testimony which was based on an assumption the costs could be larger. It's possible they could be smaller.
MR. BECKER: How much time did you spend before concluding that you didn't have time to estimate the costs of the proposal?
MR. COX: I think it was fairly soon after I got involved in this, which, as I said, was not at
the -- at the start of the period. But with the kind of time constraints, I couldn't have done the job.
MR. BECKER: Okay.
MR. TURNER: When did you get involved?
MR. COX: I think I first heard of the project sometime in July. I got involved in August.
MR. BECKER: Now you said that there's no evidence of a problem with the financial statements that results from a lack of independence. Have you looked for any evidence?
MR. COX: I talked about what was in the proposal and I didn't see any in the proposal. So there's not a framework on which I can work that sets out, here's the problem that we've seen. Here's what we've found. Commissioner Unger suggested that it related to some enforcement cases. If so, I'd be glad to look at those, but I didn't see anything like that in the proposal.
MR. BECKER: But just to make clear, it's not your professional opinion that there's no evidence out there. Right? It's just your professional opinion that there's none set forth in the proposal?
MR. COX: Right.
MR. BECKER: Okay. Let me ask you another question on the issue of evidence. I take it every time and any time an accountant is a knowing participant in a fraud perpetrated by the issuer, he's not independent; is that right?
MR. COX: That would seem reasonable.
MR. BECKER: How do you think one would be able to know whether the accountant is a culpable participant in a fraud because he wasn't independent or, on the other hand, because the accountant was a culpable participant in a fraud, that demonstrates a lack of independence? How would we be able to tell the difference?
MR. COX: I don't think that that's an economic question. As an economist, I wouldn't go about looking at the evidence that way. As I noted, in the proposal, it almost seems to suggest it would be difficult and, I don't know, maybe the proposal says impossible, to determine what's in the accountant's mind.
And I'm not suggesting that an economic study of costs and benefits would determine what's in the accountant's mind, because often in economics we rely on circumstantial evidence. But there -- and I thought more about costs -- but in this idea or this area of the problem, I think I would look at the idea, is there an association between enforcement actions or accounting and audit failures and payment of fees? So I'm not suggesting that the evidence would have to go the next step to determine what's in the mind. As an economist, I can't tell you how to determine what's in someone's mind.
MR. HILLS: May I?
MR. BECKER: Sure.
MR. HILLS: I think Charles would agree with me that there is plenty of evidence, indeed, one of the partners testified earlier this afternoon that management too often leans on auditors to accept an accounting irregularity, if I may? Maybe they don't think it's material, maybe they don't think it's huge, but they lean on them. And while I agree that almost always they resist, there's plenty of evidence that too many times they yield.
So the fact that -- and they yield because, for the obvious reason, they want to keep the accounting engagement. And I don't think it takes economic data to say that if the auditing fees are one size and the consulting fees are more, particularly if the audit partner gets a cut of the non-consulting fees, that that is evidence that it's something to be worried about. And I do think Charles would agree with me, there is a problem. The accounting firms have partners that yield too often.
MR. BECKER: Do you agree with that?
MR. COX: Well, I agree that
yielding -- not being independent would be a problem, but I'm not agreeing that I've seen the evidence of the magnitude of this problem. I haven't.
MR. BECKER: But I take it you would agree that when they do yield, they're not independent?
MR. COX: Well, if they're not being independent --I think it's really saying, if they're not being independent, then they're not independent. That's right.
MR. BECKER: Now let me ask you as a former commissioner and policy-maker, you sort of pointed to what apparently has become a loaded term, common sense in the proposal. What do you think the role of common sense should be for the Commission in formulating its rules?
MR. COX: I think that common sense is always valuable, but I would like to see that supplemented with a systematic analysis of costs and benefits.
MR. BECKER: If the Commission were simply to codify existing rules of the AICPA or the SEC practice section, if you could just accept that premise, let's assume that the worlds matched identically. Let's just assume that. If that were to happen, can you see of any -- think of any scenario in which that would impose an incremental cost on the accounting firms?
MR. COX: I really haven't thought about it very much. I think I would have to -- you know, it seems the easy answer would be to say no, but I'd have to think about it. I really would. It's not clear to me that there would be no costs to that.
MR. HILLS: The problem could be, and I've not read them recently -- but there are words that are subject to ambiguity like "legal" and "appraisal." And so one would have to be a little careful that those ambiguities would not carry into lawsuits, whereas the profession, as a matter of practice, knows what it means. The notion of throwing it into a plaintiff's bar could be difficult, without plenty of explanation.
MR. TURNER: Commissioner Cox, while you were here at the Commission, do you recall how you voted in the case against auditors in the Drysdale securities case, where I understand members of Congress believed that independence was -- a lack of independence was the problem?
MR. COX: I'm sorry. That was -- I don't remember the Drysdale case and that was at least 11 years ago. I don't remember the votes on that.
MR. TURNER: In preparing for today, did your clients give you any of the prior testimony from people such as Mr. Carmichael and some of the attorneys that testified that they have, in fact, seen independence play a role in some of the audit failures?
MR. COX: The companies -- the organizations that I mentioned didn't give me any. I reviewed what was on the Web site of -- I think it was the first hearing. But there wasn't -- there wasn't any of -- the one last week hasn't made it there yet, at least as far as I know.
MR. TURNER: You talk about the U.K. and the disclosures in the U.K.. Did anyone provide you a copy of the Brand Report done by the analysts -- the survey that the analysts prepared which did indicate a significant concern with the level of consulting in the U.K.?
MR. COX: I have not seen the Brand Report. Is that -- no, I've not seen that.
MR. TURNER: Had you seen before today the testimony in Calpers and the written testimony Copare(phonetic) in New Hampshire and TIAA-CREF, the large well-known institution of investors, where they did express a concern?
MR. COX: Calpers? Hmm. I remember some of that. I don't remember just what you're asking.
MR. TURNER: Do you believe that an auditor can do bookkeeping for his client and be independent?
MR. COX: That's not something I've thought about --
MR. TURNER: Do you believe that an auditor can calculate the life insurance reserves for a life insurance company and be independent?
MR. COX: I haven't thought about any specific services that an auditor could perform or couldn't perform and whether that would compromise independence or not.
MR. TURNER: Are there any services that you believe would compromise an auditor's independence?
MR. COX: I think it would depend on the facts and circumstances of the service. I haven't sat around trying to think of services that automatically would or automatically wouldn't --
MR. TURNER: I'm a bookkeeper. I keep the books and I can go down and audit those books as an auditor and then --
MR. COX: Well, I think what you're getting at is the discussion we've had about auditing their own work. To that extent, you know, I could see that raising problems. But, again, I think that we've seen situations where -- or we've heard of situations where auditors, auditing firms, accounting firms, have been called in and helped with these kinds of matters, and I'm not sure that that would have any impact on independence.
MR. TURNER: You talk in your testimony about the benefits of the auditing firm's being incubators for these services. Of the specific services that are discussed in the rule proposal as being proscribed, which of those different services did the auditors incubate and start? Are you aware of any?
MR. COX: What I'm getting at is that where there have been spinoffs, by following what's available in the financial press, there seems to be some kind of consulting services that are kept at these firms. That it's not a 100 percent spinoff, and that's what I'm really getting at, that, for example, Arthur Andersen has split its consulting arm, but, on the other hand, it has a consulting section within the Arthur Andersen accounting company.
MR. TURNER: On competition, you raised a question about competition which is interesting to me. In my experience as a partner in a Big Five firm, I have found that I can really tie up a relationship with the management team,not unlike what Chairman Hills testified about. And, in fact, my experience was in some situations, because we were able to tie up that relationship fairly closely, we were able to keep out, in fact did keep out, in a number of instances, competitors from being able to compete for those services. In the effect of this rule proposal was to open that up and provide for widespread competitive bidding, would it in fact in some instances increase competition?
MR. COX: I don't think so, because companies now are free to get consulting services from their auditor or from companies that have nothing to do with auditing. And just the idea of shuffling consultants around because of a prohibition on certain services for auditors, that really isn't competition.
So you say that it was wrapped up or they were able to shut out competitors, and my reaction as an economist must be that it wasn't worth it to go to others, that there were advantages for the company purchasing those services, for the issuer, if you will, in using one company for both types of service.
CHAIRMAN LEVITT: How long have you been under contract to the AICPA and the three firms?
MR. COX: As I said, I really got involved in this in August. So I would say since August.
CHAIRMAN LEVITT: And you've evidently produced a study of some kind; is that correct?
MR. COX: I am working on a comment letter that will -- a white paper that will be filed as a comment by, I think it's Monday deadline. Is that not --
CHAIRMAN LEVITT: But there's no specific study that you've completed?
MR. COX: Not besides the white paper.
CHAIRMAN LEVITT: Okay. Well, I'd like to thank both of you for your time and very thoughtful comments, and we will certainly consider them very carefully and appreciate your efforts and your commitments. Thank you.
Panel 8 (Afternoon)
The next panel is Philip Ameen, chair of the committee on Corporate Reporting; Phil Livingston, president and chief executive officer; and Roger Trupin, SEC subcommittee chair, as well, of the FEI-CCR; and Paul Koren, a partner in Goldstein, Golub & Kessler.
If you could bear with me for just one moment?
Okay. I'm sure you can appreciate it's been a long day, and I appreciate your waiting until this late hour. But if you could stay within your time limits, my wife would appreciate it.
MR. LIVINGSTON: As would mine.
I'm Phil Livingston. I'm the CEO of the Management Executives Institute. And thanks for this opportunity, Chairman Levitt.
As you well know, FEI represents 15,000 corporate financial officers out there in the U.S. and Canada, the people that sign the 10-Ks and 10-Qs and work closely with the auditors.
I'd just like to point out that over the last couple of years, FEI has specifically broadly supported the Commission's audit committee initiative, Reg FD, FASB independence, and a host of other issues. We've hosted and publicized conference calls that advanced SEC initiatives, contacted thousands of our members to promote best practices amongst the group. That's all to say that we're not just nay sayers, Chairman Levitt, we're here to help best practices be promoted.
One of the things I've learned in the first couple of years in this job, that a common theme is that our group supports initiatives when they are kind of best practices amongst our leading companies. And as Phil Ameen will outline, FEI believes the proposed rules on auditor independence go a little too far, that in fact, there are best practices, solutions, that will raise the bar without damaging shareholders' or the accounting profession.
Now I'd like to turn it over to our chairman of our committee on corporate reporting, which consists of about 40 companies. Lynn did get a chance to meet with us last week and talk about this. It was a well debated issue amongst our group and well thought out and Phil will summarize our position.
MR. AMEEN: Thank you Phil. Good evening Chairman. I'm here today to present the views of the committee on Corporate Reporting and the Financial Executive Institute.
In summary, CCR exists because its members believe in the importance of completely reliable audited financial statements.
As financial officers, our members benefit directly from robust financial audits conducted with the highest professional rigor. It's critically important to us that violations of GAAP, that inadequate financial controls, that financial fraud, and that other matters affecting the quality of those financial reports be identified when they occur and dealt with quickly and unambiguously.
As we all know, nothing is more devastating to shareholder value than a loss of confidence in the quality of a company's management and management's credibility is inextricably linked to its financial reports. In that light, CCR completely agrees with the importance of auditor independence.
CCR supports the Independence Standards Board as the proper arbiter of these complex issues. We've heard reports that certain of the ISB seeks to abdicate that responsibility, but unfortunately the board's scope ofservices mission seems to have been preempted by the SEC's proposed release. We believe the board ought to be sent back to complete its assignment of determining what the appropriate limitations are.
CCR also supports the enhanced audit committee process recommended by the Blue Ribbon Committee and we believe that the audit committee must remain the focal point for judgments about auditor independence, taking into account the circumstances of each unique corporation, it's audit firm, and the interests of its stakeholders.
CCR supports the proposed update on rules of financial and employee relationships. As I've said, we'd like to see the rules come from the ISB, but in this area, interim SEC rule-making might be an appropriate expedient, given that the rules are in urgent need of modernization.
But your proposal would also result in extensive prohibitions against many non-audit services, prohibitions that CCR does not support. Those who have spoken in support the prohibitions, as a matter of policy, base their views on the importance of fighting fraudulent financial reporting, a goal of everyone in this profession.
But even in light of recent assertions that seem to draw somewhat predicable conclusions from highly ambiguous circumstances, we continue to believe that non-audit services are highly unlikely to undermine reliable financial reporting in any demonstrable way. Thus our view is that the benefits of the proposed policy of prohibition are ephemeral and probably non-existent.
CCR's collective experience does not support the causal link between non-audit services and compromised audit independence. One matter that's drawn particular attention from CCR members is the practice of out-sourcing the internal audit function to the external audit firm. Several of our members have had success with this sort of out-sourcing, an interesting consequence given that CCR members tend to be from larger public entities.
Our members first observe that there's no rule requiring an internal financial audit functions, seems apparent to us that any internal audit discipline is to be applauded as an improvement over minimum performance, regardless of the identity of the auditor's employer, the internal auditor's employer.
In the current competitive world, it's absolutely necessary to concentrate our corporate efforts on matters in which we can achieve a core competency. Auditing is seldom one of those core competencies. The implications of this are significant. Some registrants have difficulty recruiting the best and brightest auditors into a career path that diverges significantly from the company's norm.
Predictably, some have sought to resolve this human resource issue in the same way that such problems are normally resolved, that is by using skilled specialists from outside the organization. The company's independent auditors must be among the most qualified outsiders for providing this kind of discipline in the most cost effective manner.
As to consulting, and again looking at the highest and best results for investors, CCR believes that non-audit services provided by the auditor can provide significant benefit to the share owner at acceptable costs. We do not suggest that consulting services are essential or a prerequisite to a quality audit. That would be to challenge the record of quality audits where auditors are not engaged for this type of service.
But it does seem well established that these services make a positive contribution to auditor expertise. It also seems clear that higher expertise leads to a higher audit quality. And it seems clear that the external auditor can often offer a distinct advantage in terms of insight and cost effectiveness.
In our view, these advantages should be given appropriate weight, should be evaluated even-handedly by the ISB, and should be measured against any real risks that can be demonstrated. No simple solutions exist. These matters need study and evaluation and a consensus built through the independent process envisioned for the ISB at its founding.
As I stated earlier, the ISB was founded for a particular mission and should be returned to finish the job. We don't believe that one can draw such a bright line that all services on one side of the line are benign in all cases and services on the other side of the line are tainted in all cases. Determinations about auditor independence require judgment and the appropriate judgement to apply is that of the audit committee, based on its rigorous, thoughtful review.
Where caution is needed, it should be the audit committee that imposes that caution. The audit committee already has the responsibility to reach conclusions about auditor independence and it should have the authority to make judgments on matters such as where judgment is required. Indeed, we already look for an rely on the audit committee for matters -- for judgment matters in other independence areas.
In our view, audit committees should be given suggested principles that they can use in evaluating independence, such as those proposed by the panel on audit effectiveness and audit firms must have appropriate controls in place to identify and resolve independence issues. But an outright ban on all these non-audit services is neither necessary nor advisable, aside from the most obvious, such as bookkeeping services that place the auditor in a position of auditing his or her own work.
On the subject of financial relationships, CCR urges the ISB and SEC to carefully evaluate the practical impact of requirements under consideration. As drafted, broad definitions of audit firm and client affiliates would sweep in a host of entities that CCR cannot imagine pose a threat to independence.
And the proposed rules would also be onerous to administer. We are genuinely concerned that nuances in the affiliate rules will create a situation in which large multinational companies find themselves in perpetual violation of the requirements as a result of relatively insignificant relationships, none of which has a real effect on auditor independence.
Finally, CCR recommends slight moderation of the detailed proxy disclosures that the proposal would impose on registrants, particularly larger companies. We could support some abbreviated disclosures providing information that investors would in fact use in assessing real risks, assuming such disclosure requirements could be designed to avoid competitive harm but the proposed rule in the case of larger companies would require specific descriptions of dollar and dollar amounts for each and every individual service and engagement with fees exceeding $50,000. This is often simply too much detail and will be extraordinarily difficult to extract reliably.
That concludes our prepared remarks. Thank you for the opportunity and we shall be happy to answer questions.
MR. KOREN: My name is Paul Koren. I am a CPA and have been a partner for 30 years in the New York accounting firm of Goldstein, Golub, Kessler & Company.
I'm an auditor. I'm head of the audit and accounting department for our firm. Just over two years ago our firm entered into an "alternative practice structure" with American Express Tax and Business Services, and I am now also an employee of American Express. My firm, Goldstein, Golub & Kessler, is 100 percent owned by our 67 CPA partners. We have one office. American Express does not subsidize us or market our services. My partners and I bear all the risks and rewards of ownership of our audit practice. Goldstein, Golub & Kessler primarily services privately held companies, and, to a lesser extent, SEC registrants. I appear on behalf of Goldstein, Golub & Kessler, not as a spokesman for TBS or American Express, and I understand that they will submit a separate presentation.
Middle market firms like ours provide essential services to hundreds of public companies that are not in the largest 1,000 or even 5,000. The Commission's proposed definition of "affiliate of accounting firm" would drastically impact firms that enter into "alternative practice structures" because of the perceived lack of independence resulting from such arrangements. The net effect would be to damage such accounting firms and indirectly deny audit services to these companies.
Middle market firms like ours our disappearing primarily because of demands for capital to meet technology requirements and because of the difficulty our firms have in attracting and retaining -- excuse me, attracting young professionals. And I think of firms which are no longer with us, S.D. Leidesdorf, Klein, Hines and Fink, Oppenheimer, Pell and Dixon and now Kerr, Foster and others.
The Commission's proposals will hasten the demise of the remaining middle market firms because -- by indirectly limiting APS firms' ability to practice on behalf of clients before the commissions and other regulatory agencies and probably state education departments changing their rules, the economic viability of these firms will be diminished because of the loss of business opportunities.
With respect to limitations of nonaudit services, many of our firms do not have available to them and cannot afford outside consultants for various needs. They need continuity and people who know them in their business, particularly in their formative years.
Portions of the proposal will deprive these firms of our nonaudit services and deprive them of the cost savings attributable to our familiarity with their business. Arrangements like the alternate practice structure we entered into with TBS provide enormous benefits to firms like ours and smaller firms. We can continue to provide young professionals with an attractive career path and a sense of permanence. We can offer corporate style benefit packages. We can afford to invest in technology and facilities required to survive. These benefits are real and essential to our firm and to our clients.
We believe that to retain the benefits of APS and other similar arrangements, reasonable assurances of independence can be provided. Our firm, Goldstein, Golub, Kessler, must and does observe the usual independence requirements. Moreover, because we are sensitive to the appearances created by our association with TBS, we created, as a condition for New York State acknowledging our arrangement a series of protocols that further define requirements for independence.
For example, we will not audit a firm on which an American Express affiliate has issued a research report, acts a broker-dealer, serves as a trustee on a pension plan, provides depository banking services. We do not believe that any reasonable person or investor would conclude that an appearance of impaired independence would arise if we audited a company that had some immaterial and inconsequential, normal and inthe ordinary course of business interactions with American Express.
For example, would there be diminished respect for our audit if our clients and its executive used American Express cards or ordered their airplane tickets through American Express Travel Services or American Express travelers checks? Or, for that matter, had a minor investment in American Express shares or commercial paper?
Yet, even the most remote, immaterial and inconsequential business interaction between our client and American Express would, under a literal reading of the Commission's proposals, preclude us from performing the audit.
Nor do we believe that any reasonable person or investor would perceive a risk because an American Express executive somewhere in the corporate hierarchy who has nothing to do with us, who we don't know and most probably doesn't know that we exist, could possibly try to influence our audit judgment because of an interest in an audit client.
Every auditor faces far more realistic pressures every day of his or her professional life from audit clients in the fee-for-services model. Our experience over the past two years provides empirical evidence to support our observations. Even though we always make known our association with American Express, we have continued to attract a considerable number of audit clients. Our recruiting and quality of our professional staff has improved. We have not had any interference from American Express in any way.
When we disclosed to our clients our alternate practice structure, we lost one audit client that feared the loss of personal service and oddly went to a Big Five firm. We declined one or two audits because of our conflict checking system disclosed client ties to American Express. We have discovered some other client business interactions with American Express so remote and inconsequential that we were able to resolve them.
When we established our association with American Express, we were apprehensive. That has proved unwarranted.
Although focused on the Big Five, the Commission's proposals will dramatically affect many middle market and smaller firms and their clients. It will limit their ability to compete in the marketplace because of organizational structure and by forcing clients to choose between audit and other services. By forcing that choice, the Commission will deprive these companies of the range of professional services they require and that are not realistically otherwise available to them.
The Commission raises legitimate concerns that merit thoughtful analysis. But the Commission's proposed solutions on defining client and accounting firm affiliates and scope of services do not balance the reasonable and legitimate interest in needs of much or my segment of the accounting profession and the public.
CHAIRMAN LEVITT: Thank you very much.
Mr. Ameen, in response to your suggestion that ISB be relied upon to come up with standards rather than the Commission, I would recall for you the testimony at a July hearing where former Chancellor Allen, the chairman of the ISB, said that the scope of services issue is, quote, different in kind from a lot of other issues and so it's not well suited for a board of our character. It's really a public policy choice that the government needs to make. And that's, I think, the view of us all and every one of the independent members of the ISB supported that view.
MR. AMEEN: Yes, sir. I heard that quote earlier today. It seems to me that the core of why the ISB was --
CHAIRMAN LEVITT: So we should reject?
MR. AMEEN: We should reject and send them back to do the job.
CHAIRMAN LEVITT: Just tell them, you've said you don't want to do it; you must do it?
MR. AMEEN: That would happen in my organization.
CHAIRMAN LEVITT: Gentlemen, thank you very much.
Panel 9 (Afternoon)
The final panel: William R. Kinney, Professor of the McCombs School of Business, University of Texas at Austin. Joseph F. Long, President of the Passavant Hospital Foundation. And Frank Tirelli, Chief Operating Officer of MyCFO, Inc.
And again, gentlemen, I would ask your forbearance in trying to rigidly restrict your testimony to the time allowed.
MR. KINNEY: Chairman Levitt, good afternoon or good evening. I am Bill Kinney, an accounting professor at the University of Texas. I appreciate the opportunity to express my views on the revision to the Commission's auditor independence requirements.
My comments are based on my 30 years' experience as a professor of accounting and as a former member of the AICPA's Auditing Standards Board and Special Committee on Assurance Services. Today, I am speaking only as a professor and for no one else.
In my classes for both MBAs and Accounting majors, I tell students that financial statement users' perceptions of auditors' independence is one of three determinants of audited financial statements. They include the decision relevance of accounting rules used and the care in applying those rules.
Since auditors are hired by a registrant to certify compliance with GAAP, I make clear to students that audit firms have a huge interest in investors' perceptions that their audit firm has integrity and objectivity in conduct of its practice.
If users believe that the auditor or audit firm has a substantial interest in the financial statements, then the firm's audit cannot add value for the registrant and the audit firm will be fired.
From my perspective as a professor, I will comment on two proposals. The first is modernization of proscriptions of financial and employment relationships and the second is proscription of certain nonaudit services.
First, I believe the proposed modernization of financial and employment relationships is in the interests of investors. The modernization reflects the changes in the size of audit firms. In particular, it reflects the reality that large audit firms now dominate the market for audits of SEC registrants. The proposed changes in proscriptions for individuals will significantly reduce the aggregate regulatory compliance costs that eventually will raise dividends for investors without increasing risk for investors.
The second issue, I do not believe the proposed proscription of certain nonaudit services is in the interest of investors for five reasons. First, the proscription would raise costs for small registrants. The independent audit firm is often the only outside expert routinely reviewing and revising management of small registrants that are a vital source of growth for the economy. Costs will likely rise if, for all consulting engagements, management is required to locate and engage consultants from a firm other than that of their auditor.
While these apply to small firms, they also apply to larger registrants in that restricting free choice of supply or consulting services will almost certainly raise the total cost of auditing and consulting.
Second, the proposal will narrow the auditor's perspective. Auditors familiar with professional services such as business risk assessment, performance of measurement design -- or performance measured design, I should say, and various information and technology services are more likely to recognize developing threats to financial reporting and business viability. Proscribing such services for audit clients would hamper development of the broad perspective that individual auditors need to recognize and protect investors' interest in a period of rapid change and global competition.
Third, the proposal introduces inconsistencies. As an example, the proposal would proscribe system design advice for processing routine accounting transactions but it would not proscribe what might be called individual transaction design advice such as how to structure an acquisition to warrant a specified accounting treatment. Either type of advice, if accepted by client management, could lead to material misstatement and might possibly threaten the auditor's objectivity. Yet, the former would be proscribed but not the latter. Another potential inconsistency arises for tax services, it is difficult to understand how financial information systems design advice might compromise auditor independence. But audit firm advice on preparation of tax returns or long-term planning to minimize taxes would not. Yet it is my understanding that tax services to audit clients would not be proscribed.
Note, I do not advocate that either accounting or tax advice to audit clients be proscribed. Rather, I would point out what I believe are inconsistences between proscriptions of some services that seem essentially similar to other services that are not proscribed.
Fourth, the proposal creates a possible false sense of security for investors. Proscription of nonaudit services is a rather extreme step and some investors may presume incorrectly that eliminating the nonaudit services income stream eliminates the risk that the audit engagement partner may improperly accommodate client management. However, a more important risk remains, that of the partner accommodating management for fear of losing the stream of auditing revenues.
Because of differing expected duration of revenue streams, the present value of the audit revenue stream from an audit client is, in my opinion, typically larger than that of a short term one-off consulting project for the same client. Yet the proposal is silent on the need to monitor engagement partners when zero non-audit services are purchased. In our classes, students discuss the importance of fresh integrity and temptation to violate it --
CHAIRMAN LEVITT: Could I ask you to kind of summarize.
MR. KINNEY: Yes.
It seems to me that the commission might exploit the size of CPA firms today by requiring that they establish monitoring systems at the firm level and have these reviewed by a group such as the Independent Standards Board. This proposal was envisioned in the AICPA's white paper in 1997.
Finally, I believe that the proposal would reduce the benefits of a more comprehensive alternative and that is to let Independent Standards Number One and other regulations have a chance to work in protecting stockholders' interests. There are many things that can't be anticipated by a standards setting body such as the SEC and local control for stockholders seems to me has great potential and should be allowed the chance to proceed.
These are my reasons. I hope these comments will be useful.
CHAIRMAN LEVITT: Mr. Long.
MR. LONG: Thank you for the opportunity to discuss these matters with you in a changing landscape of public accounting, which I recently left after 35 years as a mostly audit -- sometimes consulting -- partner.
Two thoughts I would like to discuss with you. One is that there has been significant growth experienced by the CPA firms. And the question to me seems to be can healthy skepticism coexist in an environment conducive to self-consulting? In other words, can you have the same level of healthy skepticism on Tuesday that you would have had if you didn't need to sell a consulting engagement on Thursday?
Much of the discussion I've seen today has focused on fees. Sure, fees bring pressure, economic loss of client, legal losses if the audit blows up, career ending loss if you happen to be associated with the problem. But in my 35 years, I never saw one time my former employer -- to their credit -- sell out because of an audit fee.
I think perhaps the bigger risk in loss of confidence may be in the entities that use aggressive behavior in seeking accounting answers that fit their objectives; not necessarily the best answer but rather one of, what can you live with.
A second item I would like to discuss with you is that, as the CPA firms try to reap some of the economic benefit from their consulting practices, they most likely will be sold or go public through a registration process with partners receiving "consulting firm" stock.
Those partners, including partners who will retire, may not if initial considerations stand, be able to be on the board of directors of audit clients. But I'm curious then what happens if the hundreds of long-retired partners decide to go out and buy consulting stock out of loyalty or if other board members, who never worked for the audit firm, buy such shares. I am not sure that the audit firm could ever control such a situation and I see other potential problems in that good companies trying to improve their financial literacy may not be able to access such partners, partners with skill sets in handling materiality and other sensitive issues can't help clients or earn income significant to their post-retirement needs. Clients may consider switching auditors to get at good board members and retired partners may wonder if that's not a better answer.
I am also worried about not-for-profit entities such as I'm associated with finding directors and ultimately finding auditors over time. There are 19 hospitals in our organization having individual boards and members coming from any number of CPA firms. These are good entities that do good things that could use help from these people who come out of these backgrounds.
I would suggest recusement as a practical answer, recusement with respect to awarding of consulting engagements. If not that, then use of trust or other appropriately tailored devices, much as are currently used.
The area of stock ownership by partners and CPA firms or by others associated with boards of directors of entities that are related to CPA firms does need to be addressed and probably promptly since some of the processes for that happening are imminent.
CHAIRMAN LEVITT: Thank you very much. I appreciate your brevity.
MR. TIRELLI: Good evening. Thank you for inviting me to testify. Having been born and raised in New York City, the offspring of parents who had a strong ethnic background and a strong belief in education and, unfortunately or fortunately for me, that belief in education for them meant Jesuits who are ostensibly an order of Catholic priests known primarily for their teaching abilities and their left hooks. And for someone who was educated in the late '60s and the '70s, I experienced both.
Two of the cornerstones of the education that Jesuits give you is the requirement to --
CHAIRMAN LEVITT: Which high school did you go to?
MR. TIRELLI: I went to Xavier High School in New York City.
And two of the cornerstones were the requirement to take Latin and to take Greek. And something common amongst the Roman and the Greek cultures was the ability to describe life in as few words as possible and I will try to do that today with respect to my testimony.
There are three issues I would like to summarize. My testimony comes to you today with a background as the chief operating officer of MyCFO, Inc., a so-called New Economy company and 21 years' experience with a Big Five accounting firm.
With respect to my current environment, a so-called New Economy company, there was a very significant paradigm shift in the business that started in April. You could call it a stock market correction, you could call it a shift. But that paradigm shift was primarily one where prior to April, most New Economy companies were trying to get to market first, get as many eyeballs on their sites as possible, generate as much revenue as possible with absolutely no adherence to profitability, because that was not what was valued.
Subsequent to April, there is quite a new paradigm for New Economy companies and that is much more emphasis on profitability. This emphasis on profitability has forced people like myself, chief operating officers and chief financial officers, to focus much more on internal controls, much more on expense management and administration to make us profitable.
I take a high degree of comfort in knowing that my audit firm can provide me with 80 percent of the consultative services, because that means I have to spend significantly less time on managing the consultative relationship. There will always be 20 percent of my consulting needs that I would have to look outside of my existing audit firm either because of industry expertise or technology expertise which is common to a New Economy company.
The second area I would like to address is I do believe that consulting services do enhance the audit. And the reason I say that is when the consulting firm and the attest function are members of the same firm, they meet on a constant basis. They talk about the client, they talk about their projects and there is always something in the consulting engagement that comes out that the audit team is not aware of and there is always something that the audit team brings to the attention of the consulting team.
I believe that that integrated confluence of people talking about my company brings much more value to me and brings much more value both to the audit and to the consulting services.
The third area I would like to address is the talent pool that will be available to the attest firms if the rule were proposed. One could argue that perhaps hiring off of colleges would not be as affected. Having spent a significant amount of time recruiting both off campus and experience hiring, I will tell you that a lot of people today are looking for diversity in their careers. And although 20 percent of the people may take advantage of that diversity, and diversity meaning that you can start in the attest business and perhaps go into the consulting business or go into the tax business, it is something that is very important to folks first coming out of school that they have that ability for that diversity.
And I think it is very important when you hire experienced individuals that they know they can diversify their careers in those areas.
Those are my statements in, I think, three primary areas. And regardless of the outcome, I appreciate the fact that you allowed me to testify today. Thank you.
CHAIRMAN LEVITT: Thanks a lot.
Mr. Kinney, in making your statement, are you affiliated or retained by any of the Big Five firms of the AICPA?
MR. KINNEY: I am not.
CHAIRMAN LEVITT: You believe that individual transaction design advice poses a threat to the independence of an auditor and you're concerned about what you term the inconsistency of allowing such a relationship as the proposal does, should this Commission also prohibit these relationships or some?
MR. KINNEY: No, those are normal, day-to-day transactions that have been done forever. Where else can you go for accounting advice except your auditor?
The inconsistency is that this seems much the same as a systematic design of system to process transactions. So there is a very fine distinction there that some may say I don't see this as a substantive difference.
CHAIRMAN LEVITT: Mr. Long, I really appreciate your candid discussion of the direct effect of big audit fees on the independence of the audit. And I wonder, based on your experience, have you seen some situations where a firm insulated itself relatively well against that kind of pressure?
MR. LONG: I think if you are a human being and you're on a big client, you worry about what can go wrong in the economic chaos that can be caused to your firm or to your career. I think the firms stand up to the tough issues. That's been my experience as a line partner.
CHAIRMAN LEVITT: Do you know of any situations where that was handled poorly?
MR. LONG: In doing some work for the regulators during the thrift debacle, I think I saw some. Not related to our firm.
CHAIRMAN LEVITT: How widespread do you think the practice of firms requiring audit personnel to sell consulting services is?
MR. LONG: I suspect that it's reasonably widespread.
CHAIRMAN LEVITT: Have you seen the audit being used as a loss leader from time to time?
MR. LONG: Not in the particular office to which I was assigned.
CHAIRMAN LEVITT: I certainly am sensitive to your thoughts about retiring partners. But how would you address the threat to independence posed by the preexisting relationships?
MR. LONG: I think what the CPA firms themselves could do would be take and let those partners sell their shares immediately. It would not be a significant number of shares. They could reacquire them and use them as Treasury shares. If the simple holding of shares is an issue, logic and common sense would say that you should be able to find away to handle the disposition of those shares.
There is a great amount of good that these people can do in helping clients, not-for-profits and others in avoiding some kind of dumb answers.
CHAIRMAN LEVITT: Mr. Tirelli, I too come from the New York area. What borough were you brought up in?
MR. TIRELLI: I was brought up in Manhattan.
CHAIRMAN LEVITT: Too bad you didn't come from Brooklyn. You'd have a big advantage.
MR. TIRELLI: No comment.
CHAIRMAN LEVITT: My son is involved in a high-tech new economy startup with all of its excitement and all of its problems. To give you some dimension of the way he approached life, his first expenditure was to buy 16 bicycles for employees not yet hired.
But your testimony mentions high-quality audits many times but didn't touch on independent audits. Surely, you are not saying that independent audits aren't critical to the new economy as well as the old?
MR. TIRELLI: No question. I may even say that independent audits are maybe even more critical to the new economy where accounting systems have not been developed for that aspect of the business.
CHAIRMAN LEVITT: Aren't the new economy companies with little public information available from third parties or a financial history, aren't they the type of companies that really require a thorough, independent audit as being critical to investors? Certainly after the tumult of last summer?
MR. TIRELLI: In my opinion again, having been in the industry for 21 years, I think it is incumbent for every single company to have a strong independent audit. Clearly, as we phase into what is perhaps the greatest business revolution in the history of man, where the Internet, the web, is changing the way we live and work and most of the new economy companies are based on some paradigm of this web and the Internet, I do think it's extremely important that strong independent audits are brought to these companies.
Now, having said that, there is also going to be a certain amount of what I would call investment money that is going to be put into companies where people have an expectation that they are either going to make very big or they're going to lose very big. And I think that is part of the existing business paradigm and something that has me concerned, being a former Big Five partner.
CHAIRMAN LEVITT: Your testimony used an interesting phrase in which you said that auditors, firms that provide consulting services, have some skin in the game.
MR. TIRELLI: That's correct.
CHAIRMAN LEVITT: I have to say that it's hard for me to fathom that being compatible with independence. How can a firm to which that phrase applies also manifest the kind of independence that I think is so essential for public confidence?
MR. TIRELLI: Let me give you my opinion of it, not necessarily meaning that I'm right but certainly my opinion.
I do believe that when the attest firm is also providing consulting services, that the attest team takes a very strong interest in what the consulting folks are doing and are probably looking over their shoulder a little bit more, are getting much more communication with that team to make sure something in the consulting services does not affect the audit.
It has at least been my experience working for my firm that our auditors do a better job because they have a much better line of communications with the consulting professionals.
CHAIRMAN LEVITT: Thank you very much, gentlemen.
(Whereupon, at 7:05 p.m., the hearing was concluded.)
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