Hearing Testimony:
Auditor Independence
UNITED STATES SECURITIES & EXCHANGE COMMISSION
PUBLIC HEARING
ON
PROPOSED AUDITOR INDEPENDENCE RULES
Thursday September 21, 2000
8:46 a.m.
United States Securities & Exchange Commission
William O. Douglas Room
450 Fifth Street, N.W.
Washington, D.C. 20549
Before:
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner
P A R T I C I P A N T S
Robert K. Elliott, Chairman
Barry Melancon, President and Chief Executive Officer
Harold L. Monk, Jr., Chairman of the PCPS Executive Committee
- Representing the American Institute of Certified Public Accountants
Stephen G. Butler, Chairman KPMG LLP
Donald C. Smaltz, Independent Counsel
Jack Maurice, Member of the Ethics Working Party
European Federation of Accountants (FEE)
Abraham J. Briloff, Professor Emeritus,
Baruch College
Don N. Kleinmuntz, Professor of Business Administration,
College of Commerce and Business Administration,
University of Illinois at Urbana-Champaign
Urton Anderson, Clark W. Thompson Jr. Professor of Accounting Education
McCombs School of Business University of Texas at Austin
SEC Staff Present
Jonathan G. Katz, Secretary, Hearing Officer
David M. Becker, General Counsel
Lynn E. Turner, Chief Accountant
Mark Ready. Chief Economist
C O N T E N T S
Panel 1
ROBERT K. ELLIOTT
Chairman
BARRY MELANCON
President, and CHief Executive Officer
HAROLD L. MONK, JR.
Chairman of the PCPS Executive Committee
Representing the American Institute of
Certified Public Accountants
Panel 2:
STEPHEN G. BUTLER
Chairman, KPMG, LLP
Panel 3:
DON N. KLEINMUNTZ
Professor of Business Administration,
College of Commerce and Buiness Administration,
University of Illinois at Urbana-Champaign
URTON ANDERSON
Clark W. Thompson Jr. Professor of Accounting
Education
McCombs School of Business
University of Texas at Austin
ABRAHAM J. BRILOFF
Professor Emeritus, Baruch College
JACK MAURICE
Member of the Ethics Working Party,
European Federation of Accountants (FEE)
P R O C E E D I N G S
Panel 1
CHAIRMAN LEVITT: Good morning. I'm sorry that we're getting off to a late start. I know you probably came in early this morning. And I know Commissioner Unger will be here shortly.
But I did want to get started, to say to all of you that I greatly appreciate your very serious attention to these issues. After you sit through testimony for hours and hours and hours and hours, you begin to think you've been at this place more than once.
And, I'm not sure how much light gets thrown on everything and how much passion is wasted passion, and how much intellect really shines through, but we do appreciate your efforts. We do want you to know that we're listening.
I listened very carefully until almost 8:30 last night. My wife would like me to listen less carefully. So take it from there.
MR. MELANCON: Thank you, Mr. Chairman. Bob Elliott is going to start for us.
MR. ELLIOTT: Thank you very much, Chairman Levitt and Commissioner Unger. Thank you for giving us the opportunity for extended testimony after last week's testimony.
I have submitted a statement this morning. I'm not going to read the statement word for word, but what I amgoing to do is go through the highlights using the slides that you have before you.
When we looked at the original proposing release and tried to figure out where the SEC was coming from so that we could respond, we, sort of, read it like this, and this is our best attempt to, sort of, figure out where you're coming from.
You start with a presumption or a statement that audit failures and restatements are up and that there's something wrong with accounting. You then assume, perhaps, that one of the reasons this might be happening is impaired independence of accountants.
And you go from there to looking at why that impairment might exist, and you see these non-audit services which are growing and perhaps believe that some of those services are impairing independence, and, therefore, the proposing release would, essentially, cut them off.
So if that's the argument, then I want to address several of those elements in the argument. I want to start with audit failures. Audit failures have been going on for awhile, and that doesn't satisfy us at all as a profession.
We wish there weren't any. But there have been a few recent ones, alleged audit failures, let's say, because not all of these have been through the legal process, but things like Cendant and Waste Management and Rite Aid, and soforth.
But if you look back in history, you'll see that really there has been an undercurrent of these types of big cases going way back. You have McKesson Robbins back in the '30s and Barcris and Penn Central and Continental Vending and Equity Funding, and so forth.
So it appears to us that when you look at the long-term frequency, the long-term frequency is really rather constant over time. These things sometimes clump, but they're really rather constant over time.
If you look at the measures, as measured by litigation against accountants, it has been running for a long time at the rate of about 3 cases per 1,000, 3 audits per 1,000 in which auditors get sued. Now, that's just criticism.
Many of those cases, of course, the auditors win or get settled for nominal amounts, and so forth. But if you just measure the rate at which criticisms take place, it has been 3 in 1,000 for a long time.
If you look at SEC enforcement actions against accountants over the long period of time that you look at that, you get to one or two cases per 10,000, and that really hasn't changed all that much over time.
So that's the case of audit failures. Our view is that although no audit failures are acceptable, that the rateof audit failures really has not increased substantially.
Then you get to restatements. Restatements have gone up a couple of percentage points over the last couple of years. About 1 percent of registrants restate their financial statements. But there might be other alternative explanations for restatements of financial statements besides just lack of independence.
For example, it might be that auditors and companies are more diligent than they previously were. It might be that the accounting model itself is under stress, and it's more and more difficult to describe a modern enterprise using GAAP financial statements.
It could be, in some cases it has been, that the SEC has asked for a restatement because the SEC has retroactively changed the accounting rules, things like IPR&D, and so forth. So that would result in more restatements.
It could be that -- while we don't like to say this it could be a matter of competence rather than independence. It could be problems like that. And finally, of course, it could be an increased degree of SEC activism in calling for these restatements.
So we think that the rate of restatements is unacceptable at about 1 percent of registrants, but we think that you really have to look underneath the covers to findout what the reasons for that are, and there are other alternative explanations besides independence problems.
I'd like to talk about investor losses because, from time to time, we hear that one restatement or one audit failure and there's a huge break in market prices. And I want to illustrate that this way with a particular company.
Here is a Company X with a market capitalization, and let's say that the intrinsic value of Company X is about $10 billion, as shown on this slide.
Let's say that the stock price looks like this over a period of time. It goes up at point A. Let's assume that something has happened, whether it's aggressive accounting or whether it's a product development that market is rumoring, and so forth.
It begins to depart more from the intrinsic value at point A, B, goes all the way up to point C, and at point C something happens. Maybe the financial statements are restated, or something else becomes public, and the price drops all the way down to point E, which is an over-shoot of the intrinsic value and then recovers to the intrinsic value at point F.
Now, the reason I point that out is that the newspapers are likely to report that there has been a $35 billion loss in this case from point C down to point E.
But if you look at the individual investor,somebody who invested at time A and sold at B, C or D made money. Somebody who invested at A and sold at F broke even. Somebody who invested at B and sold at D broke even.
If you add up all the gains and losses for all the trades over this entire period, they cancel each other out. There is no net loss or gain.
That's very different from a hurricane coming up the Florida coast and wiping out $35 billion worth of real estate. That is a real $35 billion loss.
Now, I don't mean to say that there are no losses in this case because what happens is investors interpret this situation as volatility in the market. This causes them to demand compensatory returns. They increase their demanded rate of return on capital.
That drives up the cost of capital and creates drag on the economy and, therefore, these types of cases must be minimized. There's no question about it. This situation is completely unacceptable.
But I just wanted to point out that you have to differentiate between real economic losses and transfers of wealth and how they affect the economy.
Let's move to the next point, which is the question of the non-audit services. I think there are various ways you can think about financial statement audits and non-audit services for accounting firms.
Here on this slide the up and down axis represents the revenue of an accounting firm, and the other axis represents the time. And what you see is that over time revenues from audits of financial statements have remained flat.
The reason for that is very simple. Every company that's registered with the SEC has been required to have an audit for many years. There's not much new company formation, and therefore, since already 100 percent of the market is audited there's not much room for growth, and so you'll see rather flat audit revenues.
Over this period of time, though, what you see is growth in non-audit revenues, and the reason for that is that there is no lid on this marketplace. There is no cap on the amount of help that companies might need in order to adapt themselves to the new economy.
In fact, the only thing that's constraining the growth here is the availability of qualified consultants. So over this period of time, let's say from a generation ago, when auditing was two-thirds of revenue, to today, where auditing is, perhaps, one-third of revenue. Things have changed in this way.
And it's very easy to look at this and say the non-audit work is possibly in conflict with the audit work, and that's one view of the world. But I want to propose adifferent view of the world, and that view is that if you look at the services provided by these consulting firms it's not a totally broad range of consulting.
The name "management consulting" covers a huge array from engineering to architecture to legal consulting to marketing, brand building, lobbying, a very broad array of consulting. But the type of consulting that's done by accounting firms is largely in the area of improving information systems.
And improving information systems is complementary to the audit, which is the improvement of one type of information. And when you look at it in that way, the majority and, in fact, the vast majority of the work that's done by these accounting firms is actually in the service of information integrity, and probing the quality of information available to managers of the enterprise, and then the information that they can make available to shareholders.
Now, that doesn't cover everything that's done. Accounting firms do some other work, besides information integrity. Of course, they don't do it for any client for which it would be create an independence problem. That goes without saying.
But when you look at it this way, it's a very different picture. Most of the revenues here are actually in the service of information integrity, which is in the serviceof investors and ultimately the public interest.
Let's look at those information integrity services. The first one, of course, is the financial statement audit. That's the historical one. But the other services that these firms are doing largely fall into these types of categories -- electronic commerce, information systems integration, enterprise resource planning systems, enterprise networks, executive information systems, information and knowledge management systems, activity based cost and management and financial information systems.
This would cover a large part of the work of accounting firms, and this is work is all devoted to improving the quality of the information infrastructure of these companies, which is ultimately to the shareholders' benefit and the economy's benefit.
COMMISSIONER UNGER: Is that a ranking in terms of --
MR. ELLIOTT: No. It's not a ranking, Commissioner.
COMMISSIONER UNGER: It's not alphabetical either, is it?
MR. ELLIOTT: No. It's not alphabetical. It's the order in which I thought of them. But financial information systems is at the bottom. Let me focus in on that because the proposing release would severely restrict the ability towork in that area if there's -- if there would be an effect on the financial statements.
I think that's based on an assumption that somehow the auditor might be perceived as auditing his or her own work, and I want to make a point about that.
And that is that if you have a company that has certain transactions, what ever they are, things like purchase and sales, cash receipts and cash disbursements, these are determined by the company. These exist in the real world, and the accounting system doesn't create or destroy them. They are a fact of the company's existence.
You also have a set of management decisions that management has to make about the accounting which are built into the system, and what comes out is a set of financial statements at the end.
The important thing to realize is that given these transactions and management judgments there's really only one set of financial statements that can come out at the end. It isn't colored or shaped by the accounting system.
It's not like one accounting system produces green financial statements and another produces red. The information is the information.
Now, the accounting system might be something like that, which is pretty complex, and this accounting system has a lot of people at desks with a lot of paper and pencils, isvery inefficient, and it takes a long time to get the results.
But it produces exactly the same results as a system that looks like this, which is much more simplified and streamlined, which operates much more efficiently and quickly, which provides the financial information to management cheaper, better and quicker, but it's still the same information.
The design of the system itself does not color the information, and I think it's very important to understand that. You cannot look at these types of consulting engagements and conclude that somebody might think that there is a problem here because your own release says that the test should be reasonable, individual and full possession of the facts.
And I think when you have full possession of the facts, you begin to realize that there is nothing wrong with this. And I would point out that Mr. Laskawy yesterday testified there is no reason to think that this type of system design work would actually impair independence.
Let's move on, then, to a different possibility for these audit failures and restatements, and that might go to the question of competence. In other words, the financial statements might be wrong, to the extent they're wrong, not just because of lack of independence but because ofcompetence issues.
That leads me to look at a good audit as a three-legged stool which has to be supported by three legs. It will fall without any of the three.
The first is objectivity. The auditor must be objective, or else the audit is worthless. The second is competence. We could have a perfectly objective person, but if this person doesn't know how to do audits, we won't get a good result.
And the third thing is diligence. We can have a very objective person who is very competent but who fails to come to work in the morning. So we really have to have all three of these things working for us. If any leg fails, the stool falls.
But you have to drill down below this and look below objectivity, and what you'll see is that breaks down into two sub-legs. There are two ways in which objectivity could be established for the audit. One is by integrity, and the other is by independence.
You could imagine a person with perfect integrity whose judgment could never be swerved by any interests whatsoever. So even if this person were not independent, he or she could still be objective.
Now, not too many people have perfect integrity, but on the other side let's say there's a person withimpaired integrity but who, however, has no interest whatsoever, no interest in the company, the financial statements, any other work, or what not, perfectly independent. That would be sufficient.
Perfect independence or perfect integrity would be sufficient. In the real world, you don't get perfection on either of these legs and so what you deal with with a normal level of human integrity and sufficiently high level of independence so that the two of these things working together create objectivity.
Each of the other legs also breaks down into two areas. For example, competence breaks down into education and experience, and these things are also compensatory. A little more education can make up for a little less experience, and so forth.
And diligence is a function of worth ethic and incentives. Somebody with an excellent work ethic but lousy incentives would still do the job. Somebody with a lousy work ethic but good incentives would do the job. A balance of those does it.
Now, when we look as policy-makers and within our members of the institute, our member firms, when they think about producing good audits, they have to think about all of these various areas.
They have to manage all of them, the competency ofpersonnel, the incentive structures, independence, integrity, all of these things. To the extent that we invest in one of these, to those dollars not available for the others.
So for example, we recently committed to put $25 million into independence tracking systems. That shores up one of these legs, the independence leg, but those 25 million are then not available for, let's say competency improvement because there's a fixed bankroll.
So I think it's very important to realize that these things are tradeoffs and that, when you think about them, you have to think about them as tradeoffs. Now, with that in mind, let's look at the costs and benefits of independence, because it is a cost/benefit tradeoff, and the proposing release makes some comments on cost and benefits.
But I want to extend that analysis here. On the left/right axis here, we have auditor independence ranging from none to total. Now, auditor independence is not a binary variable. It's not a question that you're either independent or not independent.
You can think of somebody at the left end who is not independent, somebody who works for the company, has stock options with the company, is deeply in debt, so on and so forth, is completely dependent.
At the right end of the scale, you can think about somebody who is totally independent as an auditor, let's sayis selected at random from a pool, paid by the government and has no other interests whatsoever.
So you could be anywhere on that spectrum. What happens to that person on the right if he or she accepts a cup of coffee? Well, you come off of the green from total independence. So it's a continuous variable.
The up/down axis, then, represents cost. And we have to look at that in this type of way. If auditors were, in fact, totally not independent, there would be cost to the economy.
There would be cost in terms of loss of confidence in the capital markets. There would be cost in terms of poor financial statements leading to capital mis-allocation. There would be a drag on the economy if we didn't have auditor independence.
As the auditor becomes more and more independent, that cost goes down until, if you had perfect independence, there would be no such cost imposed by lack of auditor independence. If that were the end of the story, we would stop there. We would say perfect independence is required.
But it's not the end of the story. There are costs of independence. There are costs of setting the rules, observing the rules, peer reviewing them, enforcing the rules.
There are costs on firms in terms of foregoneopportunities that the firms have that their people want compensation for. There are costs to companies who forego scale and scope economies in their work.
So there are costs, and those costs come up. So the total cost to the economy, then, is the sum of those two, and what you have to look for is the point at which that's minimized. And in this particular case, it's minimized a little short of perfect independence.
If we go further than that, we actually increase the costs on the economy, and it's suboptimal. So it becomes a question of these tradeoffs. Now, I point out that although this chart is only illustrative, it is very representative of what Congress decided in 1933 and '34, when they decided that auditors would be in the private sector.
They could be paid by their clients, and they could do some non-audit work as well. So that's not perfect independence. Congress was aware of that, and you might think that this chart represents that picture fairly well.
But if auditor independence costs rose more steeply -- I don't say that they do -- excuse me, Commissioner?
COMMISSIONER CAREY: Congress did not have anybody to foresee the mix of revenues as a very hold on an auditing firm's independence as represented by today's situation.
MR. ELLIOTT: I agree that they couldn't. My onlypoint is at the time they made the choice, the statutory choice, they knew that auditors accepted fees and did other work. How that's changed in the future might change the cost/benefit relationship, but the fact is that this is what it looked like more or less in 1933 and '34.
If it costs much more -- I don't say it does, but if it costs much more to create auditor independence, you'll get a very different curve and a very different optimal point. The point is that you have to make those cost/benefit tradeoffs to know that what you're doing is right for the economy.
Let me turn to the question of if we have too much independence, that is, if we force these firms to strip back to, let's say, statutory auditors, this will have an effect on the competencies that are required.
And I want to point to the competencies that are required to do a good audit today under today's GAAP. But increasingly in the future as companies become more and more post-industrial, a good auditor has to be much more than a green eyeshade person with a bachelor's degree in accounting and auditing. A good auditor has to understand the industry dynamics in which the client is playing, the competitive forces, changing bargaining power between buyers and vendors, new entrants, new technologies, these types of things.
The good auditor has to understand the businessstrategy to see whether it's a winning strategy, must understand the electronic commerce strategy because it changes the way in which the company relates to its customers and vendors. It changes logistics lines. It changes the way the company looks.
The good auditor has to be able to think about risk management. These companies are using increasingly sophisticated strategies to manage risk -- financial instruments, options, futures, swaps -- statistical methods of managing these things, and if the auditor doesn't have at least the same level of capabilities that the client has, the auditor is not going to be able to do a good audit of these types of issues.
Some of the values on balance sheets require actuarial valuations. For example, mortgage loans on the left side of the balance sheet or, on the right side of the balance sheet, life casualty and health reserves need to be thought of actuarially.
We have increasing importance of intangible assets. We have to know more and more about how the company is managing its information and knowledge management systems. We have to know more about its networking and linkages with its customers and vendors because it affects how assets and liabilities are generated and accounted for and where transactions and borders between enterprises occur.
These are competencies that are absolutely required in order to do a good audit today but would they be effectively eliminated under the provisions of the rule. It would be impossible to keep world class talent in these types of areas under the rule, if it were enacted.
So that leads us, then, to the conclusion that this view that audit failures and restatements are increasing and that that shows impaired independence, and that must be fixed leads to a different view of the marketplace.
And that's one that we're actually talking about, the potential obsolescence of financial statements. Let me say a few words about that. Today's financial statements reflect industrial era assets.
They reflect the inventories, raw materials, work-in-process and finished goods, the machinery that works on the inventories, the buildings in which the machinery sits, the land and, basically, the tangible assets of the industrial era.
But today's companies run on a very different set of assets. They run on intangible assets. They run on information and knowledge, research and development, the capacity for innovation, relations with vendors and customers, organizational learning capacity.
And the interesting thing about all of these assets -- and these are assets of the company even though noton the balance sheet -- is that they're not reflected in the financial statements.
A way of thinking about this is that over time as we've moved from the industrial era to the information era, the importance of tangible assets to companies has been going down while the importance of intangible assets has been going up.
At the left end of this diagram, think about United States Steel. The assets they require are, basically, coal, iron, steel mills and railroad cars. At the right end of this picture think of Microsoft where the essential assets of the company are the intangible assets -- the knowledge and know-how of the employees, brand name, market share, customer loyalty, and these types of things.
So where we are right now as a profession, because of the way GAAP and GAAS are set up and the way SEC rules operate is the product that we're providing to investors is periodic historical cost basis financial statements.
We have to compare that, though, with how these investors are used to getting other information in other domains. Instead of periodic information at the end of the year or quarter, they're used to logging onto the internet and getting the information on demand.
Instead of looking backward, they want to be right up to the minute. Instead of looking just at cost, they wantto know just the value of enterprise assets. Instead of looking at just financial information, they want comprehensive information that tells them more about the enterprise.
And instead of a set of statements -- a balance sheet and an income statement -- they want to be able to drill down, get the information they want in the format they want it. These possibilities are permitted by today's technology, and they're delivered in many other information domains, but they're not delivered in our information domain.
And if we stay on the left side of this picture, the relevance of today's annual audited financial statements will continue to decline. We must move to the right side here to serve investors.
Where we are right now is that over the period of the 20th Century, financial statements have become more informative to investors as accounting and auditing standards have improved. But late in the century, as the economy switches to post-industrial, the informativeness of financial statements is going down, as shown in this graph.
This is the information received by investors from financial statements. This is the information they receive from other sources. Early in this century and even when the SEC was formed investors got a large percentage of the information they needed -- they never got it all, but theygot a large percentage from the financial statements.
Today they get a small and decreasing share of the information that they get from the historical financial statements. One of the problems this relates to I think I can best give you by way of analogy.
Think of a cave man. A cave man has a very limited vocabulary. It has words like run, stone, hunt, meat, eat, fire, sleep, very simple vocabulary.
COMMISSIONER UNGER: How do you know this?
(Laughter)
MR. ELLIOTT: Our profession is a very old one. It's a very limited vocabulary, and if you would ask a cave man, let's say, to describe something more modern like a gun or a steam engine or a computer, that vocabulary would be insufficient.
Now, my story has a point here. What I'm saying is that the GAAP vocabulary today has a limited set of words. It has words like cash, inventory, plant, debt, revenue and cost. And that vocabulary is insufficient.
It's inadequate to describe a company like Intel or Microsoft or Cisco or Amazon or even, for that matter, what you might think of is a traditional manufacturing company like Motorola, because when you buy products you're paying very little for the tangible inputs in there. You're paying much more for software, research and development, networking,and so forth.
So what we see is a problem with GAAP. It has not kept up with the times. It has not become post-industrial. Therefore, what we're looking at is the question why has GAAP not kept up?
One of the reasons is that corporate preferences are not in favor of that. Another is that the SEC really has a role in GAAP, and I want to come back to those two points. Why is GAAP out of date?
In the first place, the standard-setting system is designed to be very deliberative. That makes it slow. It doesn't catch up very fast. And the conversion to a post-industrial economy is really something that's only 10 or 15 years old.
The second thing is that the business community doesn't lobby for changes in accounting standards, as you know. In fact, they lobby generally against that, and they have some legitimate reasons, things like the cost of implementation, things like informing their competitors, things like the fact that they've written contracts under the old accounting rules.
They have legitimate reasons, but the fact is that many times they don't want to change. And finally, we have innovation is discouraged. It's discouraged by the SEC's attitude, which is not friendly to innovation in financialreporting, and it's discouraged by the potential for litigation, and so forth.
So what we have is a picture, then, that looks like this. The left side is what's, sort of, implied in the release. The right side we believe is probably something that investors really need to focus on.
And I will point out that yesterday in his testimony, Mr. Schiro pointed to the fact that today's financial statements do need to be modernized to catch up to the new economy.
What we're talking about here is that these obsolete financial statements might actually be part of the cause for audit failures, accounting failures and restatements because it's impossible for these companies to well describe their enterprises using the limited vocabulary of GAAP.
The system is under stress, and it's our expectation that if the system had a richer vocabulary or better able to describe these companies that there would be fewer problems with the marketplace being disappointed by gaps between their expectations and the information that's produced by the companies.
If we're going to move to improve these obsolete financial statements and move into this new era that I'm talking about, that has implications for the competence thatthis profession can bring to bear.
And if that competence is supported best by the rendition of these non-audit services at the frontiers of knowledge and development, then we will be in a position as a profession to support the FASB, the IASC, the SEC in modernizing accounting and auditing standards and principles and practices.
But if we lose that as a profession, if we lose that capability and are not at the leading edge, we will not be able to participate in those changes. That leads us to our recommendations to the SEC today.
The first recommendation is that rather than issuing the pronounced rule is to rely on the ISB, as the SEC said it would do, in Financial Reporting Release No. 50.
The second is for the SEC to change into an attitude of encouragement both to the FASB and the IASC to focus on the new economy and what needs to be done in order to better account for these companies in the new economy.
The third recommendation is to encourage registrants to experiment with different ways of getting their information out on the internet more timely, use of XBRL, for example, to reduce the resistance and impedance between the production of the information and the ability of investors to find, acquire and successfully use it.
Fourth, we encourage the SEC to encourage theprofession to move in the direction of real time auditing. It is not going to be helpful if in the future companies are reporting their information on the internet in real time and the annual audit comes by nine month later and the auditor says there were errors in the financial statements, but don't worry. We found them and corrected them. It's too late. People have already used the information to make decisions.
In order to best support these investors, we need real time assurance, and that means investments in technology by the profession, and we ask that the SEC encourage moving in that direction.
And finally, we recommend that the SEC encourage registrants to experiment, to experiment with new types of disclosure that would be more informative to investors, and one way to encourage them would be to give them some form of safe harbor, if they met certain standards, for example, to encourage them to experiment.
So these are the recommendations that we have, and I want to wind up by saying that in the public interest it's absolutely essential to have sound financial markets. In order to have that, it's essential that we require good accounting transparency so investors can see exactly what they're buying or thinking of buying.
That accounting transparency depends on new methods, a new breadth of information beyond just the limitedvocabulary of today's GAAP, new channels -- the internet instead of the U.S. Mail -- new timeliness up to real time and real time assurance.
These are the requirements, and we cannot do these without a vital auditing profession. And that is the public interest that we are here today to advocate before the SEC. Thank you very much. Mr. Melancon.
MR. MELANCON: Thank you, Bob. Chairman Levitt, Commissioner Hunt, Commissioner Unger, Commissioner Carey, thank you for the opportunity to be here.
Let me first say that the AICPA is happy to be here to dialogue with you on the various issues that are before us today. We are committed and have been deeply committed to auditor independence and remain so in the future. You can rest assured of that. It is a core value, a core value of our profession.
The reputation of all auditors demands it. High-quality audits require it. And the strength of our financial markets depend upon it. This dialogue and these hearings is not about the importance of independence. It is about how to achieve it.
And it is about ensuring that the profession will be able to continue to perform its responsibility to the public interest in the future as well.
We are in full agreement on the imperative ofauditor independence. We can and do disagree about what approach best serves the public interest and the highest quality of independent audits of public companies, but just because we object to the rule proposal does not mean we disagree with the objectives.
Expressing one's independent view is in the highest tradition of this country and, we would hope, welcome by this SEC process. The very purpose of these hearings is to hear from interested parties, including those who disagree. Just because we oppose this rule proposal does not mean we do not respect the SEC as an institution.
We can and should conduct our dialogue in a spirit of mutual respect, accepting that the Commission and the profession are both seeking to do the right thing. In that spirit, we are fully prepared to work with you to find a solution to these issues.
One vital area where we not only agree but applaud your efforts is in corporate governance and audit committees. Mr. Chairman, without your personal leadership we would not have achieved the major reforms which have occurred in the last two years in this area.
This is just one manifestation of your devotion to protecting investors of this country large and small, and it has been an issue that has been on the agenda for improvement for an awful long time, and we commend the Commission formoving forward in that area.
The accounting profession has a proud history of working in the public interest, a history of over 100 years. All of our members are required to maintain independence from their audit clients. We have a detailed and regularly updated set of independence rules, interpretations and ethics rulings. These requirements apply to audits of public and non-public entities.
AICPA member firms that audit SEC registrants are also required to join AICPA's Practice Section which has adopted quality control requirements designed to promote both quality and auditor independence.
Member firms of this section, SECPS, have been required for over two decades to participate in a program of peer review, of compliance with independence as well as audit standards and guidelines.
In a spirit of transparency, the SEC has access to peer review working papers and quality control inquiry files. These reviews have identified lessons to be learned that serve to improve the quality of future audits.
The AICPA is committed to a self-regulatory program that focuses on protecting the public interest, in reliable financial information and in enhancing the credibility of financial reporting through the audit.
I think Bob Elliott covered a lot of those issuesin the future view of financial reporting. Without question our self-regulatory system has been an integral part of the best and strongest financial reporting system in the world.
The profession understands that the public's trust is hard earned and easily lost. For precisely this reason the AICPA has supported or initiated numerous efforts over the years to strengthen the financial reporting system and the profession's independence requirements.
A complete recital of these projects will be in our written comment letter. I would be remiss, however, if I did not mention the leadership role played by the AICPA in connection with the formation of the bodies such as the POB and the ISB.
Our support for the Commission's commendable initiatives to enhance and improve performance of audit committees and our contributions to the work of many high-level bodies which have, from time to time, studied the issue, including the Cohen Commission, the Jenkins Committee, the Elliott committee, Kirk Panel and the O'Malley Panel.
I want to pay particular attention to the ISB, on whose board I serve. The AICPA was a party to the creation three years ago of this promising partnership between the SEC and the profession. We have supported it ever since and are committed to its success. And we are pleased that much progress has been made on effort fronts.
In fact, we view the ISB as the primary place for the profession and the SEC to dialogue on independence matters. The ISB has adopted, by unanimous vote, standards mandating disclosure to audit committees of information that could have a bearing on auditor independence, addressing the difficult issue of the independence implications of audits involving investment company complexes and providing guidance on an auditor's employment with a client.
In addition, the ISB has prepared exposure drafts of new standards on financial interest and audit clients, family relationships between persons employed at accounting firms and client employees, and appraisal and valuation services.
Although we are gratified that the Commission's proposal on financial interest and family relationships are based on the ISB's work, we urge the Commission to drop this part of the rule making and rely on the ISB.
Most importantly, as contemplated at the ISB's formation, substantial work has been done to develop a new conceptual framework for auditor independence, the predicate for replacing the present rule-based system with one which is based on principles.
Supporting the ISB is fully consistent with the Commission's discharging of its statutory responsibilities. It would have to approve the new framework by a new rulemaking. The only issue is when and how it exercises its authority.
We submit the public interest is best served by allowing the ISB processes to continue as we agreed three years ago. We understand or understood the public members of the ISB at the July hearing to say the SEC should make the ultimate policy choices about non-audit services.
If the ISB were allowed to complete its work, the SEC could do just that, in fact would do just that, based on a fully developed framework. The ISB conceptual framework project is key to the creation of the principle-based approach to auditor independence that the SEC and the AICPA agree to entrust to the ISB.
But if the proposed rule were adopted with its dense thicket of prescription and prohibitions, this project would be moot. After all, what would be the point of developing a conceptual framework for a principles-based approach when the SEC would have just adopted a sweeping rule based on regulation, which would crowd out any new framework.
As our past actions demonstrate, the AICPA is fully committed to a careful and thorough review of the rules governing auditor independence. We have a long track record of working in cooperation with the SEC to make these rules more effective.
Indeed, the SEC's own expressly stated positionover a period of many years has been to turn to the AICPA's independence standards for guidance absent a clear conflict with an SEC rule or interpretation.
Having reaffirmed our commitment to an independent auditing profession and our desire to work together with the Commission in the public interest, however, we regret that we cannot support the proposed rule. And there are many reasons for our position.
Before I discuss these concerns I should explain how we see the rule. To be direct, we believe the proposed rule would limit drastically the ability of accounting firms to provide services other than audit and tax, and even some tax services could be prescribed. This would be achieved through the interaction of four components of the proposal.
An expansive list of prohibited non-audit services, the adoption of vague open-ended principles and a catch-all provision which allows for the prohibition of virtually any activity based on the regulator's perception of appearance.
A new definition of the term "affiliate" of an accounting firm which would result in imputing to the firm the activities of virtually any entity with which the firm has any commercially beneficial relationship. And the nature of the new rule's mandatory across-the-board proxy disclosure of detailed information about non-audit services.
As a result, the net impact that these fourelements have an impact on the profession's ability to continue to meet the public interest, and, therefore, we are concerned, particularly from a long-run perspective.
Let me put this in no uncertain terms. In its current form, this proposal will do significant harm to the ability of our members to provide quality auditing services in the 21 Century and, therefore, harm the public interest.
There are divergent views among the 340,000 members of the AICPA, as any large organization would have. And you have heard divergent views in this hearing.
We are here in opposition to the rule proposal with the full support of our board, which reaffirmed that support in a board meeting just last Friday, and with the deepest concern for the ability of our profession to continue to serve the public interest perform audit services of the highest quality in the future if this rule is adopted.
I'd like to also point out that many commentators in these hearings have offered different looks at these particular rules, including some who are members. We pledge to take a look at all of these suggestions just as I know you will.
What you have heard from all five firms in these hearings is that in one form or another they have concerns with the current rule. We support the right of each firm to give you its views, and we remind you that the AICPA alsomust speak on behalf of the 75 largest firms in the country other than the Big 5, who perform over 2,200 public company audits and 45,000 other firms as well as sole practitioners and members in industry and elsewhere who are CPAs.
We also support the right of each firm to follow its own business model, but are strongly opposed to a system in which one model is fit into one answer. The market will ultimately judge in the future which business model works, but it should not be the role of the SEC or the AICPA to impose its idea of what business model should be on the entire profession.
Let me turn to our specific concerns with the rule proposal. First, the process for consideration of this complicated, comprehensive and far-reaching proposal is, in our opinion, just to short.
Second, there is no basis for the radical surgery that the rule would perform on the profession.
Third, the definition of "affiliate" would stop audit firms from effective participation in the dynamic new economy.
Fourth, the rule relies too heavily on an inadequately informed and potentially legally inappropriate appearance standard.
Fifth, the rule is overly restrictive in terms of prohibited non-audit services.
Sixth, unintended adverse consequences are likely from these rules.
Seventh, the rule will not produce the desired degree of certainty or even predictability. Let me go in a little bit more detail on each one of these.
We have serious concerns, as I mentioned, about the process that you've adopted for consideration of this rule. These concerns are well known and have been fully discussed in the past and will be in our written comment, which we will submit later this week.
There is no need for me to go into that here, except to note that to close the comment period only four days after the last hearing before transcripts of the hearings are even available prevents meaningful comment by anyone on the voluminous materials covered in these hearings. Once again I urge you to extend that comment period.
Secondly, our overall concern is simply this: There is no basis for the radical surgery the proposed rule would perform on the accounting profession. We are sincerely concerned, if this rule takes effect, about the profession's ability to meet the public interest in the long term.
Given the severity of the treatment one would expect to find a substantial record of empirical studies establishing the link between audit failure and non-audit services, findings to that effect in litigated cases,enforcement actions at least alleging such a connection, or other evidences of harm. We do not find such a record.
We recognize and share your concern about recent large audit failures. We need to do all we can to reduce the risk of breakdowns. Fortunately, the frequency of these instances is no greater today than it has been historically, but we do not agree with your assumption that this risk is connected with auditor independence and specifically non-audit services.
And there is support for our view from objective observers. The U.S. General Accounting Office in a 1996 report reviewing the studies relating to auditor independence concluded:
"None of these studies reported any conclusive evidence of diminished audit quality or harm to the public interest as a consequence of public accounting firms providing advisory or consulting services to their audit client."
The insurance industry, which arguably has the most to lose from an audit failure and whose very business is that of risk management, does not consider non-audit services to be an audit risk.
And in not one of the 37 engagements involving the provision of non-audit services to audit clients studied this past year by the O'Malley Panel did the panel "identify anyinstances in which providing non-audit services had a negative effect on audit effectiveness."
In fact, on the contrary, the panel's reviews concluded that those services had a positive impact on the effectiveness of the audit in about a quarter of the engagements studied.
Lacking any empirical support, the proposing release relies instead on common sense and the impossibility of observing an auditor's state of mind. But someone's assertion of what is common sense is not a substitute for reasoned decides-making, particularly where it is at least equally likely as a matter of common sense that if non-audit services were tied to audit failure, someone -- the SEC, our profession, private securities counsel, the insurance industry, investors, audit clients or even the academic community -- would now be able to demonstrate a significant relationship. But no one has done so.
Even if there was some isolated cases in which non-audit services were found to be linked to audit failures that would not establish a proper basis for the drastic action proposed by this rule.
Even without a body of litigated cases involving findings of such linkage the issue can be subjected to disciplined analysis as it was by the O'Malley panel, the committee of sponsoring organizations of the TreadwayCommission, known as COSO, studied ten years' worth of SEC enforcement actions involving financial fraud using the SEC's own public records and identified a number of risk factors or red flags.
Surely, a follow-up review of these records, supplemented by data showing the nature and extent of non-audit services provided by the auditor in those cases, could be carried out to determine whether any causal nexus exists between the provision of non-audit services and the instances of financial fraud.
Or even a broader study could be done applying widely used social science methodology to determine whether a statistically significant correlation exist between non-audit services and with audit failure. I have no doubt the Commission could obtain the necessary data on the non-audit services provided to these clients.
The fact that the rule-making had reached this advanced stage without the benefit of such studies is, quite frankly, one of our concerns.
Thirdly, the proposed rule definitions would cripple the accounting firm's ability to participate in the new economy. Your proposed rule makes accounting firms what is the equivalent of economic pariahs in the new economy.
Because of the broad definition of "affiliate of an accounting firm," no one will want to engage in any businessventure with an accounting firm due to the imputation of independence obligations and compliance.
Let's say a software firm, a large one or a small one, let's say Oracle, were to want to be a venture partner or look for a venture partner to assist in develop a new accounting software application, a natural fit and good opportunity for an accounting firm.
If Oracle were to join in such a venture with an accounting firm regardless of the materiality of the investment, the accounting firm would have to ensure that Oracle, as an affiliate of that accounting firm, complied with all the intended independence obligations.
Oracle could not invest in any audit client of the accounting firm. Oracle could not provide any non-audit services, such as installing software, to any audit client of its accounting firm partner.
Any other entity in which Oracle had a 5 percent investment would be subject to the same restrictions as Oracle, and that entity would also be considered an affiliate of the accounting firm. Given such serious consequences, Oracle would never participate in any venture with any accounting firm.
The proposal's restrictions with respect to material indirect investments seek to prohibit situations where an accounting firm or its affiliates own more than 5percent of the equity of an entity that either has an equity interest in an audit client or in which the audit client owns any equity interest.
There is no qualification based on materiality. How would this work? Let's assume the audit client of a firm is General Motors. General Motors invests in businesses across America in due course.
Any entity in which an accounting firm or its affiliate has a 5 percent equity interest, regardless of how small the total value of that interest, could not hold even one share of General Motor's stock without violating the proposed rule.
The 5 percent threshold in the definition of an "affiliate of an accounting firm" and "substantial shareholder" in the business relationship rule depart from long-standing and well-established financial concepts of control and significant influence.
There is simply no basis to argue that ownership of a percent of a company's equity establishes control or even significant influence, and therefore should have such draconian consequences. The 5 percent tests are unworkable.
Fourth, your reliance on appearance with no adequate foundation is a considerable concern. This is not to say that appearance is unimportant. It is a concern for us and for you, but we don't agree with the approach you havetaken to appearance in this rule.
From the standpoint of appearance, the greatest threat arises from the fact auditors are paid by their clients. As the Commission knows, Congress was well aware of this in the 1930s when it established our current regulatory system, considered alternatives such as a government cadre of auditors, and concluded that the risk of auditors being paid by the client was acceptable, given the greater benefit attached to having the audit performed by a robust, private profession.
It follows that perfect independence is not the holy grail, and rather than continue to pursue it the regulatory process should focus on identifying threats and considering safeguards, precisely the task the ISB has undertaken in connection with the conceptual framework project.
Fifth, many of the restrictions the rule would impose are excessive. For example, in the area of external audit services, the ban on extended audit services will restrict the ability of a client to use the expertise of its auditing firm to fill in gaps in its internal audit competence and will degrade overall internal control quality.
We seem in this area to have a problem that I would describe as a problem with terminology. We do not view it as internal audit out-sourcing. Rather, we see many of theseservices as extended audit services, as part of the scope of the audit.
Extended audit services are permitted under AICPA rules within express limits. Management cannot shirk its responsibility and totally transfer the internal control function to the external auditor. This was a concern of the bank regulators who previously testified, and we agree with their concern.
However, one must understand the definition of "extended audit services." If the client's internal auditor is unable to review some aspect of their function, such as the books and records of a remote location, it is perfectly appropriate, cost efficient and responsible for the external auditor to extend their audit scope and do so. This is permitted now under our rules.
Your rule proposal seeks to prohibit it. Extended audit services should not be prohibited but left to the judgment of the client and their audit committee, subject to restrictions designed to ensure that the auditor does not take on management functions as in the current AICPA requirements.
Subject to that constraint the extended audit, which is essentially a broadened audit scope, should help to ensure audit quality and investor protection. Let me give and you couple of more examples.
IT auditors, from an internal audit perspective, are very scarce today in the marketplace. Let's assume that a client wants to out-source the internal IT systems function.
Let's say specifically that the service that they would like to be tested is a billing system, a billing system that management has acquired, made all implementation decisions on, and has required the use of within their enterprise.
If the external auditor were to perform services to test that billing system, in all likelihood they would exceed the requirements that are currently required by GAAS. More work would be done than would be required in an audit today.
But by doing so the auditor now has access to additional information that is the result of the extended audit engagement, and that information is required by the auditor to be used in determining their final conclusions on the year-end audit. In this case, investor protection is enhanced.
Another example. Let's assume that a client believes that there is possible employee theft occurring at a plant in a remote or foreign location. One might conclude that the appropriate place to turn is to the internal audit team.
But maybe the internal audit team does not have theresources or does not have the ability to perform the fraud audit in maybe such a remote location, or even the expertise to detect a fraud in that environment.
And so the client asks the auditor to conduct an internal audit procedure to determine whether or not the fraud had occurred. That process again would produce greater investor protection, and the results of that work would be required by the auditor to be considered in the culmination of their activities as it relates to the audit at year-end.
Another example is appraisal services. Limits on actuarial services, appraisals and valuation services and broker investment advisory services all go well beyond current restrictions and impose great cost, particularly on smaller firms, without any showing of current harm.
For example, the proposed rule would prohibit purchase price allocations in the valuation of non-material assets, neither of which is currently prohibited. Clearly, the use of the accounting firm's own appraisal and valuation specialist, particularly on immaterial assets, can improve both of quality and efficiency of the audit.
Let's turn to financial information systems. There's an outright prohibition in this area in the rule. Designing or implementing hardware or software systems used to generate information that is significant to the financial statements taken as a whole are prohibited. So let me giveyou an example.
Let's assume that the client's MIS department buys an off-the-shelf PeopleSoft program for payroll processing. Four months into the system's implementation the client determines that the project is too complex, and it will not be able to meet its future implementation deadlines.
The client asks for auditor assistance in completing the project by training its employees to effectively utilize the program within the desired time frame. The client has made all of the decisions regarding the selection of the software and the implementation of the system, has an internal team that is overseeing the system's implementation.
The auditor is not writing code but is simply formatting the database on management's desired design and training employees to use the software.
At year-end, the auditor will be auditing compliance with the processes to determine human user breakdown. The auditor can perform the service faster, better and cheaper because it knows the client staff and processes.
And one of the benefits that could come out of this is by having greater exposure to all aspects of client personnel and systems the auditor is actually learning more about the client and is more likely to be able to perform abetter audit and, therefore, to protect investors further.
In the area of human resources, recruiting, hiring and designing compensation packages and advising about the clients management or organizational structure are all prohibited in the proposed rule.
Let's assume for a second that a client merges with another company. One of the main issues in a merger is to integrate the benefit packages for employees between those two companies.
It would not be unusual that the client would ask for help of understanding the differences to be able to have an effective integration of those benefit packages between the two merged companies. That is prohibited under the current rule but does not reduce audit quality in any fashion.
Even expert services. Rendering or supporting expert opinions in legal administrative or regulatory filings or proceedings as an expert are prohibited in this proposed rule. Let's assume that the SEC is challenging a client's position in a Form S-1, and possibly is considering requiring a client to restate its financial statements.
SEC rules, as we all know, are complex, and the client needs assistance with articulating its position, a position that it has determined and that the auditor independently has reached a conclusion that the position isappropriate.
The auditor is asked to assist the client in explaining and defending its position to the SEC. We do not see any problem with this particular issue. The CPA has made an independent determination that the position that the client has taken, the decisions that the clients have made are, in fact, appropriate.
Contingent fees. Beyond barring contingent fees from audit clients, which the AICPA already prohibits, which is in your rule, the proposing release calls into question the violate of value-added billing; i.e., where the fee is based on the value of complexity of the services rendered.
This we believe could result in anti-competitive limits on billing arrangements.
To move into our next point, it is likely if not inevitable that complex and highly interventionist regulation will have unintended consequences when drafted and considered in a compressed mode.
I cannot tell you that in the short time available to study the proposal that the AICPA has not been able to identify all of the consequences which the rule is likely to engage, but we have identified some which are clearly foreseeable and I hope unintended.
Bob Elliott has already spoken of one of the most important unintended consequences, the adverse impact of theability of accounting firms to function effectively in the new economy. A proper cost/benefit analysis would uncover others.
The absence of a meaningful cost/benefit analysis of the proposed rule reflects the time frame in which the Commission is proceeding. We would also call your attention to some of the following points:
Although it appears that the Commission intends its proposed rules would apply only to SEC auditors, there is substantial reason to believe that the rules will cascade down to all auditors, small firms, and small businesses.
As a direct result of the current SEC rule-making on auditor independence, federal and state regulators have become engaged in the auditor independence issue. Several have already made it known, both in testimony before the SEC and in public forums, that they will consider the SEC's rule-making in establishing similar regulations for their constituencies.
State boards have testified that they would be significantly influenced by what the SEC does. And, in fact, the chairman of NASBA has said, and I quote, "The state boards are willing to let the SEC's public hearing and rule-making process run their course, then adopt similar rules for all auditors."
Clearly, there will be some impact on small firmsand auditors. Other unintended consequence include the following. Despite the suggestion that the rule proposal would improve auditor independence the pressure on accounting firms to maintain positive relationships with their audit clients might grow as revenue sources from other services to client.
The restrictions on cooperative arrangements with other accounting firms through the affiliate rule could lead to the dismantling of regional alliances of small and mid-size firms. That would damage effective client services, audit quality and competition.
As firms try to compensate for the cost of non-audit service severance, pressure could grow for a new round of industry consolidation. Absent consolidation, dependence on an individual audit client would grow as revenues from other business lines are lost.
Although the rule proposal purports not to restrict accounting firms from performing services for non-audit clients, pressure on these clients to take their business to non-accounting firms would be great.
But you've asked, couldn't an accounting firm simply trade clients so that one accounting firm provides non-audit services to the audit client of another firm and vice-versa. This is a fallacy.
First of all, firms are not fungible. Particularfirms have expertise in particular areas. Indeed, consulting services today are much more highly differentiated than audit service offerings.
Second, accounting firms are competing for non-audit business not just with each other but with non-accounting providers.
Third, if accounting firms have to bear the additional cost in restrictions imposed by the rule, they would be competitively disadvantaged with the loss of business to their non-accounting firm competitors.
Finally, the affiliation rule would further restrict the number of firms eligible to provide these services.
Our final point, our final major area of concern is that despite the highly detailed provisions of this proposed rule, the proposed rule provides no greater assurance of predictable decision-making that do rules now in effect.
This is particularly unfortunate because both the profession and the Commission share the objective of greater certainty in the application of the independence rules to specific circumstances.
For example, how are accountants to predict whether the staff will consider a particular service as aligning the auditor with a client in a sense of "a mutual interest"? After all, the client and the auditor have a mutual interest,one would hope, in the reporting of high quality reliable financial information.
Similarly, don't tax services, otherwise permitted by the rule, involve a mutuality of interest in that the client wishes lawfully to reduce its tax obligations, and the auditor is assisting in achieving that objective?
And don't a variety of tax services involve advocacy of the client? What is wrong with an accountant advocating a client's position on an issue which, in his professional opinion, is well founded?
And how is the staff, which makes the calls ultimately in this, to know how any of this appears to a reasonable investor? Or more to the point how is the auditor to predict how the SEC staff would perceive this perception?
The auditor would have to guess how the SEC staff would guess that the investor would guess on that point; in essence, a triple guess, rendering the rule impossible for predictability.
Realistically, the catch-all provision that's contained in the proposed rule and the four principles, the four vague principles, we would assert, would have a devastating effect on the willingness of a client to obtain any service other than traditional audit and tax from the audit firm, and that consequence would disable them from doing the things that Bob Elliott has stressed as being ofcritical importance in meeting the needs of clients and serving the public interest in the 21st Century.
Some would argue that because several of the major firms are divesting themselves of portions of their consulting business the non-audit services rules would not cause harm that we have outlined.
However, if anything, these market driven business changes taking place at major firms should cause the Commission to pause and consider. Let's see how all of this shakes out before adding new rules which the affect the work of hundreds of thousands of professionals, disrupt thousands of clients and could potentially ruin a crown jewel of the American economy, the public accounting profession.
Clearly, different models might produce different results, and those different results, some of which neither of us could anticipate today, might, in fact, be the best model to produce the accountability and the public interest that we both desire.
In this debate, the Commission and the profession are committed to a common goal, protecting the public interest in high quality audited financial information. In assessing whether the current proposal meets the goal, we simply ask two questions.
Does it threaten audit quality? We believe the answer is yes. Will it hurt companies and their shareholderswho seek to meet the challenges of the new economy? We believe the answer is also yes. As long as the answer to either of these questions is yes, then the public interest will not be served.
Mr. Chairman and members of the Commission, we look forward to continuing our dialogue to meet our mutual public interest goal. And with this, Harold Monk, who represents many of our small firms, would like to add some comments as well.
MR. MONK: Chairman Levitt, Commissioners Hunt, Carey and Unger, thank you very much for the opportunity to testify before you.
I am the chair of the Executive Committee of PCPS, now known as Partnering for CPA Practice Success, of the AICPA. The PCPS has more than 6,800 local and regional CPA firms as members, provides a forum for these firms to work together on ways of improving the quality of our service and the performance of our firms.
One means of improving the ability of the many small and mid-size firms which participate in the work of PCPS is the formation of alliances and networks of firms. The typical structure for such an arrangement does not involve cross-ownership or control by one alliance member over the other members or over the alliance itself.
In fact, no one member could be said to exertsignificant influence as that concept is understood in accounting literature. However, we are concerned that the breadth of the definition of an affiliate of an accounting firm, coupled with the collaborative business activities of the typical alliances, such as cross-referrals, shared marketing, and the like, would lead to alliance or network members being considered affiliates for independence purposes under the rule proposal.
These alliances or network arrangements are critically important to these firms in serving clients operating in many domestic and foreign locations and thereby competing with larger firms.
Our PCPS members, by definition, do not have very much in the way of SEC audit practices. Still, we believe your proposed rule will adversely affect us. If the proposed rule is adopted, we would expect the other regulators --state boards of accountancy, U.S. Department of Labor, federal and state bank regulators, for example -- will follow your lead.
Hence, we must assume that your rule would become our rule. And that causes us great concern. In particular, the definition of an "affiliate" of an accounting firm would force our members who participate in an alliance of accounting firms to treat each member of the alliance, including any foreign affiliates, as an affiliate forindependence purposes.
As a result, any work of any audit client of any member of the alliance would be attributed to every other member of that alliance, notwithstanding the fact that no member of the alliance exercises control or even significant influence over any other members. This is simply unworkable.
None of the members of the alliance would have the information about the other members required to comply, and the risk of disqualifying members from serving a client because of the attribution of the activities of other alliance members would be so great that alliances would have to be scrapped.
By creating an insurmountable hurdle to those of us in smaller firms seeking to compete against the larger firms by coming together in various alliances, the rule proposal would make it very difficult for smaller firms to compete effectively and encourage further consolidation, whether we wish it or not, and audit quality would suffer.
In addition to my role at the AICPA, I am the managing partner of Davis, Monk & Company, a local firm in Florida with 35 people in two offices. Our firm is also a member of CPA America, an alliance, a group of 60 firms similar in size to my own who have banded together to enable us to provide our clients with extended services outside of the geographic area of our firm. And to enrich the expertiseavailable to our clients.
Restrictions your rule proposal place on particular non-audit services such as human resource consulting, financial information systems consulting, internal audit out-sourcing and valuation services and the uncertainties it creates with respect to any and all consulting services provided to audit clients are of great concern.
These are traditional services that have grown in recent years. For example, human resource consulting is frequently a client-requested service and one area where small firms can add tremendous value for clients.
Small firms like mine will also be impacted adversely if the rule barring contingent fees is expanded to include value billing. We do not see any connection between fee arrangements that are contingent upon the results of our services and those where firms bill based upon the value added to the client.
I urge you to slow down and hold additional hearings, including regional hearings, so that accounting practices in other areas of the country have the opportunity to address you directly.
For a small firm to comment on the 400-plus questions in the SEC rule proposal is difficult. To do so in 75 days is impossible. There are many voices in the profession all across America who want to be heard but arenot able to come to Washington or New York City.
Consider carefully the consequences you may not intend. There is no reason to rush to regulate on this very complex issue. Thank you very much.
CHAIRMAN LEVITT: Thank you very much for a very informative and comprehensive testimony. Mr. Melancon, do you believe that these hearings have been constructive for the industry, and do you believe that the Commission should schedule, as Mr. Monk has suggested, three or four or half a dozen more hearings around the country?
MR. MELANCON: Well, I certainly commend the SEC for the hearings. I think you've gotten a lot of input. We certainly support the notion of inputting. We have no problems from that perspective.
I guess we certainly would have no problem with regional hearings, as Mr. Monk has suggested. We would encourage whatever input mechanisms as possible because we do think that there are far-reaching impacts of the rule, as we've testified.
CHAIRMAN LEVITT: So you think that the results of this dialogue in this public environment, if you were concerned about the well-being of the profession and the image of the profession with the public, you would urge the Commission to schedule more hearings, which I think we can certainly do.
COMMISSIONER UNGER: I object.
MR. MELANCON: Mr. Chairman, I think your wife may object based on your opening comment.
CHAIRMAN LEVITT: Yeah. Well, I'm not sure that this is necessarily the best way to build the image of the profession in the public's mind, but I guess we each have a different perspective about that.
MR. MELANCON: We would certainly be willing to dialogue with you on the best way to accomplish that,
Mr. Chairman.
CHAIRMAN LEVITT: If you had a choice between embracing a formula for change similar to, say, the ones put forward by Ernst & Young and Price Waterhouse or carrying on this dialogue or this debate or these hearings for another year, where do you think you'd come down?
MR. MELANCON: I guess the easy answer is to say to carry on the dialogue for another year because we have concerns about the impact of the rule. But we also respect the issues. We are willing to dialogue on those issues. We certainly will consider and look at any of the proposals.
I have not, obviously, done any detailed analysis of the proposal you referenced. We certainly will. And so it's very difficult for me to comment precisely as to whether one or the other is the better approach.
CHAIRMAN LEVITT: Well, again, it seems to me thatthis issue will never satisfactorily be put to bed. It has been raised for -- and you can put that responsibility on any number of shoulders -- but it has been raised to a higher level than it ever has in 25 years, and it has always been around.
We've had the Metcalf-Waxman hearings. We've had the studies you talked about. We've had countless stories in the media but never at the decibel level that it is today. And it would seem to me that if I were -- and I am concerned about the interests of the profession. It's a great profession. In many ways, he's a noble profession with a wonderful history. And I care passionately about the interests of the small individual accountants.
I would think that trying to reach a consensus solution would be a preferable alternative to more public hearings, more debate, more dialogue. We're never going to have total agreement on both sides. That's just an observation.
MR. MELANCON: Mr. Chairman, just a comment, I think that -- I think what you heard us testify here today was two things; one, that we are very concerned that any rule that be adopted be considerate of the fact of our profession's ability to meet its public interests in the long term, and a solution that allows that to happen is certainly a solution that is in the best interests of the public aswell as in the best interests of the profession and the SEC.
So I think that ought to be a test of however or whatever happens. I think also you've heard us testify that we would not want to see a solution passed by the SEC in the short run that would gut the ISB from the perspective of being a place where ongoing dialogue is appropriate for, as you described, maybe the next 25 years, because obviously these issues are very critical. They're dynamic, and, from that standpoint, we hope that in the construction of -- if the SEC does adopt something, in the construction of that rule that it does not take away the ability for the ISB to be a body that can constructively address these issues in the long term.
So I think that those are two important issues that we need to consider however decisions are made on going forward.
CHAIRMAN LEVITT: Well, again, as I mentioned yesterday, in the July hearing, Chairman Allen said that, "The scope of services issues is different in kind than a lot of these other issues," I'm quoting now, "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 it was the unanimous view of all of the independent members of the ISB. It's hard for us to turn itback to the ISB when they've rejected embracing it.
CHAIRMAN LEVITT: Chairman Allen is a person I have an ultimate amount of respect for. He also pointed out in his testimony that he thought disclosure was something that the Commission had to take action on if it desired to have a result in that area because it was not something that was within the purview of the ISB to address.
And I would also point out that regardless of today and regardless of what happens, if the ISB were to adopt a conceptual framework, that conceptual framework -- and it's certainly my hope, and it's my intention that the ISB will --that conceptual framework to move to a principles-based approach would require the SEC to support that particular decision in order for it to be successful.
So in many ways, I think Chairman Allen's comments could be construed, regardless of the timing, to indicate that the SEC has to weigh in on any conceptual direction from that standpoint.
We don't disagree with that, but we do believe that the ISB has done a tremendous amount of work, more to be done, in a very difficult area of addressing the conceptual framework and that that should be supported.
CHAIRMAN LEVITT: The other day I asked the question of several of the witnesses about whether they felt that the work of the ISB and the perception of the ISB mightbe enhanced if we increased the number of public representatives, and three of the firms yesterday -- Arthur Andersen, Ernst & Young and Price Waterhouse -- said that they did feel that was worthwhile.
Are you, perhaps, open on considering that?
MR. MELANCON: You had a vision for the ISB in 1997, Mr. Chairman, and you convinced me of that vision. And since that time I have been an ardent supporter of the ISB, and I've spent a tremendous amount of time being involved in it, probably as much or more than anybody other than maybe the staff of the ISB.
And I would tell you that I would welcome a dialogue with you in which we identify those things that are necessary to have the ISB meet that vision that you laid out and that I think if we jointly showed our support for the ISB to the public members and the profession members that the ISB with that support from both of our organizations could be a very effective body.
And so I welcome the dialogue, and I think that anything that makes the ISB effective and meets that obligation certainly is something that we would want to address, and there are probably several things that we would need to address.
CHAIRMAN LEVITT: I appreciate that. Mr. Elliott, you said some things which troubled me, but that's nothingnew. In your comments about the SEC, you said, and I quote, "The SEC is not friendly toward innovation."
Well, I don't think you're right. I think you're very, very wrong, and I would appreciate your comments on a number of areas of SEC involvement that I think are innovative -- our three internet releases telling companies how to use the internet for disclosure, our Reg ATS dealing with the most dramatic changes in our markets in the history of the country, the appointment of the Garten Panel to address the value of intangibles, our concept release on international accounting standards, our whole initiative with respect to plain English, an undertaking that three prior commissions have looked at and were not able to address.
It was the Commission, not the profession, that pushed for the creation of the ISB and the O'Malley Panel, the Garten Panel and the Blue Ribbon Committee on audit committees, the whole use of Edgar, our internet fraud unit, our use of exemptive authority that was given to us in recent congressional action. Where are we lacking?
MR. ELLIOTT: Mr. Chairman, if I had that list of accomplishments to my name, I'd be very proud. I think they are outstanding achievements of the Commission under your leadership. There's no question about that.
I was not referring to innovation in every sphere. I was referring to the GAAP model, and what we have there isa model which fundamentally is the same model as the one when the Commission was established in 1934.
If I misled you into thinking it was a broader statement than it was, I apologize. I'm speaking about accounting and the GAAP model.
CHAIRMAN LEVITT: I'm totally disarmed.
MR. MELANCON: Mr. Chairman, that is something new.
CHAIRMAN LEVITT: Is the FASB, in your judgment, sufficiently tuned to the new economy?
MR. ELLIOTT: The FASB is working on the area. The recommendations of the Jenkins Committee, which was established by the AICPA, were handed over to the FASB, and they've been working on them.
And it's my understanding that they're trying to work in the sense of best practices that could be voluntarily adopted by companies, rather than rule-making or required standards.
And I think that is all to be much applauded. But I don't think the pace is what it needs to be. The Jenkins Committee reported, I believe in 1994, and we still don't have substantial results. So it's a question not of the direction but of the pace, Chairman.
CHAIRMAN LEVITT: I share your feeling. The pace sometimes frustrates me. Were you supportive of the efforts of an FASB under prior direction to expense the cost of stockoptions?
MR. ELLIOTT: Are you asking me as the chairman of the institute or as an individual?
CHAIRMAN LEVITT: Give me both.
MR. ELLIOTT: As the chairman of the AICPA, my answer to the question is that those choices are appropriately made by the FASB; it's their area of domain. We have an Accounting Standards Executive Committee which is our standard-setter which interfaces with them, and they select their policy positions.
Speaking as an individual, I will say that I think that stock options are not free. They are not valueless and need some form of accountability. While the form of accountability selected by the FASB is somewhere in the middle of the scale, it does, in fact, inform investors of important information. So I think that the FASB made excellent progress.
CHAIRMAN LEVITT: At the last hearing, we talked about the fact that the AICPA's own rules prohibit, among other things, appraisal and broker dealer investment services as impairing independence, and the Practice Section's rules currently prohibit certain valuation, actuarial and human resource services.
Barry, I think you said then that even if our rules parallel the AICPA's or the SECPS's rules, you would not becomfortable with them. Is there any way of reconciling this?
MR. MELANCON: Certainly, Mr. Chairman, as a matter of definition of independence, let's say, or a matter of policy, one could not argue that if your rule were identical to the rule that's currently in place within the profession that that would necessarily be, in today's world, a bad result.
I will point out that in the proposed rule, even though those broad topic areas are covered, they are not identical to the current rules, and I think you've acknowledged that.
I think the point as to whether they are in a self-regulatory environment or they are embedded into a government process of regulation is one that reasonable people can debate as to the role of regulations and the role of how easy those can be changed.
I think, as an example, your own rules for decades have pointed to the AICPA's ethics rules where they do not conflict with SEC rules.
Obviously, if you had a feeling towards one of those from a substantive standpoint and we sought to change one of those, you would, obviously, make that known, and you could potentially adopt something that would then be in conflict, and your rule would supercede from that standpoint.
Our concern in trying to answer your question --which was a very artful question, because we don't disagree from the standpoint that those ruse should be in place today and should be enforced.
Our concern is that the process that's used to adopt rules -- there are different levels of complexity of fixing those things as the world changes. We live in a very dynamic society today.
For instance, we have the ISB talking about a different approach to a principles-based look at independence in general, which, again, I think if both of us support that and give that charge to the ISB, I think they can succeed from that standpoint.
I think that, however, putting them in SEC rules makes them more difficult to change. Just look at the process we're going through today to adopt. And that's our fear.
I mean, reasonable people can disagree as to how much of a problem that will be, but it's a legitimate concern, we believe, from the standpoint of evaluating where rules that get to that much specificity should reside.
CHAIRMAN LEVITT: I really believe that the '33 and '34 and '45 Acts have been remarkably flexible in terms of the ability to conform to changes in the business community. And I disagree with you in terms of where these rules belong, but I hear you saying that you're open to a discussion onsome aspects of this.
Now, the O'Malley Panel found that leaders of the largest firms, largest accounting firms, "treat the audit negatively like a commodity." And based on this finding the O'Malley Panel recommended that the firms and the AICPA take steps to emphasize and promote the importance of audits.
Do you think the attitudes of the O'Malley Panel that they found have contributed at all to the problems that you say firms may have in recruiting new auditors?
MR. MELANCON: Well, first, I have had interactions over the years with the chairmen of each of the five firms, as I know other people in this room have, and I would respectfully disagree with the assertion at the beginning as to how they treat audits. I don't think that they do that.
I think auditing is a very significant part of their firms and their businesses, and I think they view it that way, as you would expect the heads of those types of organizations to do so.
As to the issue of attractiveness to students, we do a tremendous amount of research with high school students and accounting students in college, high school students who might be contemplating, et cetera.
We've spent a lot of resources and have grave concerns in this particular area, as to the attractiveness of the profession. We go focus groups. We do research, etcetera.
One of the interesting things about 18-year-olds, and I think you'll find this result pretty interesting, what we have found is that high school students who attend a high school that has an accounting program are less likely to major in accounting at college than those who come from a school with an accounting program.
And through the digging into that research one of the conclusions we reach is that the first exposure to what this profession is about is very influential to young minds, as first exposure to anything is very influential to young minds.
And what is taught in those early programs depicts the auditor as very narrowly focused. We've had focus groups are students have said, "I don't want to be an auditor because all I'm going to do is work in some cubicle someplace and never interact with humans," or whatever.
We all know that the audit environment in today's complex business enterprises is very much interactive; otherwise, we would have very poor audits.
So I think what the research shows is that the number one hurdle that we have to overcome from an attractiveness of students standpoint is an ignorance of what the profession is really about.
So I don't believe that how the Big 5, however theO'Malley panel referred to that, how their conclusions reached are the driving factor in that. I think there are much more subtle impacts at an 18-year-old level, and I think it's major concern we have as a profession.
CHAIRMAN LEVITT: However, in your 15-page letter to your members asking them to write to the SEC and to Congress opposing the rule-making, you state that the proposal will affect recruiting because, "the best and the brightest students will not be drawn to firms with a limit on upward opportunities."
MR. MELANCON: I definitely believe it will have an impact, and I didn't mean to imply I don't think it will have an impact. I was responding to what I heard your question to be was that was the attitude of -- the alleged attitude of the firms towards auditing a driving force or a significant force in that. And I was trying to comment as to there are many factors.
But clearly, if a profession -- if ignorance of the profession is one of the driving factors in turning people off or not having them proactively come into the profession, the more narrowly focused that the profession is, the more difficult of a communications process that we have to teach them something else. And I think that's the point that we were trying to make there.
CHAIRMAN LEVITT: But doesn't that say that thereare no upward opportunities for auditors in accounting firms, only consultants? And isn't that an example of what the O'Malley Committee was talking about?
MR. MELANCON: Well, there is certainly upward mobility opportunities for auditors in firms. I think young students today, Mr. Chairman, they have a very different look. Their reward systems are very different. What their expectations are are very different.
We described, for instance, the accounting profession and majoring in accounting of, let's say, in the '70s. When someone made a decision in a college campus to go into accounting, we believe that at that time they were making a decision that said, "If I get an accounting degree, I'm going to have this world of knowledge about a broad base of information that allows me to have many opportunities.
"I mean, I can go into auditing, or I could go into management, or I could go into government service, but I'll have a wide base."
Today, in accounting programs in universities, students have the exact opposite view. They say, "When I major in accounting, it's very narrow, and therefore my opportunities will be limited." They tell us that all the time.
So if the profession moves in the direction of limiting, that will reenforce that. We have to fight to tryto change that perception because, like you just said, we don't agree that those are the only options that are available.
But the more the public persona is that it is narrow, it is statutory audit firms, if you will, the harder it will be to rebuff that in the minds eye of students.
MR. ELLIOTT: Mr. Chairman, may I comment on that? The students, I think, are aware of the fact that accounting records, accounting statements no longer very well portray companies.
We never, as accountants, said that the net worth on the balance sheet was supposed to equal the value of the company. We never said that. In fact, we said the opposite. But 20 or 30 years ago the average market capitalization was about twice the net book value of companies, on average.
Today it's about six times the net book value on average. What that's telling us is that the accounting reports are not capturing as large a fraction of the information as they used to capture, and I think part of that then reflects down to the students.
They come into a curriculum where they know that what they're learning is less and less depicting of the real world. It's not an exciting and challenging curriculum ,as it might be if we had an accounting model that was more descriptive of reality that let these students feel thattheir work was of higher relevance.
CHAIRMAN LEVITT: In three of the hearings that we've had thus far, Mr. Elliott, we've heard from a broad number of witnesses, practicing lawyers, expert witnesses, accountants, and others, who have assured us that they've seen instances where non-audit services and lack of independence contributed to audit failures.
What do you think of that testimony?
MR. ELLIOTT: Well, in the first place,
Mr. Chairman, I did not hear most of that testimony, and I haven't read it. So it makes it very difficult for me to comment on somebody else's testimony. I'm really here to comment on the proposed rule.
But the information that we have, the best information is that there is no correlation between non-audit services and failed audits. If somebody makes those types of allegations, we could certainly consider them, but the point is not that we should base public policy on an anecdote or even a bunch of anecdotes.
The point is that there is a system in place here which would yield to a disciplined study of the net effects of non-audit services.
Mr. Melancon indicated the way some of the studies could be further worked out, larger samples, and so forth. But there are ways of doing this, of, in effect, looking atthe good effects of these non-audit services of which we believe there are substantial good effects -- and the O'Malley Panel identified that in a quarter of the cases, there were good effects -- and the bad effects, and put them all on a scale.
I think to just look and search out a few bad effects, find a few anecdotes, is not a balanced study of the system. It would be almost like if a drug company took a drug to the FDA and said it fixed the -- it helped 90 percent of heart attack victims recover faster and the FDA said, "Well, that aside, we're going to look for any cases of side effects and base our decision on that," it wouldn't be a balanced study. And we believe it needs to be a balanced study.
COMMISSIONER CAREY: But it would be a study that considered the public interest, correct?
MR. ELLIOTT: I think that would be the criterion. Absolutely, Commissioner Carey.
COMMISSIONER CAREY: But you'd have to consider the effects on the remaining 10 percent before making a decision.
MR. ELLIOTT: You have to consider all the effects. That's the problem. Just looking for negative effects of which we're not aware of any, but just looking for them and not looking for positive effects is not an unbiased study.
CHAIRMAN LEVITT: Well, what possible motives couldthe custodians of the largest pension funds in the nation, CALPERS and TIAA-CREF and people such Paul Volcker and the Controller of the Currency, what motives could they have in calling for resolution of these issues, other than they are concerned about the public interest?
MR. ELLIOTT: I certainty can't comment on the motives of the other witnesses.
CHAIRMAN LEVITT: All right. Commissioner Hunt.
COMMISSIONER HUNT: First of all, again thank you for taking the time to testify before us again. Nice to see you again. I'm intrigued by a couple of things that you said, Mr. Monk, and others have made this comment as well, that we do have now or soon will have at least two models of what an accounting firm should look like and how it should operate.
And I don't think either of us have a perfect forward-looking glass ball to see what's going to be the best model. So I am intrigued by the idea that looking at the two models for some time is not an illegitimate idea, because you'll have two very distinct models, at least at the large firms.
I'm also concerned about what some witnesses I guess yesterday mentioned, which the unintended consequences of our rule, and some of you mentioned that too.
Particularly, I personally am somewhat concernedabout the unintended global consequences of the rule because we are going to have influence, and the unintended consequences of the other standard-setters, the state boards of accountants, the people who regulate accounting for banks and others.
And also, I don't know how to get at, but I will think about what you mentioned, Mr. Monk, about your size firms and how the affiliate prohibition might affect the way they do business and the way they manage to enter into arrangements so that they can more effectively compete with the larger firms.
And, along that line, I'm particularly concerned about -- I think we all have been on this Commission -- of not having unnecessary negative effects on small business entities of any kind, small firms or smaller business entities, so we have to look out for that.
Mr. Melancon, you mentioned that value-added billing will lead to competitive restrictions, or words to that effect?
MR. MELANCON: We're concerned about that. Certainly, our own profession has been challenged back in our history by the FTC on certain restrictions on how billing occurs.
If you go back in many professions, there were restrictions on how things happen, we were challenged as aprofessional organization -- I guess it was in the '80s or maybe late '70s, early '80s -- along those lines.
So restrictions that get into how financial arrangements exist between two parties not by your agency but by other agencies of the federal government bring certain inquiries, and we were in the middle of several of those inquiries, and that's why we wanted to point that out.
I would also tell you that value billing, the ability to look at a service that's provided -- and no one would agree, for instance, that that would be on the basis of the outcome of an audit. No one would assert that.
But there are certainly instances where other work is being done, that certain solutions and certain value that's being created actually creates a significant value for the economy, the company, the shareholders, et cetera. And different financial arrangements exist out there in the marketplace.
They are probably more numerous than either of us could identify in the next two hours if we just tried to brainstorm them all. So that's our concern from that standpoint.
COMMISSIONER HUNT: And, Mr. Elliott, I am intrigued by your statement. I never talked to any 18-year-old accounting students. I don't know a lot of people who were born to be accountants or lawyers, but I could be wrong.
MR. MELANCON: There are some, Commissioner.
COMMISSIONER HUNT: There are some? Okay. But I have known graduate business students who were accounting majors when I was in education and I was shocked by their limited view of what an accounting degree would do for them and what they could do with it and what the opportunities were. So I'm sure it's even more of a problem at the undergraduate level.
I don't have to go into any more the very different world views or professional views of those of you who oppose the rule and those others of the profession who think the rule or maybe the rule as modified is a good idea. But I was interested in a remark made by one of the witnesses yesterday to the extent that we do have some, as the Chairman said, anecdotal -- anecdotal in the sense of non-statistical, non-quantitative -- evidence of perhaps non-audit services having marred the judgment of audit participants on a few occasions.
I don't want to say it's endemic, but on a few occasions, at least we have evidence to that effect or have had evidence to that effect.
I am intrigued about what you think about the idea of either using the appearance model and you said we rely too much on that standard, or relying on the relatively small series of anecdotal evidence that there have been audits marred in the past because of the other services provided.
What do you think about -- now, that's looking sort of at the present time or looking backwards. What do you think about the idea that as you look forward in the profession, that perhaps the audit side of a particular accounting firm and the consulting side are going to develop different world views and necessarily have different relationships with the clients and that maybe those are incompatible?
MR. MELANCON: Commissioner Hunt, you mentioned a couple of models. I think that scenario might well occur. I think that there are many scenarios that will occur. I think that it is very difficult for either of us to predict what is the right model.
Just to comment, there's more than two models out there right now. There are many, many, many different models. We could certainly look at some in the past, though. We've certainly all read about, you know, Andersen and Andersen Consulting. Arthur Andersen sort of recreated some of its consulting capabilities because they felt like they had a need to have those competencies in those firms.
There are small firms that strategically align because they don't have the capital resources to be able to deliver or build the competencies that they need and they do that through strategic alliances. Some have sold out. Some smaller firms have sold out to larger enterprises to be ableto access technology.
I would say to you, Commissioner, I wish I was smart enough to predict exactly which one was the right model, but I do know that if we sort of arbitrarily make a decision that one model is the right or that the model that has served us well for, you know, however many years is right, that there are some risks associated with that.
CHAIRMAN LEVITT: I think that this is a little bit aside the point. The Commission doesn't have the luxury of just putting things out and letting things develop as they will.
This issue is not a new issue. It's been with us for years and years and years. All four of my predecessor chairmen have dealt with this issue. All four of them have felt that the issue cries for resolution.
MR. MELANCON: I said before that public attention, which is very much more our concern, perhaps than yours, although I think if I were running an accounting firm I'd be very concerned about it, calls for some sort of closure, some sort of resolution.
MR. MELANCON: I understand that point, Mr. Chairman. I was just responding from the standpoint that how a rule is crafted could cut off maybe unnecessarily some other options to develop and I think you want to be considerate of that and based on my knowledge of yourthoughts along those lines, I think that you would be considerate of that.
CHAIRMAN LEVITT: That's true.
COMMISSIONER HUNT: Well, again, thank you. We look forward to trying to work with you to see if we can fashion a rule that is satisfactory to the profession and to the investing public, for all of us. I am heartened by your expressions of a willingness to work along those lines, as you expressed both today and in the hearing in New York last week. So thank you.
MR. MELANCON: Thank you, Commissioner.
COMMISSIONER HUNT: Thank you, Mr. Chairman.
CHAIRMAN LEVITT: Commissioner Carey.
COMMISSIONER CAREY: Thank you, Mr. Chairman.
And thank you for your extensive and informative testimony this morning.
I am slightly concerned that when we throw around the results of surveys and statistics and panels that we sometimes do it selectively and so I wanted to use what I thought were a couple of examples to perhaps further elucidate the conclusions of some of the panels that have been discussed.
I'll address this to you, Mr. Melancon because I think that most of these examples were from your testimony, correct me if I'm wrong.
From the O'Malley Panel, you testified that the panel was not aware of any instances of non-audit services having caused or contributed to an audit failure. Is that the quote that you used? Something sort of indicative of the fact that --
MR. MELANCON: It was based on the 37 that it reviewed, it reached a conclusion along those lines.
COMMISSIONER CAREY: The panel, I would point out, also noted that the firms' management consulting practices have expanded far beyond those skills required for audit support and the traditional areas related to financial planning and controls, certain investment banking and legal services, outsourcing a variety of corporate functions, strategic business planning and business process reengineering advice. Independence questions arise when these services are marketed to audit clients. Chapter 5, Section 11.
Also, the Penn and Schoen poll that was commissioned by the AICPA, one of the results it that 89 percent of investors thought it would be important for shareholders to know if a company's auditor also provides consulting services to that company.
Doesn't this overwhelming interest in increased disclosure indicate that investors see a connection between the provision of non-audit services and auditor independence?
Would you agree that in light of this finding that at least the appearance of the auditor's independence will be strongly influenced by what consulting services the auditor is providing?
Why else would 89 percent of the respondents want that information?
MR. MELANCON: As a representative of a profession that certainly agrees with disclosure in a lot of different areas, I can certainly understand that information would be useful and I think we first off support vigorously the Commission's position that information such as that needs to be disclosed to the audit committee, and the audit committee has a reporting responsibility related to the matters that it considered in making an independence determination. And that certainly is a form of communication and information that comes out in the sampling.
COMMISSIONER CAREY: Also, would you say that you share the results in large part of the Earnscliffe, share the views supported by the Earnscliffe study?
MR. MELANCON: I didn't specifically in today's testimony reference Earnscliffe.
COMMISSIONER CAREY: I'm sorry. I'll be fair and not use Earnscliffe as an example. But you did quote the GAO and refer to their findings.
In their 1996 report on the accounting profession,page 8, the second paragraph, final sentence, "The accounting profession needs to be attentive to the concerns over independence in considering the appropriateness of new services to ensure that independence is not impaired and the auditor's traditional values of being objective and skeptical are not diminished."
MR. MELANCON: We agree and, as an example of that, that's why we supported the Chairman's initiative along the lines of the ISB. So we agree with that dialogue. We agree that those are important issues. We have agreed with that for over 100 years.
COMMISSIONER CAREY: And, also, I want to make sure because some of the paperwork flies fast around here, but the talking points titled "The E&Y and PWC Proposed Rule Demonstrates that the SEC's Rulemaking is Fatally Flawed," is that an AICPA document?
MR. MELANCON: I don't know the document that you are referring to.
COMMISSIONER CAREY: No? Okay.
MR. MELANCON: It's not our document.
COMMISSIONER CAREY: Would you like to see it?
MR. MELANCON: I don't think it's our document. I don't know what he's talking about.
This is not our document, Commissioner.
COMMISSIONER CAREY: Well, good for you.
All right. Thank you.
I have no further questions.
CHAIRMAN LEVITT: Commission Unger?
COMMISSIONER UNGER: Thank you very much.
Thank you. I appreciate your coming back. I thought your testimony was very helpful. I appreciate the slide show and I was very impressed by that stool. I thought that was good graphics.
I do think I sense a change --
MR. ELLIOTT: Your opinion was not universal, I'm sure.
MR. ELLIOTT: I use that in my Social Security presentations.
COMMISSIONER UNGER: The stool?
MR. ELLIOTT: Yes. The three-legged stool.
COMMISSIONER UNGER: Not just the three legs, but then the little prongs underneath. I couldn't have done it.
I do think I sense a change in the tenor of our discussion today, too, as opposed to last week and that pleases me enormously. I think you're a much more powerful ally or effective ally, although you are a powerful adversary, and that the dialogue is really essential to getting not just something done, but the right thing done.
Because we've had the benefit of a number of other witnesses in the interim since last week, I thought it wouldbe helpful if you could sort of help me put in perspective some of the differing views that I've heard as opposed to maybe some of the things that you all were talking about today.
You talked about -- and a lot of what you said really resonated with me, especially what you were saying, Mr. Elliott, about sort of modernizing GAAP and really trying to take advantage of the technology available today.
I would love to sit down with you and talk about that some more, because I think that's very, very interesting and I agree with you.
MR. ELLIOTT: We can make an appointment to do that.
COMMISSIONER UNGER: Okay. I would really like that.
But one thing I don't understand is despite all of what you've said in terms of attracting talent and having the right people and being sort of business minded in the audits, all of which I think is true, why do you need to perform the auditing and the consulting services under the same roof, as it were?
MR. ELLIOTT: If they're not under the same roof, you don't have the same interchange of information. In order to move in the direction that I was speaking about, Commissioner Unger, what you're really talking about is avery different model that involves different skills, leading edge skills.
I tried to indicate some of them: strategy, information technology, mathematical modeling and capabilities, actuarial skills and so forth. And if these are just outsourced, let's say, you go to another firm and try to learn what they know, you don't have synergies the way you do when these people are working together on engagements, whether it's audit engagements on this day of the week and different engagements on that day of the week.
If there is too much of a restriction put on what services can be performed for audit clients, then the most economical thing for the firm to do will be to divest those. And if you look at the proposals, the proposal that's outstanding, the one that we're commenting on today, although it does not in any place say that you can't do non-audit services for clients and it does not in any place say that firms must divest themselves of non-audit services, if you put all the provisions together, the affiliate rules, the open-ended catch-all provision, the list of services, if you put everything together, it makes it really uneconomical to have those services under the same roof, as you put it. It makes it uneconomical.
It's not worth as much to have a firm that can only focus on 60 or 70 percent of the market, instead of 100percent. That's a more valuable firm. And I think you are seeing firms undertaking transactions in the marketplace and when they're selling off these consulting divisions, what you have to see that as is a market signal that these consulting operations are worth more outside than inside. That tells you something about the loss of economic value that comes from having a restricted range of clients.
So what we're talking about here is setting up a set of conditions under which these skills can be under one roof because only if that's the case are we going to be able to move into the future that I was talking about.
COMMISSIONER UNGER: Well, today, how do you use the crossover in terms of the experts from the consulting service to assist you with the audit or vice versa?
MR. ELLIOTT: It comes about in several ways, Commissioner. One way is that on a given audit where the audit team needs these services, they can call on them directly and they can call on them from consultants who are in the firm that are subject to the same independence rules, the same culture and so forth, and they know that these people are going to be ethical and upstanding and so forth.
If they have to go outside to get those services, they are not under the independence rules and who knows what would be accomplished. So that's one way, you actually bring the consultants onto the engagement.
A second way, though, is that when firms are developing their technologies for auditing, and developing their benchmarking for clients and so forth, the availability of these capabilities within the firm helps to design a better process or product or database or something like that, which can then generally be used on all audits.
And some of it is strictly informal. It's the give and take in a collegial environment in which people facing issues from different perspectives educate each other.
The auditor, isolated in an only audit firm, talking to everybody in the firm who is talking about the debits on the left and the credits on the right, is not going to have as rich an experience as somebody who is in a firm that has a broad variety of perspectives and begins to understand these different perspectives -- strategic, competitive perspectives, technology perspectives.
So there are a lot of reasons. There are a lot of ways that that transfer takes place, Commissioner.
COMMISSIONER UNGER: But there is nothing in the rule proposal that prohibits you from using your management experts or -- I forget the exact term -- to accomplish that same objective, even if the proposal was enacted as it stands.
MR. ELLIOTT: Well, that was the point of my first comment, which I probably wasn't very sufficiently clearabout.
I agree with you that the proposal in no place says you have to divest consulting operations. It's the joint operation of all the conditions together that create a framework in which it's just not, we believe, it's not going to be economical for firms to have robust consulting practices under the same roof. And we think that that is not in the interests of the shareholders.
COMMISSIONER UNGER: But today, do you use the same management experts from the consulting side to work on the audit and then to later perform other duties or services for that client?
MR. ELLIOTT: That happens, yes.
COMMISSIONER UNGER: So is that the synergy that you are afraid of losing?
MR. ELLIOTT: That's part of it. As I indicated, there are other aspects of it, too, including the use of this expertise to develop services and technologies to support the audit process, so it can happen at the individual audit level, it can happen at the firm-wide level, and it can happen informally.
COMMISSIONER UNGER: So you had mentioned in that three-legged stool that I complimented you on that one of the main three legs was objectivity, right?
MR. ELLIOTT: Yes, that's correct.
COMMISSIONER UNGER: And two of the components under that leg was independence --
MR. ELLIOTT: Integrity and independence.
COMMISSIONER UNGER: Right. So if that's a concern you have today, then I am assuming you have in place some kind of mechanism to ensure the independence of the relationship that we just talked about.
MR. ELLIOTT: Yes.
COMMISSIONER UNGER: Can you describe that for me?
MR. ELLIOTT: We've had, as you know, independence requirements in our profession even predating the SEC. And we have rules and we have the requirement for quality controls and we have peer review that comes in to test the application of these quality controls and so forth.
What happens then is as the AICPA or the SEC or, more lately, the ISB comes up with new rules, they become embedded, they become absorbed into the rule base in each firm and it has to educate its people and change its systems and so forth. But it's like any of the other quality controls.
We actually have a long list of quality controls. They go not just to independence, but competence and supervision and review and the way we do hiring. All those things are elements of quality control and we -- we, when I say we, all the firms in the profession -- are required tohave quality control systems to make sure that those things function. And one of those areas and one of the most important is the independence area.
COMMISSIONER UNGER: And how does that function? Can you give me a practical example?
MR. ELLIOTT: Well, I might get too much in depth, but, for example, there are rules that prohibit ownership of securities by people in the firm. So people in the firm therefore report --
COMMISSIONER UNGER: No, in the specific instance where you have what we've been talking about, an individual who works on an audit and then who provides consulting services for that same client.
MR. ELLIOTT: The rules right now are not engagement based, they cross the whole firm. So it wouldn't make any difference whether individual A was working on an audit or not an audit. All partners in the firm, for example, are subject to the same set of rules.
Now, your proposing release would change that if it were adopted, but right now, all the partners in the firm are subject to the same rules.
COMMISSIONER UNGER: Mr. Melancon?
MR. MELANCON: That's the case. I mean, they are subject to, being member firms of the SECPS, a whole set of quality control rules that they must comply with that aretested to and even non-CPAs, non-auditors, must comply with those rules as part of the system of quality control for the firm to remain a member of the SECPS.
COMMISSIONER UNGER: We talked a little bit yesterday with some of the witnesses -- actually, in probably all the days of the testimony -- about loss leader engagements.
Do either or all three of the witnesses, is that a prevalent practice in the industry? Could you describe it a little bit for me?
MR. ELLIOTT: Well, I believe one of the witnesses, I wasn't here, but I believe Professor Antle testified that auditing is a very profitable practice for the firms; in fact, at the gross profit level, it's the most profitable practice in the firms. So, on average, audits are profitable.
So you're asking a specific question, would a specific audit be not profitable. And the answer to that question is that, when audits change firms and they're put out for bids, new firms may price the audits low and they may do that in order to get the engagement because in the future it will be profitable.
There is no rule against that. In fact, if we had such a rule against that, the FTC, as Mr. Melancon indicated earlier, would challenge that rule.
These firms are free to compete as long as they meet the standards. And that's what makes them, by the way, loss leaders, because they are actually doing all the work necessary to conform to the standards, which may not cover the revenue in the first year or something like that.
Then it gets to the question why would they do that? And given that a small fraction of audit clients use non-audit services, I believe the release points to 25 percent, the reason they're doing it is not to get this other work because that's not a sure bet at all. The reason they're doing it is because in the future they expect it to become a profitable audit and an audit has a different characteristic than consulting work.
An audit continues year after year. As you know, the number of firms that change auditors in a given year is quite small. So while it's not an annuity, it's more like an annuity than a consulting engagement which, when it's over, it's over.
So, in order to get this profitable stream of future engagements, some firms may bid less in year one.
MR. MELANCON: Again, just I'll reference the comment that I made, I think it was to Commissioner Hunt. The FTC has certainly had influence on many of the professions as relates to how they bill, how they advertise, et cetera.
I think the most important part is that we do not interface between the client and the CPA firm as to what they negotiate on a price for a service to be developed or delivered. However, what is not debatable is that the CPA, in deciding on whatever it's going to charge for that service, cannot do a substandard audit. They are required by auditing standards, their ethical commitments, et cetera, to do the work. This cuts across all lines, whether it's public company audits or non-public company audits. And so, you know, that's the rule.
So if you choose to do it for less than that, that's fine, but you can't do less work.
COMMISSIONER UNGER: Well, I guess you didn't hear the testimony of Rod Hills because he said as the chairman of the audit committee that he had heard in some cases CFOs bragging about the fact that, well, we got this firm to perform the audit for less than what it cost them. And he said that then they said, well, they think they're going to make it up on the consulting business. And his response to that was, of course, well, then I'd check and see why we're being overcharged for the consulting work.
But notwithstanding, and I've heard this from a couple of witnesses, that the reason for charging less in the bid for the auditing work is in hopes of getting the consulting business. And I think part of the reason we'rehere today is because the consulting business is more profitable for a lot of the Big Five firms than the auditing. If it's 70 percent, 60 percent, 50 percent of their revenue, then it's at least equal to or more than the auditing revenue.
MR. MELANCON: First off, I think an audit committee interaction on that particular point is very appropriate and I think that should be something that audit committees should do in discussing the relationship with the auditors, et cetera, as to whether or not the audit fee is a reasonable fee or not. But that is a role of corporate governance and should be handled from that particular standpoint.
There are a lot of reasons, however, particularly if you take a small firm, or even a large firm, that you might look at the proposing on a particular engagement and decide what your pricing might be.
For instance, firms are required to maintain certain levels of staffing because of certain workload commitments that they have at different parts of the year. At other parts of the year, the work that the firm may have may not be commensurate with the level of staffing that they have built up.
From that standpoint, if they have an opportunity to do an engagement for a different price at that time ofyear when they have less work, from a pure economic analysis perspective, it may make economic sense for the firm to keep their staff busy, even at a lower realization rate, than at other points of the year because of the workflow considerations.
So there are many factors into that.
MR. ELLIOTT: It's like an airline that's about to take off with an empty seat. It would be better to put somebody in the seat for $10 than fly with an empty seat. And it's the same thing here. There are peaks and valleys in workloads and during the valley period, it would be better to get some revenue for the people that are on your payroll.
COMMISSIONER UNGER: Did you want to say something, Mr. Monk?
MR. MONK: Well, I would agree with what Barry was just talking about as far as the seasonality and especially with the smaller firms, the seasonality issue is critical to us from the standpoint of having -- because our practices are probably a greater percentage tax oriented than they are audit oriented and all of that comes at one time primarily, it's critical to be able to find something to help carry you through during the slower times which are primarily during the summer. And so you will see discounting of different types of work that become available.
I think there is a perception in our profession ofwork being bid at cost or below in many instances. I'm not sure how true the perception really is, but I believe that at the smaller firm level that it appears to have a greater impact, just because smaller firms don't have the ability to make investments in that first year audit.
We have to make money every year we audit or we just can't stay in business and so our inability to invest in that early work makes it difficult for us to compete in some instances. But I think that it's more of a perception issue than a reality.
COMMISSIONER UNGER: Well, I don't see how if you're auditing the same company year after year you can give them a cheap rate for one year and then all of a sudden you're going to make that up in subsequent years. That's contrary to what intuitively I would believe and what other witnesses have said. That makes no sense.
MR. MONK: Well, a lot depends on what you consider cheap and the percentage of change.
COMMISSIONER UNGER: Discounted.
MR. MONK: A 10 percent change in an audit fee could make a great deal of difference in our firm. If we were able to raise our rates that much, it would be wonderful. So some small increases can make a significant difference, especially in the smaller firms.
COMMISSIONER UNGER: Okay. Well, unless there'ssomething you really want to say, I'd like to move off this.
MR. MELANCON: Just one quick point, just to give you an example of this workflow issue. One of the issues that has been a real issue for the profession since the tax reform act of 1986 has been something called workload compression. And it particularly applies to smaller firms where based on that act of Congress, virtually all small businesses have to have a December 31 year end. Prior to that, the year ends pretty much were evenly distributed throughout the year.
That sort of concentration of corporate year ends, which a lot of year-end accounting work and year-end tax work is done, has caused a lot of the issue of higher levels of staffing versus needs later on in the year.
And so from a small firm perspective, that's one of the most emotional issues that a lot of our members have had, for instance, so it is a big issue, the workflow issue.
COMMISSIONER UNGER: Well, thank you. That's the first I've heard of that, so that is helpful.
You touched upon the relationship with the audit committee and that was something I wanted to find out a little bit more about, as well.
Some of the witnesses have said that they're not getting the information about what services the firms are providing in terms of the auditing services and oftentimesthey don't find out about it until after the fact, at which point they have no input into determining whether or not there's a conflict or whether it's appropriate for the firm to be providing those services.
MR. MELANCON: ISB Standard No. 1 requires the auditor to proactively go to the audit committee to discuss matters that they considered in determining that they were independent. That's a new standard that's now in place. That's number one.
There's been some requirements that the SEC has brought forward as it relates to audit committees that are now just coming into effect and I think will have very positive impacts from that standpoint.
And I think the Blue Ribbon Committee and audit committees, as an example, had several model audit committee charters and, if you look at those, I know that because our own audit committee charter was one of them that was a model in that particular pronouncement. And, as part of that requirement, as management of the AICPA, for instance, I am required to discuss with the audit committee any engaging of our audit firm for any services other than that audit, so that the audit committee is fully aware of that, can deliberate on the appropriateness of it, however it sees fit.
So from an AICPA perspective, as manifest by our own charter, we certainly believe that that's appropriatedialogue.
MR. ELLIOTT: If the audit committee members --
COMMISSIONER UNGER: Going forward, but it's not a dialogue that a lot of companies and auditors are having today. Is that what you're saying?
MR. MELANCON: But, Commissioner Unger, I think there are several provisions that are coming into play --
COMMISSIONER UNGER: No, I'm just asking you --
MR. MELANCON: -- that I think will improve that. If they aren't occurring, as you say the witness testified to, which I'm sure it's not in that person's situation or they wouldn't have testified to that point, but I believe that the provisions that have been put forward, I think if you were having this exact same hearing in the years to come and asked that same question, I think the likelihood is that you would get a more positive response to that because of those things that have occurred in the last couple of years.
COMMISSIONER UNGER: Mr. Elliott, did you want to say something?
MR. ELLIOTT: Well, I was just going to intensify the point that we have as an organization supported independent audit committees since the late 1960s. And we have been encouraging the SEC to move in that direction all those years. And it wasn't until the current chairman came in that actually the log jam broke and something got done.
And that's fairly recent and I agree with Mr. Melancon, that if you have this same hearing a year from now, I would fully expect that you would be hearing a different story from audit committees because of the work that has been done at the initiation of the SEC.
COMMISSIONER UNGER: Which sort of causes me to circle back to what I asked you earlier, but if the audit committee -- or you're saying the audit committee's role is to determine whether the relationship of auditing and perhaps additional consulting services poses a conflict or independence issue, is that not something that the firm also undertakes?
MR. MELANCON: First off, at the very first, it's the audit firm's responsibility to determine that they are independent. So the obligation is clearly on the auditor. The auditor cannot put that obligation off solely to the audit committee in any form or fashion. And even if the audit committee were to determine things were okay, the firm is still responsible to make an independent judgment that they are in fact independent. And if they are not, they have violated the standard.
So I would say, I hate to use the word, but it really is a partnership based on the way the process is being set up now, that dialogue occurring with the audit committees, the audit firm having to make thosedeterminations and then the audit committee also being able to interact on that information.
MR. ELLIOTT: The audit committee, of course, has that as only one of its many duties, looking at the other work that the auditor is doing.
COMMISSIONER UNGER: So speaking from personal experience, have either of you ever turned down or declined to do additional work for your clients because you were concerned about independence?
MR. MELANCON: I can tell you, I came from a small firm environment prior to being CEO of the AICPA, and I will tell you that being in a small firm practice, absolutely we have turned down work.
MR. ELLIOTT: The answer from my perspective is yes.
COMMISSIONER UNGER: The last question I wanted to ask is the AICPA has an enforcement arm. Is that correct?
MR. MELANCON: Yes.
COMMISSIONER UNGER: We've brought a number of cases, we've talked about that in the course of these hearings. How active is your enforcement arm? How many cases have you brought, say, in fiscal year 1999 for audit failures?
MR. MELANCON: I'll be glad to provide you with the specific numbers. I don't have the numbers at recall, but itis -- it's a very active division. It has dedicated staff. It has separate committees that are functioning in those areas. We publish results on a frequent basis, both electronically and in our monthly newsletter publication process, when results occur. And there are whole plethora of other cases that come to closure that don't require disclosure because the particular problem wasn't at that particular level, but other actions were taken against the CPA. So it's a very active process.
MR. ELLIOTT: In addition, Commissioner Unger, I wanted to make the point that because of liability and litigation concerns, cases are put off at the request of the accountant until the litigation is completed, which means it takes a while for this process to work its way through. And because of concerns that while that was going on you might have a bad auditor, in effect, doing additional bad audits until such time as the case was completed, we recently developed a way of, in effect, either taking somebody whose work is under criticism off the bench -- I'm sorry, putting him on the bench, or double teaming him so that the risk of a bad auditor staying in place and continuing to do bad audits until the enforcement process winds its way to completion is reduced substantially. So that improves the timeliness of the action.
COMMISSIONER UNGER: Well, for a number of casesthat we have talked about, the high profile cases, the Waste Management case, I won't enumerate all of them, what is the practice of the AICPA once they discover an SEC action of that magnitude?
MR. MELANCON: First off, we would open a case on the basis of public information, which might be a newspaper article or something along those lines or a complaint.
MR. ELLIOTT: Or a regulatory action or litigation.
MR. MELANCON: Or a regulatory action or litigation. If litigation is involved, we do specific reviews to look at the firm to see if in fact the firm's quality control system needs to be addressed so that whatever the alleged problem is is not likely to reoccur in the future. So that's sort of a separate process.
Then, in addition to that, there is an investigation that occurs on the basis of the individuals. That investigation includes obviously the due process things that you would expect. People get their, if they wish, their day in court. They can respond to allegations. They can provide information to consideration and there is even a trial process if they choose to appeal it to that standpoint.
MR. ELLIOTT: If, of course, we find the person is guilty of the infraction and it's not possible to remediate it and we have to deprive them of their membership, you might say how many teeth are in such a bite, but that informationis then shared with state boards of accountancy, and if they are so inclined, they can in effect retract the CPA certificate.
So there's a connection of these processes to each other.
COMMISSIONER CAREY: Laura, may I ask a follow-up question?
COMMISSIONER UNGER: Please.
COMMISSIONER CAREY: If someone is in fact sanctioned and the sanction is something short of removal from the AICPA, is there any ability for the public to gain access to that information?
MR. MELANCON: Suspensions as well are on our website.
COMMISSIONER CAREY: Okay. Thank you.
COMMISSIONER UNGER: Right. But Commissioner Carey asked whether that was publicly available information.
MR. MELANCON: Yes. It's on our website.
COMMISSIONER UNGER: Oh, I'm sorry. I didn't hear you.
MR. ELLIOTT: Yes.
MR. MELANCON: Suspensions or expulsions.
COMMISSIONER UNGER: Okay.
MR. ELLIOTT: Yes. When there is a finding of a problem against a member, we publish that, both in print andelectronically.
MR. MELANCON: Admonishments as well.
COMMISSIONER UNGER: Pardon me?
MR. MELANCON: Admonishments as well.
COMMISSIONER CAREY: And your admonishment is your least severe sanction?
MR. MELANCON: In minor cases, there is something called a letter of corrective action. That is purely remedial if the case doesn't rise to the level of a more severe infraction.
COMMISSIONER CAREY: Thank you.
COMMISSIONER UNGER: I would like you, if you could, to provide that written information about the number of cases.
MR. MELANCON: We will be happy to. In fact, what we will do is put it in our written comments to the proposal, if that's okay.
COMMISSIONER UNGER: That would be very helpful.
Thank you very much.
CHAIRMAN LEVITT: There are some questions from General Counsel.
MR. BECKER: I have a few questions.
Mr. Elliott, just to understand the point you were making with your economic analysis, that chart, the one that showed the stock price going up and then fallingprecipitously, is the point, to make sure I understand it, other than some incremental change to investor confidence in the market, which may be reflected in some sort of premium stock price because of uncertainty, that there really is no -- because every investor loss is offset by an investor gain, there really is no economic impact of a restatement?
MR. ELLIOTT: No, that's not what I said and that's not what I meant. I was simply trying to make the point that when you read $35 billion was lost in a newspaper article because of that picture that I showed you there, that's different from $35 billion of houses blown down by a hurricane. The gains and losses do balance out.
I went on to say that that does impose costs on the capital markets and those costs were important costs and they needed to be considered and we were not at all condoning that or anything else, but there are investors there who made money in that picture, there are others who lost money.
I would point out that while this is not much comfort to those who lost money, that the first rule of investing is diversification and that's a diversifiable risk.
COMMISSIONER CAREY: May I just interject?
If you're a family that has placed its life savings into the shares of a company, perhaps because you were a career long employee there, and you've lost all that, for you it may be difficult to distinguish between a hurricane andthe loss of that capital. And I think to trivialize it by saying that while there are those who lost money, and those who gained, I think that's somewhat glib in the face of something quite severe.
MR. ELLIOTT: I agree it's quite severe. I said it was quite severe and we don't condone it and we want to eliminate it. It affects capital markets, it affects the reputation of the auditors involved and so forth. We don't condone it and I am very sympathetic to that individual whose entire life savings were in one company that went down. I don't mean to trivialize that.
MR. BECKER: So what's the point, then? From an economic standpoint.
MR. ELLIOTT: The point is the one that I made, that there is a difference between true destruction of wealth and the reallocation of wealth. That's the only point that I'm making. I'm not suggesting that the reallocation of wealth is a good thing, I'm just suggesting that reallocation is different from destruction.
MR. BECKER: Well, let me ask it a different way. Now that you have made that distinction, what's the significance of it?
MR. ELLIOTT: Let's say that the application of some rules, referring to auditing, whether independence or some other aspect, would create costs and drive up auditfees. For example, the O'Malley Panel made suggestions to have a forensic phase of an audit.
Now, I don't know what that would cost, but it wouldn't be cheap. So audit costs would go up. And let's say they would go up for the economy at large by 2, 3, 5 billion dollars.
One could say that that is a small cost to pay to avoid losses of, in this example, $35 billion. But what I'm saying is that that's not an apples to apples comparison. That's all. So you have to take that into account when you consider the cost-benefit relationship of the policy decisions that you make that would affect audit costs.
MR. BECKER: So that from the standpoint of the Commission's policy judgment, do you agree that the Commission should take into account the impact on individual investors? I mean, you don't think our attitude should be you lost $35 million, but good news, someone else made $35 million.
MR. ELLIOTT: I am not saying that at all.
MR. BECKER: Okay. You talked about the need to improve a financial reporting system that in some respects is obsolete. How long do you think it would take to get into place the types of improvements that you were talking about?
MR. ELLIOTT: It's like any other change process. It's not that you go from level A to level B in one jump, butrather you introduce improvements as they're available and the recommendations of the Jenkins Committee, for example, have an extensive list of types of things that could be disclosed, each one of which individually would make an improvement in investor information.
So you wouldn't have to wait. It's not like it would take us five years to figure out a new model and adopt it. There are many of those recommendations that could be adopted immediately and investors would begin to immediately benefit.
So I think the question on timing is it could start immediately and the question as to when it would end is never. Improvements are never over.
MR. BECKER: I'm just trying to understand -- well, improvements are never over -- I take part of what you're saying is that the Commission should not focus its efforts on these independence matters until there has been progress in these other areas. And I'm just trying to get some dimension. Surely you don't mean never ending as to how long you think the Commission ought to wait.
MR. ELLIOTT: Specifically, what I said was that the direction that we see the new economy going, not the new economy, but accounting for the new economy, business reporting in the new economy, we don't know exactly how that's going to work out, but we have some suggestions andwhat not.
The Garten Panel is in place. We all await their findings and so forth. Until we have a better fix on where that's going and what types of measures will be involved and so forth, it just seems to us that any action that would precipitously strip talents from the auditing firms that would turn out then to be essential talents to move forward into this new accounting model would be the wrong sequence of events.
Once those talents are gone, it would be very slow and time consuming to regenerate them and so given that there is no evidence of a crisis here, it seems like we ought to, as a policy matter, see where the new model accounting would be going and see what talents are necessary and then see what type of independence rules would be supportive of having those talents in the profession.
MR. BECKER: And do you think that would take months?
MR. ELLIOTT: Well, I think that you could make excellent progress on it in months. We have called for a concept release on business reporting for the new economy in a short timeframe, you know, like by the end of the year or something like that.
MR. BECKER: Well, but as a practical matter, you said "until we know" and you must have in mind sort of somesense as to how long "until we know" takes. Are you talking a few months, are you talking five years? Do you have any --or do you not know? It could be as little as a few months or as long as five years?
MR. ELLIOTT: No, I think it could be as little as a few months or as long as a year or two. I think by the end of five years we should have all the time necessary to see where we would want to go.
MR. BECKER: So something between a few months and two years is what you would say?
MR. ELLIOTT: That sounds feasible.
MR. BECKER: Well, I just want your opinion. I don't know whether it's feasible or not, but that's your opinion.
MR. ELLIOTT: Progress could be made in that space of time, yes.
MR. BECKER: Okay. In terms of stripping away the capabilities that the firms need, I just want to make sure that the Commission understands the dimension of this. These are capabilities -- we're measuring this by the usefulness to the audit. A silly question perhaps, but if these are capabilities that firms need in order to perform audits, why not simply hire people to do them, pay them, and say to the client who is after all buying a service that by statute the client has to buy, this is how much it costs and we areasking you to pay for it?
MR. ELLIOTT: So you're saying you would take these talents and hire them onto the audit staff and use them to do audits?
MR. BECKER: I'm asking what is it that makes that impossible?
MR. ELLIOTT: Well, I wouldn't go so far as to say impossible, but I would go so far as to say that people employed in that type of relationship would not be at the leading edge. They would not be at the cutting edge of developments in their field.
The people who are at the cutting edge are the people who are moving into the future, who are dealing with the most forward-looking client problems, and these are what the consultants are doing in these firms.
Think about the capabilities of a building inspector versus an architect, for example. The architect has the creativity, is on the cutting edge of developments and so forth. The building inspector has to come along and see whether he met the code.
You are not going to be able to attract as a building inspector somebody who is at the same level of capability. And when you're faced with a client, and we have many of them who have extremely high capabilities in these areas, financial instruments, you know, the types of thingsthat are going on on Wall Street and so forth, if that's the level of sophistication that the client has and we bring somebody to the audit who is a full-time audit compliance policeman type, it's our view that the talents of that person will not be up to the talents of the person in the client and that that would result in an asymmetric relationship and the audit would not be as good as it needs to be for investor purposes.
Whereas when you can bring in this person from a consulting function, a person who on Monday, Tuesday and Wednesday is out designing at the leading edge and on Thursday is able to help the audit partner then evaluate the same type of issues for another client, it's obvious to us that you are going to be able to maintain much higher talents in that type of setting.
COMMISSIONER UNGER: But, Mr. Elliott, nothing in the rule precludes you from doing that. Nothing precludes you from taking that consulting expert and using them on the audit.
MR. ELLIOTT: That's assuming that there are --
COMMISSIONER UNGER: But they just can't go back and work on the same client.
MR. ELLIOTT: That's assuming that they are under the same roof. And, as I said before, our view of the interaction of all of the components of the proposal is thatthat's unlikely to be the case in the future, if the rule is adopted as exposed.
MR. BECKER: But the notion is, I take it, that auditing is not inherently interesting enough that you can get good enough people to do these things, if all they're doing is in an audit context. They have to be doing other things, too, in order to be attracted to the auditing profession.
MR. ELLIOTT: I believe that auditing actually is a very interesting occupation and the people who do it find it interesting. I think if you ask Mr. Turner, who not too long ago was an auditor, he would probably tell you it's quite an interesting job. The question is not whether it's an interesting job, it's whether in that setting you can have cutting edge technology and capabilities.
MR. MONK: Can I respond as well?
MR. BECKER: Sure. Please.
MR. MONK: If you bring it down to a very simplified process in a small firm environment such as mine, I can afford to have limited numbers of people with specialized expertise in other areas such as someone that can facilitate strategic planning or some HR specialties or evaluation specialties, but I have to be able to use those people in other areas because we are not large enough nor have the client base enough to keep those people working 100percent in those specialized fields.
If I can't utilize those people in our audit area as well to perform audit work, then I have to make the choice of getting out of auditing or giving up those people and limiting the size of my practice and the ability of our staff to be able to properly perform. Our ability is enhanced by being able to have these people with some specialized knowledge.
Now, we're not necessarily on the leading edge, as Mr. Elliott would be able to do, but certainly we have people that do work in specialized fields that we can call on and utilize in the audit area that enhance our ability to audit.
MR. BECKER: I just have a couple of questions for Mr. Melancon, if that's okay.
Mr. Katz showed you an unsigned statement, if you would like, I'll show it to you again, and you said that's not your statement. Had you seen that before Mr. Katz showed it to you?
MR. MELANCON: I heard about it being circulated yesterday because I think some people testified that it wasn't theirs. It's not our statement.
MR. BECKER: Well, but is it the first time you saw it?
MR. MELANCON: Yes, it is the first time I saw it.
MR. BECKER: Okay. Do you know whose statement itis?
MR. MELANCON: No.
MR. BECKER: Do you know who circulated it?
MR. MELANCON: I do not.
MR. BECKER: Do you know who wrote it?
MR. MELANCON: No.
MR. BECKER: So it's a complete mystery to you how it got circulated?
MR. MELANCON: I do not have -- it's not our statement. I mean --
MR. BECKER: Well, what do you know about it?
MR. MELANCON: I know you're asking questions about it.
MR. BECKER: Do you know anything else?
MR. MELANCON: That obviously Commissioner Carey was concerned about it.
MR. BECKER: Do you know that it was handed out by a press representative of the AICPA yesterday?
MR. MELANCON: I do not know that.
MR. BECKER: And it comes as a complete surprise to you?
MR. MELANCON: I heard about it yesterday afternoon as you just asked.
MR. BECKER: But -- I'm sorry, you learned yesterday afternoon that this was something distributed byyour press person?
MR. MELANCON: No, that it was distributed and that people who testified related to it said that it wasn't associated with them.
MR. BECKER: Okay. So right now is the first time that you learned that this was being distributed by your press people?
MR. MELANCON: I don't know that it was.
COMMISSIONER UNGER: Mr. Becker, why don't you describe the document for the record?
MR. BECKER: Well, I think we ought to put it into the record. It says -- and it's unsigned. It says "The E&Y and PWC Proposed Rule Demonstrates that the SEC's Rulemaking is Fatally Flawed."
And point number 1, "The E&Y and PWC proposal demonstrates how seriously, flawed fundamentally misguided and wide of the mark as a policy matter the SEC's original proposal is."
It goes on to say that "The original proposal is bad policy, bad government, utterly unworkable and would lead to material diminution of audit quality."
Other than that, it says it's lovely.
And it goes on to say that the fact -- actually, a comment very similar to yours, the fact that it comes out three days before the end of the comment period shows that wehave to extend the comment period.
Is that your view as well?
MR. MELANCON: I think I answered how I felt about the various issues that were presented in the question and answer that Chairman Levitt and I had in that it is our hope that we can dialogue and discuss and evaluate various points of input that have been presented to the Commission. I am confident that we will be able to do so. And we will look at all of those input measures. There have been several things that have been suggested.
It is our opinion that, and I testified to that extent, that the fact that there is, you know, four days or whatever to the deadline for comment, that that's a very difficult timeframe. I don't think that that's a surprise. I think we have said that from day one. And that doesn't --you know, that doesn't take away from the statement that I made to Chairman Levitt in his questioning as it relates to wanting to look at all the proposals and to dialogue on them.
MR. BECKER: You folks are going to --
COMMISSIONER CAREY: Would you find fault in any way with the Commission entering into a constructive dialogue with two firms who represent such a large portion of the industry as E&Y and PWC as to how the proposed rule could somehow be improved?
MR. MELANCON: Do I find fault with you enteringinto a dialogue with those two firms? Is that the question, Commissioner?
COMMISSIONER CAREY: Well, I'd like you to include the rest of the words, too. A constructive dialogue on how a proposed rule could be improved in their view. I mean, they represent -- I believe these are accurate numbers, over 50 percent of the employees of the Big Five.
MR. MELANCON: I don't know that I represent over 50 percent of them, 50 percent I think was the number --
COMMISSIONER CAREY: No, that PWC and E&Y collectively represent over 50 percent of the either revenues or employees of the Big Five.
MR. MELANCON: I don't know that. I mean, that sounds about right or reasonable based on just general knowledge. I can't attest to that But --
Do I have a problem with the Commission dialoging with anybody as it relates to this rule? No. I don't think that that's a problem whatsoever. We have dialogued and we will continue to dialogue, and obviously you have many interests --
COMMISSIONER UNGER: You just started dialoging with us.
MR. MELANCON: Many interests that you have to take into consideration. And I think I expressed our desire to do that. I think I expressed our concerns as it relates to theexisting rule and where those need to be improved upon or addressed and what the concerns or the outcomes could be based on what they exist.
So, the fact that you would dialogue with a firm or a combination of firms, I certainly would hope that if something were adopted it would be acceptable to the profession as a whole. That would be my goal, as I'm sure that would be your goal.
MR. BECKER: Well, I just want to make sure I understand your views about extending the comment period and why. Your organization is going to put in a comment on Monday. Is that correct?
MR. MELANCON: That's correct.
COMMISSIONER CAREY: And that's the last day of the comment period. Is that correct?
MR. MELANCON: That's correct.
COMMISSIONER CAREY: And I take it it's going to be a substantial piece of work.
MR. MELANCON: That's correct. You wouldn't expect anything less, would you.
MR. BECKER: No, I wouldn't. And knowing all the lawyers who are working on it, I certainly hope that they are charging you all that money for a substantial piece of work.
Is it your view that simply because a substantial comment comes in at the end of a comment period that thatmeans the comment period should be extended so that everyone else can look at it?
MR. MELANCON: Our view is that you've had a series of hearings, you've had a lot of different pieces of input, I think that for us in general to give you a more thorough discourse on things that have been said or commented on, that we would need the ability to access the record, et cetera, and it is difficult from that timeframe. I think that is unreasonable.
MR. BECKER: Well, what about folks who presumably will have views about some of the things that you said?
MR. MELANCON: I think that they will be able to access the record from our testimony and they would certainly be able to comment on that and I would say they will probably have difficulty in doing that between now and Monday.
MR. BECKER: Well, no, I'm talking about the comments that you file on Monday. What I'm trying to do, I'm trying to figure out --
MR. MELANCON: Well, there's a difference --
MR. BECKER: Excuse me. Figure out how you end a comment period without this sort of having it turn into a perpetual motion machine.
MR. MELANCON: Right.
MR. BECKER: You guys are going to file comments on Monday, people are going to want to comment on that. You'regoing to want to comment on their comments and they're going to want to comment on those comments. Isn't there -- by their nature, don't comment periods end?
MR. MELANCON: Yes. They do.
MR. BECKER: Thank you.
COMMISSIONER UNGER: Thank God.
You know, my colleague raised an interesting issue or question, rather, and that is who does the AICPA represent? Because two of the firms specifically said yesterday you did not represent their views, two of the five substantial -- top five, whatever you call yourselves, the Big Five. And then we had a number of smaller firms say that you did not represent their views and other assorted witnesses who will be reflected in the record.
So I was wondering how do you reconcile the differing views of your membership, what does it take for you to represent your membership and what are the mechanics behind that?
MR. MELANCON: Well, first off, you will in any issue, with 340,000 members, you will have people disagree, regardless of what position is taken and that's certainly understandable. And I commented to you on that at the last hearing.
I think that in addition to that, you should understand that we have very sophisticated processes orcommittee structures where people are involved that represent certain constituencies and they express their views and we consider those views.
I think it's also important to understand the AICPA as a professional organization has to take issues from time to time that are not commensurate with all of its members. That is a requirement that we have.
For instance, when we issue auditing standards and when we issue peer review standards or ethical standards, we have comment periods. Several of our members will object violently to some of the provisions that are proposed, but in the end, in order to protect the public, in order to do the job that we are set out to do, we have to take positions that some may not agree with. So we have processes in those cases where people comment and we go in a different direction.
You asked me earlier today about ethics investigations. We have certainly taken positions against members in ethics investigations, in some matters, filing suit against them because of non-cooperation or whatever the case may be.
And so all of those things are factors and, as a professional organization, we have to take positions that not necessarily every member of the profession agrees with, but that we believe are in the best interests of the profession.
Our board has discussed this issue as well and iscertainly onboard, to use that word, from the standpoint of, as I had said in my testimony, as to the positions that have been -- and I think, Commissioner Unger, I think it's important to understand that when you believe something is right, you have a leadership position or, in some cases, when you believe something is wrong, you have a leadership responsibility to be able to articulate that, and that's part of the process.
COMMISSIONER UNGER: Right. What I just want to have is clear in my mind who you do represent because we've had people --
MR. MELANCON: We have 340,000 members and 46,000 firms.
COMMISSIONER UNGER: No, I understand that, but how you arrived at this point of consensus, whatever it may be, and who --
MR. MELANCON: We had input from various segments. We have -- Mr. Monk represents 6800 firms. We have the committee of managing partners that represent the 75 firms that are next in size below the Big Five. They have provided input.
CHAIRMAN LEVITT: It is rather extraordinary, though, for the head of a group such as this to affiliate with the views of perhaps less than 50 percent of his members and endure a sharp difference of organizations representingover 50 percent. It seems to me that all of our interests would be better served if you were able to harmonize those views, rather than the kind of strident attack that was made upon them yesterday.
MR. MELANCON: I did not make any strident attack on their views and I said in my testimony today that we support their ability to operate under different structures and we welcome evaluating the proposal that they made.
In addition to that, there are times that we have to disagree with segments of our profession in order to do what's right for the profession.
COMMISSIONER UNGER: Right, but --
MR. MELANCON: But I agree with you, Chairman Levitt, that the best result is, as I think it is in virtually every case, would be harmony, not opposition from the standpoint of a professional organization. That is the ideal and we share that ideal.
MR. ELLIOTT: Just as a point of clarification, the two firms mentioned are not 50 percent or more of our members. It's probably about 6 percent of our members.
COMMISSIONER HUNT: I think he was referring to 50 percent of the audit employees are employees of the Big Five firms.
MR. MELANCON: I think that's what he said.
MR. ELLIOTT: Right.
COMMISSIONER UNGER: I guess I'm just struck by the fact having worked on trying to reach a compromise for many years of my life how the trade group for the industry could really make this conversation into an argument, and how it could be so divisive, largely, no offense, as the result of the way you've taken upon this issue by, as I said last time, and I don't want to repeat that, because, as I said, our relationship has improved so much that I don't want to damage it, but I'm kind of hurt by it. You know, you never did come in and talk to us, and you never did have a dialogue with us and, you know, your colleagues have and you have taken 50 percent of the views of the top five, or however you want to characterize it, and really sort of attacked the agency for a proposal that you agree with the goals, and if you agree with the goals, why can't we sit down and say, well, what's our point of commonality, how can we -- you tell us how to better achieve these goals, rather than just saying it's not enough time. It's never going to be enough time.
I think you can make the best use of that time, though, by being constructive and not destructive in approaching the goal and reaching the goal.
COMMISSIONER CAREY: I do want to give credit where it's due, when I made the assertion that I had not heard from the AICPA, within five minutes of that remark a letter came across my fax machine, so your tardiness was quickly erased.
MR. MELANCON: Commissioner Ungar, I think that --I would hope you understand that we have very sincere -- very sincere -- and very serious concerns about the impact of the rule as it's currently proposed on the long-term ability of the profession to serve its mission and to perform quality audits in the public interest. And we have had very sincere frustrations on that point. And we can talk about process points, or we can talk about why you feel the way you do or I might feel the way I do, and I think that's a very important dialogue. But I think the most important thing is to understand that our objections are very sincere.
I think that they are in the spirit of the same goal as you describe, because we are concerned about that, and that for us to have those concerns, there is nothing inherently wrong with that. And it is my hope, as it is your hope, which you just articulated, which I appreciate, that we can dialogue or work together or however you want to describe it, to find something that meets those objectives that I laid out in my testimony.
COMMISSIONER UNGER: I again want to compliment you for your testimony. I think you do have some very valid concerns and you raise some very interesting points that I believe I am sensitive to, but now I am even more so. So I appreciate that.
MR. MELANCON: Thank you.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Our chief economist, Mark Ready, has several questions.
Mark?
MR. READY: Yes. I just wanted to follow up on the -- I think it was mostly the testimony of Mr. Melancon regarding the distinction that you are making between what you call anecdotal evidence and sort of a more rigorous statistical test of association between management consulting fees and, say, audit failures. And the reason I want to ask this question is it strikes me that we actually have a situation here where it doesn't take very many observations to get what would be called a strong statistical relationship.
And the reason I say that is while we don't have available to the SEC information about management consulting fees by firm, you have that in your SECPS database, we do have information in summary form that tells us that only 2 or 3 percent or so of the SEC audit clients also receive management consulting services that are of an amount equal or greater than their audit fees.
So if you wanted to test your assertion, basically the standard form would be to say let's set up what's called a null hypothesis, which is that there is no relationship between the provision of management consulting fees and theprobability of an audit failure, and then the way that you would test that is take a look at the audit failures and see do they tend to have unusually large audit fees.
Now, a lot of people aren't that familiar with statistical tests and so I think it's really helpful to think of an analogy everyone understands, which is roulette. You know, roulette is a wheel with 36 numbers, a zero and a double zero, so there's 38 slots in a roulette wheel. Any one slot has about a little under 3 percent chance of appearing.
Okay, now, if you were to spin that wheel five times in a row and each time the double zero came up, your intuition would tell you something wrong's with that wheel and the math would back you up. That would be incredibly unlikely.
Now, in the same sense, if you were to look at five audit failures and ask did those firms have consulting fees provided by the auditor greater than the audit fees, which in general is only a 2 percent probability, and if all five in fact did, you have essentially the same kind of result, five double zeros in a row.
So it seems to me, one, it doesn't take a large number of observances of this correlation before you have strong statistical evidence, and the other thing that strikes me is that you and the AICPA do have the data by firm and I know that for competitive reasons you don't want to provide it to the SEC, and we've asked for it several times and I understand your reason for not giving it to us, but you also certainly have the ability to run that test. You say that you look at audit failures, so you know what the set of audit failures is.
I wonder have you done that kind of analysis and, if not, why wouldn't you just ask -- I know Rick Antle has the data, you have employed him to do other studies, why not just ask him to do it? It's a very simple statistical test.
MR. MELANCON: Well, I think you would also argue, though, that you would have to look at those roulette wheels that you would spin. First off, you made your analysis on the basis of the fact of a certain percentage of non-audit services to audit fee. The proposed rule has a prohibition on non-audit fees, non-audit services, in virtually all instances, regardless of its size, and so therefore you would have to look at a population that was much greater than just the population that you just described.
MR. READY: Yes, I agree. I thought you said --I'm sorry, and maybe you were saying -- I was misquoting you. Did you say that there is no evidence of any association between the provision of management consulting services and audit failures?
MR. MELANCON: We believe that the duty that isnecessary to show the evidence along those lines has not been demonstrated. And, quite frankly, if you or any vehicle from the SEC wants to provide that analysis that you described is so easily attainable and obviously allow us the time to comment on the appropriateness of that analysis given the whole magnitude of the rule, we'll be glad to have that.
MR. READY: But you won't give us the data to do it. That's the problem.
MR. ELLIOTT: Aside from --
MR. READY: And the problem -- you know, then the obvious step from that is, if such analysis is a precursor to any rulemaking and is within your ability to preclude us from getting the data for that analysis, then by definition by not providing us the data, you automatically block the rulemaking. I don't think the Commission will accept that.
MR. MELANCON: I don't think that we have -- first off, I'm not certain that we have all the data that you just described, number one. I think it probably is resident in each individual firm, so that's point number one.
Point number two, the question would be in your roulette analogy, if in fact that you found that there was something wrong with that roulette wheel because it came up double zero five times in a row, I don't think that you would conclude from that that you would shut down the entire casino.
MR. READY: That's right. You would merely reject the hypothesis that there was no relationship.
MR. ELLIOTT: I would like to comment on that, if I may. The test that you are proposing is one that is one-sided. The proposition that we are bringing to you is that the availability of the talents and the non-audit services that deepen the understanding of the auditor actually have positive impacts. And so if you wanted to set up a fair test, you would be looking at the correlation of non-audit services to successes and failures. And if, for example, you found out of a thousand cases there was no effect in 500 cases, in 450 cases the audit was better and in 50 cases it was worse, the 50 cases, I'm making these numbers up, just as you made the numbers up, it seems to me that you would in a balanced test, in a fair test, you would want to know both the plus and the minus. And so I would object on a matter of principal to having a one-sided test on this type of question.
CHAIRMAN LEVITT: I don't think we need to pursue this any further. Thank you.
Does our chief accountant have any questions?
MR. TURNER: A couple of comments, a couple of questions.
Harold, you made some points about the affiliate issue and this relates to the smaller firms and I think weare very interested in those comments and I certainly encourage you to give us your thoughts on that because I think we're open to ideas there and certainly want to pursue that, so I would encourage you to do that.
MR. MONK: Thank you, Lynn.
MR. TURNER: Bob, with respect to the new financial reporting model, you and I were both on a panel together at Creighton last year with a bunch of students, and I think we do share as it relates to financial reporting, some common ideas there. There are some places where we probably disagree. But I think that the Chairman has clearly noted the need to make some progress in this area when he called for the Garten committee last October and, as he indicated perhaps the process has moved too slowly in this area. So we're certainly looking forward to the Garten committee report and what has come out of the Chairman's call to try to, in fact, move this along and perhaps move along further.
If you have any particular ideas as to the specifics that you would put into a concept release, I would encourage you to put those down on a piece of paper and send them in to us. I would be very much interested in not only seeing those, but having an opportunity to meet with you and to discuss those with you as well.
MR. ELLIOTT: I will gladly do that, Mr. Turner.
MR. TURNER: There's been a lot of discussion aboutISB-1 and let the audit committee process work and let the ISB process work.
Shortly after ISB-1 came out, Chairman Allen wrote a letter in which he said that as auditors interpret this they need to look at it from a reasonable investor's perspective rather than just their own perspective and certainly we've seen a number of instances where actual violations of the independence rules did occur and the audit firms had not taken it to the audit committee.
Would you agree with Chairman Allen's letter and the fact that ISB-1, if people are going to let it work, has to be viewed from the perspective of the investor rather than just the auditor?
MR. MELANCON: I vaguely remember the letter. Your recollection of it has triggered the letter, so I don't remember all the aspects of the letter, but just from a general principle standpoint, clearly, the reasonable investor notion is one that the Commission certainly has a concern about, as do we. However, you cannot solely have a second guess capability. It's a very difficult position to put anybody in.
You know, how do you evaluate whether their evaluation of reasonable investor perspective was sufficient? I mean, there's a lot of softness to that, Mr. Turner, as you well know. As a goal or as an objective, it's certainlylaudable, but from a practical implementation standpoint, it certainly has certain retroactive problems.
That is not to say, however, that -- and I would agree with Chairman Allen in this case that the auditor should make extreme efforts to be open and communicative with the audit committee about all the issues that the audit committee should be viewing and should make an attempt to consider things like individual investors. I think it's just very difficult to put any individual, regardless of their profession or what they do, in a position of being secondguessed based on a subjective evaluation after the fact. And I think you recognize some of the difficulties with that as well.
MR. TURNER: But, Barry, if they had actually violated an existing rule that was out there in black and white, would you think that's one that should go to the audit committee?
MR. MELANCON: I think if they are in violation of a black and white rule, first off, if that's the case, they're probably not independent, as you have in your hypothesis, so that's obviously a problem. But, secondarily, if it is something that they believe is a violation of a black and white rule but is -- I don't know, if you're implying they're making a significance issue or something along those lines, it certainly should be discussed with theaudit committee because they're in technical violation. That's your hypothesis. So the concept is to discuss those matters that the auditor considered in reaching a conclusion that he or she was independent. If they violated a rule, then, you know, it's almost -- they're not even at that point, you know, they aren't independent.
MR. TURNER: I think Bob made the comment about this being an interesting job and I would agree with you, Bob. In all of my years as being in the audit profession, I would echo what everyone has said at the table, the Chairman and you guys as well, that I think it's a phenomenal profession and it's one of the most attractive jobs you could get to.
MR. ELLIOTT: Could I send you out to talk to the students?
MR. TURNER: I've actually been out to the students, okay?
MR. ELLIOTT: I know. You and I have worked together.
MR. TURNER: I went to Creighton, I've gone to a number of other universities. They don't always tell me the same thing you guys tell me, but I have tried to go out to outreach and get them to come in because I think it's a phenomenal profession. But one thing, I do have an 18-year-old son, so I know what you're talking about 18-year-oldswhen you talk about perhaps they have a different perspective today than what they had 20 years ago. One thing, though, that has not changed, I've noticed, is their affinity for money. And along those lines, you talk about the difficulties with recruiting and enrollment. A number of colleges within the schools have dropped even some of the interesting ones like engineering, but one thing that is also interesting as I look at the statistics is if you go back about ten years ago, accounting was one of the higher paid positions within the college of business and certainly the engineers made more than what we did at that point in time, but over the last ten years, that gap has spread significantly to where now there is a sizeable gap and the only people coming out of the business colleges that get paid less than we do is the marketing people in the first year offers.
So when my kids read the newspaper and see that the lawyers are trying to address the dot com issue that we all talk about and they see the 125,000, they say law school doesn't look all that bad. But at the same time, they turn around and see what accountants are getting paid and what the firms are investing in their auditors versus what those same firms are investing in the consultants and they notice that that same kid can get a lot more money and that in fact the spread has grown exponentially over the last ten years.
Lawyers are trying to deal with it with cash. Do you have any idea of what the accounting profession is trying to address that with, to try to narrow what that gap is? Because that's a phenomenal gap and it certainly has an impact on where kids will go.
MR. ELLIOTT: It used to be that we did pay better relative to other opportunities as you point out, Mr. Turner, and one of the reasons for that was that the perceived value of the audit function was much higher. And that, I think, is for basically two reasons. One is that corporate America in general didn't have the accounting talent on board in order to do a good job and create GAAP financial statements and they had to look to the outside auditor to do that. But over the last generation, literally hundreds of thousands of people have left public practice and gone into business and industry and the typical large company today has excellent financial accounting talent. They no longer need the auditor to come in and help them clean up the mess and prepare a good set of financial statements. So that's one problem with value.
Another problem is the one I mentioned earlier, a continuing growth of the gap between the market value and the accounting values, if you want to call them that, in the balance sheet. And what that means is that clients and investors don't see as much value in the audit relative toother sources of information today as they did a generation ago. And if they don't see much value, then people aren't willing to pay fees that permit auditing firms to, in effect, pay as much as engineers or lawyers.
To me, the answer to the problem, and it's not because accountants or auditors are a bunch of cheap people who just don't pay going rate. They can't pay any more than the value of the services that they can collect in the marketplace.
To me, the solution to the problem is to increase the value of the service. The audit is crucially important to the capital markets. It has been and it always will be. But it has to be refreshed and reenergized in the way that I was talking about earlier and, if that happens, if the types of information that are prepared and audited are more diagnostic to investors and create a larger market share of the useful information, the high quality information that they get, then the perceived value of the function will go up, we will be able to collect higher fees and that will pass through into the ability to pay the young students to come into our profession.
So when you look at it from an economic perspective, I don't think you can focus just on salaries. You have to focus on the value function and how that can be increased.
MR. TURNER: But, Bob, the accounting firms today have consulting, have all the services, have a phenomenal breadth of services that we didn't even have ten years ago. And, as we developed these and expanded the services that we've provided, as we are expanding them, they are growing exponentially, rather than seeing that tie into what we did with the salaries of the individuals that were coming into the audit practice or chose to go there, which again I think it's probably the best training program in business period, we didn't turn around and invest in those people and put money into them, even as we grew. So I'm not sure that even if we grow and go where you're talking about, we'll see the investment being made in the audit side because certainly the last ten years' track record has shown that when we did exactly what you're talking about with the business, we didn't put it in the kids.
MR. ELLIOTT: That was in another part of the business. That was in the consulting part of the business, which is perceived by clients as higher value.
We're not inventing this marketplace, we're responding to it.
MR. TURNER: Barry, when the AICPA decided to take its position, did it consult with PWC or E&Y before they took that position?
MR. MELANCON: We have ongoing dialogue withrepresentatives of the firms, yes.
MR. TURNER: So you did consult with them on the position you were taking prior --
MR. MELANCON: We have ongoing dialogue with representatives of the firms in various areas. They knew clearly what position -- where the firms were and where the institute was.
MR. TURNER: Mark raised some questions on economics. I would note that in the rule proposal there are a number of questions in the area of economics and we would be most appreciative if you could respond to those questions because I think a number of those responses would be extremely helpful to us.
One last question for Harold.
When the Commission adopted -- well, in my own state, in the state of Colorado, the Commission has some rules on its books related to independence that we don't have on the books in Colorado and certainly for the private companies out there there is the difference in the rules between what is for public and what is for private today.
And when the Commission went in and adopted, for example, Rule 102(e) here, we didn't adopt that in our state.
MR. MONK: Right.
MR. TURNER: Does Florida also have some differences?
MR. MONK: Yes, Florida does have some differences. Actually, Florida is fairly liberal in some of their rules. But what I think concerns me, especially after the hearings and some of the comments that have come forward as a result of this process, was the comment from the NASBA representatives that said that after this process is finished that they would anticipate seeing similar rules adopted.
Now, NASBA clearly has direct access to all of the state boards and if the state boards adopted this same rule, I could see significant harm being done to firms my size, not just from the standpoint of SEC clients, because most of them don't have many SEC clients, but if the same rules applied to all of their audit clients, they would have to make a choice between types of work that they want to do.
CHAIRMAN LEVITT: There are any number of federal laws, I could cite many of them, that have not been mirrored by state laws because they're totally inappropriate. And I have stated very clearly what my position in that regard was and I think Dennis Spackman's words about states' rights in this issue are pretty plain, that the notion that whatever the Commission does will be mirrored by the states, I think, is overstated.
MR. MONK: Well, I appreciate your comments and obviously I think you share that same concern and I appreciate that.
I think you also need to look at even the smaller public companies as well as being a little bit different. I know in some areas there are no Big Five firms available to serve some of these smaller public companies without the expense of bringing in people from a sizeable distance and to have a local firm that could not provide any other services other than audit to those companies that need some of these services --
CHAIRMAN LEVITT: Well, I don't think the proposal calls for that draconian response. Most of the prohibitions that are mentioned in the proposal are your own prohibitions, so I think we should try to restrict ourselves from drawing the lines at the extreme.
I think we have exhausted you and ourselves and we greatly appreciate the spirit and the openness. It ain't easy and I think you know that, and we know it and we'll do the best we can to work with you as constructively as possible.
MR. MELANCON: Thank you.
MR. ELLIOTT: Thank you very much for the opportunity to come back again today.
COMMISSIONER UNGER: Thank you.
Panel 2
CHAIRMAN LEVITT: The next witness is Steve Butler, the chairman of KPMG.
Steve, all I can ask of you, since we are way overtime, is if you would try to be as concise as possible.
MR. BUTLER: I'll try to be, Mr. Chairman.
CHAIRMAN LEVITT: Thank you.
MR. BUTLER: First of all, Mr. Chairman and Commissioners, I would like to introduce myself. I am Stephen Butler and I am chairman and CEO of KPMG and, as you may know, we are a worldwide audit, tax and consulting firm. We have approximately 108,000 people located in 159 different countries around the world.
I would really like to begin by thanking the Commission for making the additional time available for me to be here to speak with you because I believe there is no question facing the accounting profession today that is more grave than the matter before us.
The outcome of this issue, I am convinced, will set the course for the continued health or the decline of the accounting profession and the public trust that we guard.
I have spent my entire business career in the accounting profession. Right after graduating from college, I joined the audit practice of KPMG in Kansas City, Missouri and I have been with this firm ever since.
My background and my training and my understanding of the role of the accounting profession are all those of an auditor. My position in the firm has evolved as I have moved from Kansas City to Memphis to Jacksonville, to Amsterdam andultimately to New York and rose to serve as the worldwide chairman of KPMG. But the values and the visions that I bring to work every day were molded by the auditor training I received starting 30 years ago in Kansas City.
I was taught that quality, objectivity and integrity are the hallmarks of our business. I was taught that when you sign your name to a public filing you are committing your entire firm to your best independent judgment. I learned that when you issued an opinion you are putting your partners' capital on the line. I learned there is no immediate gain that can ever be worth compromising your independence because ultimately our reputation is our firm's only asset.
I have heard it said in the public discussion of the rulemaking that my profession thinks appearance doesn't matter. This is certainly not the case. When your reputation is your sole asset, you bet appearance matters. You and I agree on that.
I think we also agree that it is the appearance to investors that counts. It is the investors we are both committed to protect.
Appearance is important because and only because investors must have confidence in the soundness of the capital markets and that of course includes confidence in the integrity of the financial reporting system and theindependence of the auditor.
Investor confidence isn't a matter of arbitrary opinion. It isn't just a hunch. Investors, after all, are putting their own hard earned money at risk. They don't base those decisions on untested impressions. They want to know the facts.
So I suggest that today's high confidence in our capital markets is based on an extremely rigorous self-regulatory system of audit quality, the fact of firm peer review, second partner review and a highly developed professional disciplinary mechanism, the fact of strenuous requirements for audit training and continuing education, to name only a few.
It is also a fact that disincentives to compromised auditor objectivity are enormous, a potentially career ending event for the individual and potential liability to the firm far exceeding any one-time fee.
The fact is that this profession, including KPMG, has been providing non-audit services to audit clients for over a century without incident and to the great benefit of our clients and the economy.
The most important fact of all is our profession has a record of performance excellence that other businesses can only dream of, an audit failure of less than two out of 10,0000.
Of course, the average investor probably isn't familiar with the elaborate architecture of auditor independence in this country, but they do know that America's capital markets are the best, the deepest, richest, most liquid capital markets in the world. And it is no coincidence that the auditing profession in the United States is second to none.
The best available survey data supports the conclusion that investors do not perceive an appearance problem with the provision of non-audit services. Phase I of the Earnscliffe study found a positive view of auditors and the way in which they perform their jobs. If there was a concern among the stakeholders about the provision of non-audit services, it was mostly that repeated public criticism would create an appearance problem. And I would like to quote that report: "Most participants, with the notable exception of regulators, felt their interests would be poorly served by a high-profile, high-tension debate on these issues."
Phase II of the Earnscliffe study reinforced these findings. Based on extensive focus group discussions with individual investors, the study found with respect to non-audit services that investors were saying that they felt that the level of risk was modest, the track record was pretty good, the checks and balances seemed to be functioningreasonably well.
Bruce Anderson, the leader of the Earnscliffe study, explained, and I quote, "there is no groundswell of demand by either individual investors or executives for the prohibition-type approach favored by the SEC."
These results are consistent with real-world experience. The truest test of what somebody believes is how they behave and investor behavior indicates they are not troubled by the appearance of audit firms providing non-audit services.
There is no evidence that investors impose a higher cost of capital on companies that choose their auditors for other services. The insurance markets do not assign a greater risk to accounting firms by virtue of their providing non-audit services to their audit clients.
The Commission has heard from a couple of institutional investors that they chose not to use their auditors for other advice, yet none of these organizations indicated that they steer away from investing their funds in companies that use their auditors for other advice. Clearly, they saw no compromise of their fiduciary duty.
While the appearance to investors of sound capital markets is crucial, appearance itself is a faulty basis for public policy. The public interest demands that law and regulation rest on solid evidence, sound research and acareful study of cost and benefits.
Since perceptions are by their nature shifting, charting public policy according to appearance is like setting a navigational course against a moving object. You won't get where you want to go.
If appearance alone is the test for regulating human activity, what is and is not permissible behavior will change as each public officeholder comes and goes. With neither consistent principles nor factual evidence to rely on, economic actors will be deprived of predictability, a condition necessary to stable markets.
And clearly if an appearance standard for audit independence is adopted, I will have no rational basis for planning KPMG's business, no way of knowing what services might be permitted or prohibited at any given time.
Mere appearance as the standard for regulation will inevitably yield unpredictable and unintended consequences. If you think about it, the logical consequence of a true appearance standard for auditor independence would be a government takeover of the accounting profession. After all, the most blatant affront to appearance is not that we provide complementary services, but that clients pay us for the audit itself.
Indeed, Congress considered and rejected the possibility of government-conducted audits when it wrote thesecurity law. Perhaps that is why Congress in its wisdom set independence in fact as the sole standard for auditor independence.
An appearance standard is a stern enforcer of the law of unintended consequences and that law is hard at work in this rulemaking proposal. Let me give you just a couple of examples.
IBM is not an audit client of KPMG, but if we had a minor equity investment or other business relationship with IBM and IBM provided a prohibited consulting service to a KPMG client, then under this proposal IBM would be an affiliate of KPMG, so we would have to either sell our investment, eliminate the business relationship or resign those clients.
In another area, the proposal's prohibition on advocacy could preclude my partners from serving as fact witnesses about their own audit engagements and could even prevent the auditor from explaining or defending a client's accounting treatment before the Commission staff.
These examples are merely illustrative. The rulemaking proposal is fairly riddled with head-scratchers like these. Any number of them may be fixable through drafting changes, but there is one unintended consequence of the rulemaking as a whole that drafting cannot fix and it is the most devastating.
It is that this regulation in its premise and basic thrust would actually weaken, rather than strengthen, the quality of auditing and investor protection.
Speaking on my behalf at your hearing last week, my partner John Guinan highlighted how this rule would inhibit us from attracting the talent and innovating the solutions necessary to perform quality audits in the 21st century. I would like to amplify on this point for a moment because this is the heart of our concern about this rulemaking.
The immutable goal of the independent audit is to protect the investing public, but as circumstances change, the means of achieving the goal must change with them and circumstances have changed dramatically in the almost 70 years since Congress enacted the audit requirement.
At that time, most companies were industrial, most assets were tangible, most trades were domestic and most information relevant to investor decisions was captured within the four corners of a financial statement, a statement printed on paper and filed at the end of a quarter or the year. The average investor wasn't an average citizen. Lots of people didn't own telephones. The television hadn't been invented. The Internet was not imaginable.
Today, the disparity between the book value and the market value of a new economy company proves that investors are basing their decisions primarily on information outsidethe financial statement. They seek information about intangible assets like research and development and non-financial statement measures like same-store sales or frequency of website hits and they have no interest in information three months or a year after the fact. They are getting it real time over the Internet, which they use to place trades around the globe without intermediaries.
In this radically different environment, we need to rethink the business reporting and investor information model. If we as auditors are to meet our duty to protect investors, we need to lend assurance to the integrity of information that investors are actually using.
We need to be able to provide the assurance continuously, online, in real time. We need to attest not only to the quality of information companies disclose, but also the reliability of the systems that generate it.
We cannot get there -- we simply cannot get there -- with technology designed for scouring P&L statements and skill sets of traditional accounting disciplines alone.
The fundamental flaw of this rulemaking besides its reliance on appearance is that it is firmly grounded in yesterday's financial reporting model. By locking audit firms into that model, this rule would ensure that we never attract the talent or develop the technologies necessary to provide true investor protection in the information economy.
I spend more time than I'd like to admit in the Silicon Valley and other places like that trying to convince my brightest professionals to stay with KPMG rather than jump to a new economy company rich with stock options. If this rule were in place, I may as well not even begin those discussions.
The best and the brightest minds, looking at multiple opportunities as solution providers to leading edge businesses would view auditing firms as a stagnant professional environment, little more than an extension of the regulatory enforcement apparatus. And, candidly, I don't know how I'd argue with them, because I know I won't work in that environment.
Considering the absence of a crisis of investor confidence in the audit, and, indeed, much evidence to the contrary, and considering the risk of doing real harm to investor protection, the Commission's headlong march to so drastic a measure is deeply troubling.
I will not recount here the numerous process objections that other witnesses have compellingly set forth. I will simply add my voice to the many commentors, small business people, CFOs, legislators, colleagues in the accounting profession and others, who have called upon the Commission to slow down and consider the consequences of its present course.
The rush to regulate is all the more baffling in view of requirements only recently put in place to address these concerns, measured, market-oriented policies. The Commission's rulemaking not only fails to afford these policies a chance to work, but runs contrary to their spirit.
In doing so, the rulemaking seems hostile to three important considerations, each of which I will touch on briefly. They are the role of the audit committee, the role of the Independence Standards Board, and current regulatory trends in managing economic risk.
Just last December, the Commission adopted new proxy statement requirements to expand audit committee disclosures regarding communications with auditors on independence matters. This approach is consistent with this Commission's longstanding and highly laudable emphasis on empowerment of audit committees.
As you yourself have often said, Mr. Levitt, audit committees are the most reliable guardians of the public interest. Yet before we have even seen the first round of proxies under this requirement, the Commission is proposing a rule that would remove audit committee discretion and substitute regulatory prohibitions for directors' judgment.
In a similar vein, ISB Standard No. 1 requires enhanced communication between auditors and audit committees regarding any relationship that might compromiseindependence.
As with the proxy requirements, this is geared towards transparency, rather than prohibition. And, like the proxy requirements, it had not had time to bear fruit before the Commission proposed its contradictory rulemaking.
As a member of the Independence Standards Board, I am concerned that the Commission's actions are preempting the mission of the ISB. Central to this mission is crafting a conceptual framework for auditor independence which would establish overarching principles by which specific instances of independence would be judged. Such a framework has been lacking for too long and its absence is sorely felt in the Commission's rulemaking proposal.
According to the Commission's statement of policy known as FRR 50, not three years old, the central mission of the ISB is to establish independence standards. Indeed, the Commission declared, and I quote, "It will consider principles, standards, interpretations and practices established or issued by the ISB as having substantial authoritative support for the resolution of auditor independence issues."
In light of this recent history, I was puzzled by reports from the Commission's hearing last week that Chairman Levitt declared that the Commission had never delegated, and would never delegate, responsibility for independencestandards.
While I appreciate that as a legal matter the SEC must retain ultimate statutory authority in this area, your comments appear to run directly contrary to the terms under which the ISB was established. They leave me puzzled, as I'm sure they do other members of the ISB, as to what role, if any, the ISB has going forward.
The spirit of the new proxy requirements and ISB Standard No. 1 is consistent with current worldwide trends in regulatory process policy generally and auditor independence requirements specifically. This trend is towards a system of assessing risk and establishing safeguards commensurate with those risks. If the risk is one of appearance, as the Commission perceives it to be in the case of non-audit services, then the safeguard directly responsive to that risk is disclosure. In other words, it better serves the public interest and the free market to open the door to sunshine than to throw up barriers to economic activity. Yet the Commission's proposal runs exactly in the opposite direction. It is the rough equivalent of reenacting Glass-Steagall separations, long after the marketplace has rendered that regulatory model obsolete.
These divergent approaches to regulation begin with different assumptions about the conducts and motives of those regulated. The trend elsewhere in the western world istowards a principles-based approach to auditor independence, focused on threats and safeguards. This approach assumes that the men and women conducting audits are by and large doing right, so if risks are made evident to them, they will take the steps necessary to avoid doing harm.
The Commission's proposal, by contrast, adopts a command and control approach based on rules and prohibitions. This assumes that auditors fundamentally are inclined to do wrong, to violate their responsibilities to the public interest for personal gain unless concrete barriers and such other conduct are imposed to prevent it.
In case I am sounding like an overly sensitive auditor, I would refer again to the Earnscliffe study, which concluded that even though investors like the idea of disclosure, they, and I quote, "generally trusted the stakeholders involved and didn't want to set in place cumbersome regulations that implied a higher degree of distrust."
Frankly, I believe that my profession's 100-year record of demonstrated service to the public interest deserves the presumption of honorable intent.
This brings me to my final observation. A fair degree of concern has been expressed lately about the deteriorating relationship between the accounting profession and the Commission. I share that concern. Throughout myprofessional life, the accounting profession and the SEC enjoyed a tremendously constructive relationship. The history of our profession is abundantly clear that when the Commission or any other body made a recommendation for a way in which we could improve what we do, we seized it. Very often, the profession has taken the lead in proposing improvements through high level panels of its own. And whenever the SEC or the GAO or Congress has offered up ways to improve the financial reporting process or audit quality, we have responded. We have done so over and over again.
So it is unusual, if not unprecedented, that the profession should adopt a posture adverse to the proposal by the SEC. I personally do not do it lightly or happily. It certainly isn't in any company's best interest to be at odds with the SEC. This has nothing to do with personality. It is not about winning or losing. The fact that the accounting profession has chosen to oppose this rulemaking should be seen purely as a measure of how fundamentally harmful we believe it will be, to our business, yes, but more importantly to the investing public.
The situation is all the more lamentable in view of the larger challenges we should and could be working on together. While we are arguing over auditor independence rules, arcane stuff to most of the world, we are letting slip the big picture.
As I discussed earlier, the basic model of investor protection, of corporate reporting and third-party review is obsolete. There is much work to be done to transform this model into a global, digital economy. Meeting this challenge will require the best thinking and sustained efforts of all interested parties, investors, companies, standards setters, the accounting profession, the SEC and other public policymakers.
As a businessman and as an auditor who loves my profession and someone who takes seriously that profession's duty to the investing public, this is what I worry about every day.
Mr. Chairman and members of the Commission, there is no greater challenge to our common public obligation than keeping the financial reporting system sound and vibrant for the 21st century. KPMG and I believe the rest of the accounting profession are ready to join with you in this work immediately.
CHAIRMAN LEVITT: Thank you, Mr. Butler.
In the interests of time, I will be brief in responding to your comments.
I, too, am concerned about the public nature of a dialogue which I think can't help the public perception of the industry. I think you probably agree with that.
I would ask you a question similar to that which Iasked Mr. Melancon and that is if you had the option of developing a rule, any rule, or delaying this process, having more public hearings, greater dialogue over the next year, can you conceive of any rule that would embrace an industry consensus as opposed to the alternative of a more prolonged public discussion or would you prefer the more prolonged procedure?
MR. BUTLER: Let me talk about -- Without getting into the length of time involved in this, Mr. Chairman, I would say that I have a very, very strong preference that auditor independence issues be dealt with in the private sector, not at the government level, that I believe the Independence Standards Board, which you were a very strong supporter in getting started, is the right venue to deal with auditor independence issues, dealing with a strong conceptual background, based on principles, based upon the assessment of risk, and the evaluation of counter moves that adequately take care of that risk. I think that is the proper forum to resolve this debate.
CHAIRMAN LEVITT: Am I correct in my recollection about the Independence Standards Board that you were very much opposed to going ahead with that during its formative period?
MR. BUTLER: In the early part of the discussions, Chairman Levitt, there were issues and I can't remember thespecifics of them that I did not agree with in the constitution and construct of the Independence Standards Board. Having been a functioning member of that group for three years now, I have a much different view and maybe my view has evolved beyond where it was four or five years ago when we first started discussing it, but I do believe it is the right forum today to address these issues.
CHAIRMAN LEVITT: I'm glad there's some flexibility. Do you share the feeling of three of your colleagues that it might be well to add another public member to the board to give the preponderance or the majority membership to the public members?
MR. BUTLER: I may have a different view there, Mr. Chairman. Again, I mentioned that I've had the opportunity to serve on that board for three years and I would tell you I see no polarization between the public members and the professional members at the Independence Standards Board. I think that we have active dialogue. I think that we in almost all instances come to consensus around the issue.
In that three years, I can only remember one instance where there was a deadlock vote.
CHAIRMAN LEVITT: So you would tend to oppose the notion --
MR. BUTLER: I'd like to finish the answer, if I could. I'm not saying that I'm opposed. What I'm saying isthat in a period of three years there has only been one vote that tied and it was a three to three vote and it was two public members and one professional member on one side, two professional members and a public member on the other side. It was not polarized by public versus professional.
I think the other thing that is very, very important to understand is the implication that having the professional members there with an equal vote, to me the insinuation in that comment is that the professional members are not interested and committed to independence.
CHAIRMAN LEVITT: I don't think so. I think that's a great leap. There certainly are enough bodies in our society today which recognize the importance of demonstrating the weight given to the public interest to suggest that is in no way a denigration of the importance of the regulated. I think you and I would both agree that self-regulation simply doesn't work without the input of the regulated. So, again, I would guess that you're not favorably disposed towards that action. Is that --
MR. BUTLER: Well, I think -- and, again, if I was to consider that issue, Mr. Chairman, I would suggest that we have to consider the entire construct and constitution of the Independence Standards Board. You can't change one element unless you change all of the elements that really gear in together with that piece.
And, as you remember, in the development of that, this is not a simple process, there are many, many elements to the ISB.
If we wanted to consider the composition of the board, I think we should reconsider the entire constitutional construct of the ISB.
CHAIRMAN LEVITT: I think your meaning is plain.
With respect to giving the ISB more of a say in terms of the issue of independence, once more, I would ask how you would respond to Chairman Allen's statement that "this issue is different in kind than a lot of other issues and it is not well suited for a board of our character. It's really a public policy choice that the government needs to make, and that, I think, is the view of us all."
MR. BUTLER: I also remember in Mr. Allen's testimony before this Commission that he said he was agnostic about this particular issue and I think it is an affront to the members of the Independence Standards Board that they would cut and run on a difficult issue like this, that leaders do not delay crucial decisions, they face into them and make that decision and don't try and push them off to another body.
CHAIRMAN LEVITT: We are not affronting them, I am just suggesting to you, Mr. Butler, that this is --
MR. BUTLER: I wasn't suggesting that theCommission was affronting them, Mr. Chairman, I was suggesting that I find it inconsistent with any organization that I've ever been to that you push the tough issues off somewhere else.
CHAIRMAN LEVITT: But it is what it is and that's what we have been confronted with.
MR. BUTLER: I would suggest that we tell the Independence Standards Board to go back to work and deal with this issue.
CHAIRMAN LEVITT: Your statement that the profession has consistently been supportive of the Commission through the years and worked cooperatively I think is not borne out by the record. I can only give you my personal observations and those of my four immediate predecessors that of all the constituents that we've dealt with, this profession has provided us with the greatest amount of truculence in terms of reaching consensus decisions.
The other point you made about the role of the audit committee, give it over to the audit committee, how would you reconcile that with the testimony of John Whitehead, the chairman of the blue ribbon committee, who testified that this rule would help audit committees and it would be somewhat unrealistic to rely solely on audit committees to deal with this issue?
MR. BUTLER: Well, I think there are other peoplethat have differing views, for example, the O'Malley report said that audit committees are perfectly capable of dealing with this. I didn't hear Mr. Whitehead's testimony. I don't fault him for having his own opinion. I disagree with that opinion. I think audit committees in the private sector is the right venue to have these sorts of discussions and serious decisions made about independence.
In a capitalistic society, that seems to me the best place for these types of decisions to be made.
CHAIRMAN LEVITT: Certainly in terms of his credibility as chairman of that panel, the Commission is going to seriously weigh his judgments.
In the interests of time, I'll pass over to Commissioner Hunt.
COMMISSIONER HUNT: Thank you for appearing, Mr. Butler.
MR. BUTLER: Thanks for having me.
COMMISSIONER HUNT: It's been a long morning and I'm sorry we're so late with your testimony.
You mentioned in your prepared statement that in your view we are adopting an appearance standard for auditor independence. I certainly think that appearance is part of the problem, but I wouldn't want to characterize the adoption of any standard at which we arrive -- and I'm gratified to hear that you are willing to work with us to see if we canarrive at a satisfactory standard -- as an appearance standard, although I don't know how much of the testimony you've heard this week or last week, but clearly there are strongly held, strongly differing views among members of the profession as to whether this is the road of wisdom or the road of idiocy, and I know that. But if all of you are willing to work with us who represent the various views of the profession, I am confident that we can come to some meeting of the minds and have a constructive dialogue and develop a constructive rule.
I have heard what you said about affiliation, other people have made comments in their testimony about the problems, small firms, as you may have heard this morning, so we are going to take all those things into consideration and I look forward to having a dialogue with you and your representatives. Thank you for coming. In the interests of time, I will just say thank you and look forward to working with you.
MR. BUTLER: Okay. Thank you.
COMMISSIONER UNGER: Well, I am interested in time, but I am not that interested in time. I have some questions for you.
MR. BUTLER: Good.
COMMISSIONER UNGER: How long have you been the chairman of KPMG?
MR. BUTLER: Since 1996.
COMMISSIONER UNGER: Okay. Good. What was the revenue of the firm for the last reporting period, fiscal year 1999, probably?
MR. BUTLER: Well, actually, we're in registration right now and I'm not able to give you that number.
COMMISSIONER UNGER: What number can you give us?
MR. BUTLER: We're in a quiet period right now. We have not filed our year-end financial statements on that.
COMMISSIONER UNGER: The SEC is asking. How could you be in a quiet period to us?
MR. BUTLER: But I believe there is press and the public sitting behind me and I am not at liberty under the security laws to disclose that information to you.
COMMISSIONER UNGER: I am violating our own rules. I apologize.
MR. BUTLER: That's, I think, a fairly innocent question, though, that just maybe you didn't focus on the difficulty I have in answering that.
COMMISSIONER UNGER: No, I didn't, but maybe we can have this dialogue on a different level.
MR. BUTLER: Hopefully, in the next couple of days it will be public information.
COMMISSIONER UNGER: Okay. What I was trying to get at was the percentage of revenues as they've increasedin -- perhaps even the time period that you've been the chairman. Is that something that you couldn't really give us an indication of either?
MR. BUTLER: Well, I can certainly give you some indication from the financial statements that are already in the public documents.
COMMISSIONER UNGER: Okay.
MR. BUTLER: And consulting has been our fastest growing business over the period that I've been the chairman. I think that's fairly true throughout the entire profession.
COMMISSIONER UNGER: Yes.
MR. BUTLER: But I would also tell you that throughout that entire period of what is now the beginning of my fifth year as chairman that we have had double digit revenue growth in our assurance business as well. And I think that's probably the more relevant question, is the audit business healthy, is it growing, is it a profitable business. And the answer to that question is yes, it is.
COMMISSIONER UNGER: So what percentage of your overall revenues is the auditing from? How does it fit in?
MR. BUTLER: Auditing is about -- if I can do the math in my head real quick -- it is about 40 percent of our revenue.
COMMISSIONER UNGER: I guess what I'm curious about and what I'm sort of struck by in the testimony, especiallytoday, is what are the underlying business issues in connection with this proposed rule and the impact it will have on the ability of the accounting firms to grow? And I spend a lot of time thinking about technology, not necessarily how it pertains to financial statements, although I'd like to give more thought to that, but the impact on the economy generally.
And so I guess what I'm trying to figure out is why do our rules have such a significant impact on, say, for instance, the Big Five accounting firms? What is it -- and I guess we've heard from the smaller accounting firms, too, so we could say the industry as a whole -- what is it about the consulting business that makes the synergy so profitable and how can we accomplish that synergy without having an issue with respect to independence?
MR. BUTLER: Right. Well, I think you focus on not the real issue from my perspective. You're taking a narrow focus on the consulting business and I take a much broader focus on the prohibition of non-audit services, of which consulting is just one. And it is a much, much broader definition than just consulting. And I happened to be here to listen to some of the questioning of the preceding panel and I think they went into this in a great amount of detail.
There are synergies between many of these non-audit services and being able to perform good audits. Some ofthose are not resident in the systems integration consulting business, by the way, they're in other parts of non-audit services businesses that many of us have, things like information risk management, which is a technology practice that a good portion of their revenues come from actually being part of financial statement audits.
They also do work in other areas like security and data integrity sorts of services, protecting websites from hackers and those types of services. So those are very valuable skill sets when it comes into assessing the integrity of information that we do throughout the audit process.
So I take a much broader view and I'm looking at prohibitions of non-audit services, a list of 10 today, but an open-ended provision that that could be anything that the next group might want to prohibit.
COMMISSIONER UNGER: But aren't most of those already prohibited?
MR. BUTLER: I would not use the word prohibited. I think there are limitations.
COMMISSIONER UNGER: Not permitted?
MR. BUTLER: There are limitations on some of those services that are incorporated in the AICPA rules and the SEC practice section rules, but for the most part, it's not broad limitations like the 10 that are listed in this proposedrulemaking.
COMMISSIONER UNGER: So if not consulting, what is -- could you pinpoint what is the prohibited service?
MR. BUTLER: Yes. Again, I come from a different conceptual point of view, I think, because what I'm interested in is having a conceptual framework that sets guidelines for how we operate as a business far into the future, not something that puts rules in place that as the economy changes, as the business changes, as the demands of companies and investors change are immovable and impossible to change. I want principle based that deals with risk. What are the risks to the investor and what are the safeguards that can be put in place to mitigate those risks.
So I come at it from a different perspective. I don't think prohibition is the right approach to deal with the kind of business world that we're in.
COMMISSIONER UNGER: Well, you did say that you thought that the private sector should come up with a solution to these problems and not the government.
Well, my first question is do you think there is a problem?
MR. BUTLER: No, I don't.
COMMISSIONER UNGER: So what would the private sector solution be, then? Would that be nothing?
MR. BUTLER: No, I don't think so and I thinkyou've seen from the Independence Standards Board, although a lot of their very, very significant work is still in progress and I would point principally to the conceptual framework project, but I think they've dealt with a number of issues and they tried to prioritize a few to deal with before they had a conceptual framework.
CHAIRMAN LEVITT: But their independent members have all -- all -- asked the Commission to ban consulting services.
MR. BUTLER: I don't think that's the case, Chairman Levitt. I'd have to go back and read their testimony, but they said I'm agnostic about it and if you want to do it, go ahead, but I have not decided for myself that I think it's right or wrong.
CHAIRMAN LEVITT: Well, I think your view that they have not taken a position is incorrect.
MR. BUTLER: I also believe that they are capable within the framework of the ISB, with the SEC at the table, to resolve this issue in a principle-based fashion as opposed to a prohibition fashion.
CHAIRMAN LEVITT: But you say there is no issue.
MR. BUTLER: I say that I don't believe there is an issue.
CHAIRMAN LEVITT: Okay.
MR. BUTLER: I don't believe there is anycorrelation --
CHAIRMAN LEVITT: So there's no point in having them resolve it.
MR. BUTLER: No, I don't believe there is any correlation between non-audit services and audit independence.
CHAIRMAN LEVITT: There's no point --
MR. BUTLER: And I give you that perspective as somebody that's been an auditor for 30 years.
CHAIRMAN LEVITT: Then there's no point in asking them to resolve an issue that doesn't exist.
MR. BUTLER: Well, I think that doing the conceptual framework, studying investor perceptions is important and they have taken that upon themselves.
CHAIRMAN LEVITT: Well, we --
MR. BUTLER: I don't object to the fact that they've taken that upon themselves, even though I might disagree that there's an issue there.
CHAIRMAN LEVITT: Not a new question. It goes back 25 years.
MR. BUTLER: And consistently the answer has been that prohibitions are not appropriate throughout that 25-year period.
CHAIRMAN LEVITT: Yet the issue remains.
COMMISSIONER UNGER: So if your firm -- well, Imean, whatever the non-problem, non-solution would be by the private sector, do you have any belief or opinion as to how the problem -- the non-problem should be addressed?
MR. BUTLER: Well, I don't think stirring up investor concerns is the right way to deal with the problem. I think that you can study this issue, if there is a real concern. If there is a real issue, then we deal with it, but I don't think causing some sort of hysteria is the right way to do it.
COMMISSIONER UNGER: How would you go about studying this issue?
MR. BUTLER: Well, I think you have to build a conceptual framework. You have to understand what the threats to independence are to begin with and how would you deal with those risks in a principle-based approach, what are the overriding principles of auditor independence?
I mean, there are a few you can come to very quickly and they've been hallmarks of the profession. You don't have a direct financial ownership in your audit client. That's pretty simple. But that is an underlying principle.
COMMISSIONER UNGER: Well, I think you should understand -- and I will speak for my colleagues -- that we believe it's an honorable profession and I just found out today it goes all the way back to the caveman years.
MR. BUTLER: Is that right? I didn't know that.
COMMISSIONER UNGER: But that's even more --
MR. BUTLER: We're not quite that old.
COMMISSIONER UNGER: What I would like to move on to, then, is your own experience with these issues in terms of your firm. Do you have any type of internal procedures with respect to audit clients and other services provided to those audit clients?
MR. BUTLER: Well, we absolutely follow the limitations in the AICPA rules on services that you can't provide. Over the years, we have gotten out of a number of businesses because of those, executive search is probably the easiest example. We have actually on our own gotten out of a number of businesses that are probably part of that list, but we have done it for reasons totally unrelated to independence. We have gotten out of them because we don't think they're businesses that we have a core competency in or that we can be successful in.
A great example is what we called our compensation and benefits practice, which was an actuarial consulting business and unfortunately we were about number 10 in market share and saw no way of getting into a leadership position and decided that it wasn't a very profitable business for us.
COMMISSIONER UNGER: Ten out of five?
MR. BUTLER: Well, no, there's a lot of other organizations. None of the five were really there.
CHAIRMAN LEVITT: Do you think that represented any independence issues?
MR. BUTLER: No, I didn't, Mr. Chairman, but we made the decision to get out of that business purely from a business standpoint, a profitability standpoint, not because of any concerns from an independence standpoint.
COMMISSIONER UNGER: Well, aside from those business decisions --
MR. BUTLER: Could I finish? I didn't really get to the heart of your question.
We do follow all the existing limitations on service. We do have very extensive procedures in house to monitor the direct investment issues. The complexity around that is pretty incredible today, especially with the family situations that we face, two wage earners, 401(k) plans, stock options, all the complexities that are there today that weren't there when those rules were adopted.
So we have great emphasis, we enforce those rules rigorously in our organization. We will tolerate to a certain extent inadvertent or unknowing violations as long as they're cured within a proper period and are reported through the right channels.
We do not give people a second chance on a knowing, intentional violation. We terminate those people and we do it immediately.
COMMISSIONER UNGER: Well, what about the business type of services that you provide? I say consulting, you say that's a small part of it, so I can just say generically business, to your auditing clients. Do you know what percentage of auditing clients you provide additional services for?
MR. BUTLER: Well, I think in the last SEC practice section report that discloses that information I think that 22 percent of our consulting revenue came from our publicly held audit client base.
COMMISSIONER UNGER: All right. So you do the math.
MR. BUTLER: That's a year-old report, by the way.
COMMISSIONER UNGER: Okay.
MR. BUTLER: I don't know the exact numbers in this one, but it's been that sort of a trend line.
COMMISSIONER UNGER: So 80 percent of your non-audit revenues come from --
MR. BUTLER: Yes, but, you know, it's difficult to look at that sort of a statistic because that's not a constant 20 percent that buys that service from us. It might be 20 percent of the number of our clients this year, it might be the same percentage next year, but it might be a totally different 20 percent.
COMMISSIONER UNGER: Right.
MR. BUTLER: Typically, consulting services are not annual, recurring sorts of things. And if you look at it from the perspective of over an extended period of time, and I don't have the answer to the question, it would be a good question, though, over an extended period of time, three to five years, how many of your publicly held audit clients bought consulting or non-audit services from you. It would be much higher than that 20 percent.
COMMISSIONER UNGER: Well, do you recall instances where you rejected a client's request for other services besides audit services because of potential conflict?
MR. BUTLER: Yes, absolutely. And I also remember the other side of it, where we've resigned the audit to be able to take other services, where we want maybe to have a direct business relationship with somebody that is an audit client now and we have to make the choice between that direct business relationship and whether we want to have them as an audit client. In a number of instances over the last two or three years, I would tell you we resigned the audits.
COMMISSIONER UNGER: And does it ever work the other way, that you resign --
MR. BUTLER: Yes. No, both.
COMMISSIONER UNGER: -- the consulting?
MR. BUTLER: Yes. Absolutely. Absolutely. And, Commissioner, it's a business decision. We do run ourselvesas a business and we make those decisions based on economics.
COMMISSIONER UNGER: What's your relationship with the audit committee? When do you bring them into these types of decisions?
MR. BUTLER: Well, I think the audit committee is, I hope, I think our emphasis is that we keep audit committees very, very informed of every activity that we have going on. I'm involved with many of the audit committees directly of the major clients that we serve and I think our communication and discussion of any sort of issue around auditor independence is very up front, very forthright, maybe over communicate, but I think we do a very good job there.
COMMISSIONER UNGER: Do you provide them with information about prospective business relationships with audit clients before you enter into those relationships?
MR. BUTLER: Yes, obviously. And, in fact --
COMMISSIONER UNGER: Not so obvious to some.
MR. BUTLER: Most audit committees today have as a regular agenda or regular policy that they are somehow in the loop on the approval of services that they buy from their audit firm. Very, very many audit committees have that as a rule. They may have a discretionary piece that management can buy at a certain level, a dollar level, without audit committee approval, but very many audit engagements are really engaged in that discussion today.
COMMISSIONER UNGER: Do you think that they could be given more responsibility to assist in determining independence?
MR. BUTLER: Well, I think actually the knowledge and the engagement of audit committees over the last couple of years, I think beginning with the blue ribbon panel, I think also factoring in Independence Standards Board Statement No. 1 has really elevated the level of interest and the level of understanding of independence issues at the audit committee level. We have some great discussions on those issues with audit committees.
COMMISSIONER UNGER: Well, as part of your business decision, I guess what you were talking about earlier, one thing that you seemed to emphasize in your testimony was the challenge that you would have in terms of recruiting talent and you're probably -- we can definitely share and empathize with you on that, especially with the constraints that we have in this vibrant economy, but why does that problem exist? How much do you pay a brand new consultant as opposed to a brand new auditor?
MR. BUTLER: Well, we may be unique to the profession in that we don't usually hire brand new consultants at KPMG. We're typically hiring people that have a substantial amount of experience before they come into the firm. We don't recruit at the college level, principally. So it's hard to make that comparison, but I think that probably the standard answer there would be that the starting salaries are probably not dramatically different for people in those two areas, but I think the thing that is important to those people, and I want to focus on the accounting graduates first, is I think young people today want a career opportunity where they have a great deal of flexibility, where they can move from one position to another. Maybe they start out in audit and want to go to tax, maybe they want to go to this information and risk management practice that I talked about, maybe from there to consulting or consulting back to information and risk management. And I think a lot of the appeal of our profession is that you don't have to change jobs to get a variety of experiences that add value to your own personal career. That has tremendous appeal to the people that we recruit.
COMMISSIONER UNGER: But, see, I don't see how this proposal would change that because there is no prohibition --
MR. BUTLER: Well, I would suggest and maybe I am over alarmist at this, but I think if this proposed rule were to pass in its current form where you prohibit 10 services, where you have a catch-all provision to prohibit almost anything else in the future depending on whoever happens to be the decisionmaker at that time, that in a very, very short period of time, we will be audit only firms. That will beall we'll offer. That will be an outcome.
Now, maybe that's an intended outcome, but in my view, it won't be long before we're there.
CHAIRMAN LEVITT: I don't think it is an intended outcome and, again, there are ways of expressing this dialogue at the extreme.
I think you have to recognize, Steve, that you and I sit in different positions with different responsibilities. You appropriately must defend your business interests. The interests of the Commission is the public's interests and I am kind of haunted by something that you said before.
As I recall, you were supportive of some statements that I made several years ago about the issue of managed earnings and the danger that represented and so much judgment is required with respect to an auditor's views on these issues, judgment in determining the useful life of assets, judgments in determining the future cost of a liability associated with cleaning up a hazardous environmental site, judgments in terms of establishing a reserve which would record whatever might be called for to cover potential damage awards against a company in litigation. And, maybe most important of all, judgment in evaluating the materiality of situations where the company has not followed GAAP and whether the auditor should withhold its audit report or maybe issue a qualified report.
I guess that's where I think your observation about threats and safeguards, where the auditor himself is to identify the threats to independence in a world which depends so much on personal judgment, where there are close calls which don't represent illegality, in a world which is so subtle, I'm not sure this is really the best approach that serves the public interest and I don't think the public can be persuaded of that as well, regardless of the number of reports and surveys.
MR. BUTLER: I understand your position, but I think you very much reinforce my view. My view is if you want people in this business that are not required to make judgments, that are not trained to do that, then you will have a rapid denigration of the audit profession. And independence is just one of the judgments that we have to make. And I think you went through a fairly good list, by the way, of some of the things that we face on a day-to-day basis and we've had a 100-year history of dealing with those judgments. We make them every day, it's part of who we are, part of the way we're trained as auditors and I believe we are absolutely capable and competent at making those judgments in the best interests of the investor community.
CHAIRMAN LEVITT: And yet you agreed with me two years ago that corporate America had moved further toward managing earnings than they had in some time before that.
MR. BUTLER: I agreed with you that that was an important issue for auditors to focus on and, in fact, in our firm, I think that -- the reason that you say I agreed with you is I sent you a copy of an internal speech that we had given on the very, very same subject that was before your NYU speech on that subject, so we recognized that as an issue.
I'm not sure that we recognized it as something that had changed dramatically in history, just the impact of it had changed dramatically in history because of the way the investment community and the stock market reacts to quarterly earnings releases more aggressively than they have at any time in history.
But earnings management, Mr. Chairman, has been with us since financial statements have been put together.
CHAIRMAN LEVITT: That's quite true.
COMMISSIONER HUNT: Before we get to the general counsel, one final question.
You must do a lot of planning for your firm. Do you foresee a time in the future where the culture of the auditing profession and the culture of the consulting profession will be such that they can't live under the same roof?
MR. BUTLER: Well, Commissioner, I think maybe you're aware that we are in fact splitting off our consulting unit. We have already split them off into a separate unit. It wasn't done for cultural reasons, it was done for different business reasons than that, and it certainly wasn't done for independence issues.
There are subtle differences in the culture between the two organizations. You know, I think it was mentioned by Bob Elliott earlier this morning that the audit side of the business is much less marketing oriented because most of our work is repeat work, so you don't -- you have to perform well, but you don't have to resell it every year.
COMMISSIONER HUNT: And it's a mature business.
MR. BUTLER: Yes. And it's a mature business. Whereas consulting, on the other hand, a consulting partner has to sell for his livelihood every day.
A comment that I made to Chairman Levitt several months ago is when I look at our consulting business today in year 2000, it is not the same business that we had in 1996 when I became chairman. We were an ERP business then, today we are an E business consulting. Five years from now, I don't know what the consulting business will be. My view is it won't be E business. My view is that E business, we will look at that as an appliance.
Five years from now, you're using the Internet just like you use the telephone today. And I don't envision a tremendous amount of consulting going on around that.
COMMISSIONER HUNT: I agree.
MR. BUTLER: So the consulting business that we have today that we are spinning off, I don't know what it will be five years from now. And the possibility is that I may be in whatever business they go into five years from now, not because I'm trying to compete with them, but we may gravitate towards the same market opportunities.
And, again, it's because their world changes much faster than ours does that there become these cultural differences that you refer to.
I've found it over the years, by the way, to be very, very manageable and in our organization we have a set of values that we insist all of our people live by and if they don't they're not part of our organization. So to a certain extent, we enforce a culture across the entire firm.
COMMISSIONER HUNT: Thank you.
I think our general counsel had a question.
COMMISSIONER UNGER: I actually --
COMMISSIONER HUNT: Oh, I'm sorry.
COMMISSIONER UNGER: I was interrupted. But I have just two more questions.
MR. BUTLER: Okay.
COMMISSIONER UNGER: One was who do you see as your biggest competitor? Other accounting firms or consulting firms?
MR. BUTLER: Well, I would tell you it's a widevariety of organizations. You certainly cannot limit it to just the Big Five or other accounting firms, especially in some of the non-audit services businesses. In consulting, we compete with organizations like IBM, for example. We compete with start-up technology systems integration, E business consulting firms, some that are very, very narrow in terms of their scope of business. Very few that have the depth of capabilities that we have. All of the Big Five are clearly in that competitive arena.
We look at other organizations, the consolidators in our business, the American Expresses that are entering our business. So there is no lack of competition. You know, I think our fear when we look at the audit business, and if I could be parochial for just a second, we have always felt like if you were one of the Big Five in the audit business of large companies that the price of entry into that market was almost impossible for anybody else to come up and gain a huge amount of market share. They might have a few clients, but never the scope of the Big Five.
What I worry about now is a technology solution to audit that could be an entrepreneur in a garage that comes up with an idea or it could be a Microsoft or it could be somebody else that comes up with a way to do audits using technology and real time that removes that steep entry price into the Big Five audit market. That's what we worry about.
COMMISSIONER UNGER: Well, you had said in response to Chairman Levitt that you thought that our proposal could possibly drive your firm into an audit only model. Well, if that's a less profitable side of your business, why wouldn't it drive you into the consulting?
MR. BUTLER: No, you really shouldn't be mistaken that it's not a profitable part of our business. It's very profitable.
COMMISSIONER UNGER: I understand that, but if it's 40/60, then why would --
MR. BUTLER: You asked me audit, I didn't give you tax. I didn't give you corporate finance. There's a lot of businesses. I wasn't trying to tell you that 60 percent of our business is consulting, because that's not the number.
COMMISSIONER UNGER: Okay. And have you had a chance to look at the PWC and E&Y proposal?
MR. BUTLER: Well, I will tell you, unfortunately, I was in Berlin yesterday chairing our international partner conference and to have the opportunity to be here today, I left in the middle of that conference to fly back last night, so I just arrived from Europe. A marked up copy of it was shoved in my face about 9:00 this morning and I wasn't sure what planet I was on. And about the only thing I had the opportunity to do was look at how the current proposal had been marked up. I didn't have a chance to read any of it.
COMMISSIONER UNGER: Is it something that you might be interested in participating in?
MR. BUTLER: I'm absolutely very interested in having a look at the document and having some greater experts in my firm also take a look at it, but my reaction on the surface was that it looked like a fundamental -- I hate to refer to the seven-point document that you were passing out, but I actually kind of agreed with that when I was listening to it, that it is a fundamental re-write of this existing proposal. And I'm just basing that on the number of edits and mark-outs that I had seen in the copy that I was looking at.
COMMISSIONER UNGER: I appreciate your testimony and your devotion to the cause in traveling here.
MR. BUTLER: Thank you.
COMMISSIONER UNGER: But I was sad to see your last week's testimony, the testimony of Stephen Butler if he had the chance to appear, so I'm glad you did have a chance to appear.
MR. BUTLER: We obviously ran into a scheduling difficulty and it was impossible for me to be here in the afternoon last week, but I am glad you gave me the opportunity to come. I really appreciate it.
COMMISSIONER UNGER: Thank you very much.
COMMISSIONER HUNT: Mr. Becker?
MR. BECKER: Well, I wasn't going to ask about the seven-point document, but now that you mention it, what do you know about that?
MR. BUTLER: Well, I know it wasn't on European size paper.
MR. BECKER: Yes, and do you know anything else?
MR. BUTLER: No, I really don't. I hadn't even seen it, actually.
MR. BECKER: Well, you know it's seven points. I didn't mention that it was seven points. So you know that.
MR. BUTLER: I heard you read it this morning.
MR. BECKER: Well, you've got to know a little bit more than what I read, because, as I said, I didn't mention it was seven points. I didn't want to bore everybody.
MR. BUTLER: I wasn't sitting by myself in the audience when I heard you talk about it.
MR. BECKER: So as far as you're concerned, that's not a KPMG document.
MR. BUTLER: That's not a KPMG document, but it might be something similar to what I would have said.
MR. BECKER: But it's not something that was authorized by KPMG.
MR. BUTLER: No. Again, I got off an airplane from Germany late last night.
MR. BECKER: Well, I must say I'm stumped. We'vehad three firms and the AICPA say they don't know anything about it, but -- stump the wizard, what can I say?
MR. BUTLER: I say in all seriousness, and I didn't read the document, but I heard your commentary on it and I did fundamentally -- unless there is some subtlety in the words that I didn't catch by listening to it, if I had written, I guarantee you I would admit it because I agreed with most of the stuff I heard.
MR. BECKER: Okay. Now, you folks, KPMG LLP, is getting out of the consulting business.
MR. BUTLER: We're getting out of the systems integration consulting business.
MR. BECKER: Assuming that once that goes forward, assuming that the rule -- just focusing now on the scope of services part of the proposal, what is it that if that rule were promulgated in something like the form in which it is proposed, what is that KPMG wouldn't be able to do that it now does, excluding the part that's being sold off?
MR. BUTLER: I wish I could answer that question, but I think when you put a catch-all provision into a rule, you can't define what the future is going to hold for you.
MR. BECKER: Okay. Well, other than that. I mean, any of the specifics? I mean, what's the impact going to be on your business?
MR. BUTLER: I think I enunciated what I think theimpact on our profession will be in that I think that we will become an audit only profession.
MR. BECKER: Well, what I am trying to do is get a little flesh on that. Are there services that are set forth in the rule that KPMG now performs that after the sale of what I call the consulting unit probably because it's called KPMG Consulting, are there businesses that you won't be able to do that you now do?
MR. BUTLER: Well, I think internal audit outsourcing is one of the businesses. Although legal services is not a business that we're in today, we have a great deal of interest in that outside the United States.
MR. BECKER: Away from the American Bar Association --
MR. BUTLER: Some very major businesses around the world. I have complete confidence that the American Bar Association will remove its fee splitting rules at some point. And, again, I tried to articulate earlier to one of the commissioners that I am against prohibitions. What I would like to see is something that's based on a conceptual framework, something that's based on principles, something that deals with risks and how you counterbalance those risks and prohibitions does not get me there.
MR. BECKER: You mentioned something about SEC stirring up investor concerns. What were you referring to?
MR. BUTLER: I'm referring to the Earnscliffe report, where the Earnscliffe report stated specifically that there doesn't seem to be a concern other than those articulated by regulatory authorities.
MR. BECKER: Well, as you may or may not know, there have been folks who have testified here who have expressed their concerns. You're not suggesting that those aren't their concerns?
MR. BUTLER: Well, you know, I didn't control who testified here. I don't know how broad a base you got of people that believe the opposite of that view.
MR. BECKER: I think we've had a fair number.
MR. BUTLER: I think there are a number of companies that I think don't think this is their issue and they shouldn't affront the SEC on an issue that's not their issue.
MR. BECKER: No, but I'm just saying with respect to the people who have come forward, you don't have any reason to doubt their sincerity.
MR. BUTLER: I have no reason to doubt their sincerity.
MR. BECKER: Okay.
MR. BUTLER: But I do have questions about why they were here.
MR. BECKER: What do you mean by that?
MR. BUTLER: Did they take it upon themselves to come because they believe --
MR. BECKER: As opposed to what?
MR. BUTLER: As opposed to being invited.
MR. BECKER: Are you aware of anyone --
MR. BUTLER: Well, I'm aware of situations where people were asked --
MR. BECKER: Excuse me. Let me just finish the question before you know the answer. Are you aware of anyone who had a view that wasn't afforded an opportunity to come here?
MR. BUTLER: No, I'm not. But, as I said, I think this is not their issue, and many of the people that would probably have a view differently, and probably if I was the CEO of a listed public company or the CFO of a listed public company, I would not want to come and testify on something that's really not my issue.
MR. BECKER: Okay. You talked a bit about the speed with which the Commission is moving. Do you think we're moving too fast in this area?
MR. BUTLER: Well, I don't think you should be moving at all, so in that context, obviously I think you're moving too fast. And I stayed specifically in my prepared comments away from talking about the process and I think you've had enough witnesses and enough feedback on theprocess that I should spend my time other places. And that's what I said in my comments, that I wasn't going to address that.
MR. BECKER: Well, no, but assuming you don't have any objection to being asked about it and answering if asked --
MR. BUTLER: I think the process is too short.
MR. BECKER: There was a time, was there not, when you thought the Commission, if it was going to move, ought to move quickly in this area?
MR. BUTLER: Well, there was a time when I wanted the Commission to rule on a specific issue relative to my firm.
MR. BECKER: Well, there was a time, was there not, that in that connection you expressed the view that if the Commission felt that the matter had to be dealt with by rule, that it ought to move quickly.
COMMISSIONER UNGER: I'm sorry, could you elaborate what you're talking about?
MR. BUTLER: It had to do with the public offering of my consulting unit and I asked the Commission to consider rules around alternative practice structure. It was a very simple issue, by the way, how much of it I could continue to own and be out from under the independence requirements for that consulting unit.
MR. BECKER: And we asked the ISB to look at that, right?
MR. BUTLER: Yes.
MR. BECKER: You weren't pleased about that, were you?
MR. BUTLER: I wasn't pleased because I didn't have any expectation they could finish it in the sort of time period that I was interested in.
MR. BECKER: Well, what does that say about your suggestion that we send all this back to the ISB? Do you think they can do this relatively promptly?
MR. BUTLER: I think the answer, Mr. Becker, is that you found a way to deal with it in a no action letter for another firm and you could have dealt with it in a no action letter with my firm when I started the process two years ago.
COMMISSIONER HUNT: Is this a personal argument now?
MR. BUTLER: I think it is.
MR. BECKER: I don't think so, no. I think that --
COMMISSIONER HUNT: Well, it seems to us up here that it is and so if we're going to have a substantive argument, let's have it. Or a substantive discussion. I don't want a personal discussion coming into this.
MR. BUTLER: Thank you.
MR. BECKER: Okay. That's all I have.
COMMISSIONER HUNT: Thank you for coming.
Yes, Mr. Turner? Yes?
COMMISSIONER UNGER: Have you screened your questions with us first?
MR. BECKER: Just so that you know, I actually had.
MR. TURNER: Steve, you made a comment about the Commission, the Chairman's comment last week about not giving up authority to the ISB. I just want to make something clear for the record here and this is exactly what the Commission said in its release that everyone read and all the members of the ISB were provided and it says "The Commission also retains ultimate authority to not accept or to modify or supplement ISB independence standards and interpretations in the same manner that the Commission can modify or supplement accounting standards and interpretations."
And it goes on to turn around and say "As ISB reconsiders and effectuates changes in independence standards and practices that involve SEC guidance, the Commission will consider modifying or withdrawing unless the Commission determines it should not accept the ISB position in a particular area."
I think that is in black and white and that is almost exactly what the Chairman said last week, so I don't know that there is any surprise in what's out there in blackand white and what the Commission has said with respect to the ISB.
With respect to ISB No. 1, you talked about let the system work and let ISB No. 1 work, in a public ISB meeting shortly after ISB No. 1 came out, there was a discussion of a letter that Chairman Allen had issued saying that from his perspective the interpretation of ISB No. 1 should be from something similar to a reasonable investor-type perspective as opposed to just the auditor's perspective. And, as I recall in that meeting, you spoke up vocally against that in the application of ISB No. 1.
Do you think it should be dealt with from a reasonable investor's perspective or just from the auditor's perspective, as it's currently written?
MR. BUTLER: I would have to tell you I don't remember that discussion at the ISB, but I would tell you I must have been there, I haven't missed any meetings. And, as you know, I normally participate actively in those discussions, but I don't remember any comment along those lines.
I believe what the standard says now is that the auditor will discuss with the audit committee any matters that in his opinion should bear on independence. And clearly it's an auditor judgment to have a perspective of what would be interesting or concerning to an investor, I think in myopinion it is inherent in that.
MR. TURNER: If a firm actually had a violation of a rule, do you think in that situation, an existing black and white rule and there's a violation, do you believe the auditor should take all of those to the audit committee?
MR. BUTLER: Again, I think they should, Lynn. I don't know the specifics you know, if you're talking about something that's purely de minimis or if somebody held a share for a day and they figured out it was a problem and sold it, which is a technical violation, I don't think I would encourage people to report that if the normal process catches it and corrects it.
If you found out, for example, in the situation I mentioned in an earlier question where you thought it was an intentional or egregious or such a lack of duty and responsibility that it shouldn't have occurred and you terminate somebody for it, absolutely you talk to the audit committee about it.
MR. TURNER: When you complete your transaction with KPMG Consulting for a number of years thereafter you'll have a non-compete and not be able to compete with them and rebuild that systems implementation integration practice that you're talking about. During that time period, what steps are you taking to be able to retain staff or to access the technology such that you'll still be doing -- because Iassume you would agree you would be performing high quality audits at that point in time, but during that time period, that technology, that piece of the practice won't be available to you. How are you dealing with that? Because it seems in your remarks you're saying those are the things --losing that will cause you problems with retaining people and having the knowledge you need to do a high quality audit.
MR. BUTLER: I think the basic answer is that we're keeping sufficient technology capabilities within our firm to be able to deal with the audit issues that we see today as being the primary audit issues. Our major point, and I think our testimony back in the July meeting was that we think that somewhere in the future the technological capabilities that we will need to perform audits real time over the Internet will change and our need for technology expertise will increase. But clearly we don't believe that we will not be able to do a quality audit today in the structure that we have.
MR. TURNER: That technology, the IT technology skills that you're retaining, are those people that have typically been associated with the assurance practice in the past?
MR. BUTLER: Not necessarily. Some of them have grown up in the assurance practice and became technologists. Many of them are specialists, especially when it revolvesaround the new technologies that we're dealing with today, especially the issues around security.
MR. TURNER: In terms of chain of command, have those people typically been under the assurance side of the practice or under the KPMG Consulting?
MR. BUTLER: They report through the assurance side of the business.
MR. TURNER: You mentioned the question about investor concerns. Brand Finance from the U.K. and AIMR also shared with us, in fact, on AIMR we just saw it yesterday, so I assume you probably haven't seen that yet, but both of those indicated that with respect to certain services, in the AIMR case or in the case of the Brand Finance, a very significant percentage of the panelists indicated that they thought that there were valid concerns about auditors' independence with respect to some of these services.
In light of those concerns and in light of the testimony from people like TIAA CREF, CalPers and the like, I mean, these are pretty bright, intelligent people, why do you say that there's not any investor concerns?
MR. BUTLER: Well, I referenced in my prepared comments today that I think it's interesting that some of these companies come in and say they prohibit their auditors from providing other services, but they don't ask and they don't really care in the companies they're investing in. Andthat's absolutely clear to me that they don't make investment decisions, they don't instruct their buyers to ask that question.
MR. TURNER: Does that mean they don't care about auditor independence at all?
MR. BUTLER: To me, it means that this is not an issue to them in running their own business, that they're dealing with it from their own internal structure, but not how they invest the money that they have fiduciary responsibility for.
MR. TURNER: But just because they don't ask the question, you're assuming then they don't have any concern over auditor independence?
MR. BUTLER: Well, I'm sure that CalPers if they wanted to call a company they were investing in and say do you use your auditors for outside services, they would be able to get that answer.
MR. TURNER: You mentioned the O'Malley panel report and I agree with you, it talks in there about the importance of the audit committee and I think the audit committee does play -- can, I don't know that it does today, -- can play an important role in this.
They list out 10 factors in the O'Malley panel report that they recommend that the audit committee use in determining whether or not an audit committee would come to aconclusion that the auditor's independence has been impaired.
Since you bring up the O'Malley panel report, do you agree with those 10 factors that they came up with and that in fact we should have the audit committees involved and they should be using those 10 factors?
MR. BUTLER: I'll have to decline to answer, Lynn, because I don't remember what the 10 are and I'm not sure I've analyzed them in depth.
MR. TURNER: Okay. Let me just close --
MR. BUTLER: Sorry to not answer a question, but I couldn't answer it intelligently.
MR. TURNER: Okay. That's fine. I would just say that I disagree with you that ISB cut and run. I think the four gentlemen are sharp businessmen, very intelligent people, I think what they have accomplished in the past demonstrates that. And, as they've explained it to me, it's not that they're cutting and running on a big issue, but they think this issue is -- and they would agree with you, it's a significant issue to the profession, but it's an issue that should be subject to a widespread public debate and the forum to give the widest breadth of input in that public debate was the SEC. So I do disagree that they cut and run.
MR. BUTLER: I would make one last comment on it and I would absolutely agree with you, I have the utmost respect for the four public members on that board. I thinkthey have put in a tremendous amount of effort trying to come up the learning curve on our profession and the independence issues, but in my view, we should make no mistake about why that panel was created. That panel was created to deal with scope of service. That is the primary issue they were created for and to walk away from that issue I don't believe is the right thing for that board to do.
MR. TURNER: Okay.
COMMISSIONER HUNT: Thank you for your time and your patience. We'll let you get some rest now.
MR. BUTLER: Okay. Thank you, Commissioner Hunt.
Panel 3
COMMISSIONER HUNT: Our next panel is Mr. Jack Maurice, Mr. Abraham J. Briloff, Mr. Don N. Kleinmuntz, and Mr. Urton Anderson.
Gentlemen, welcome. I'm sorry you had to wait so long for your chance to appear before us. Why don't we go from left to right.
Dr. Kleinmuntz, why don't you start? And welcome.
MR. KLEINMUNTZ: Thank you, Commissioner.
I'll try to be brief in respect for the time. I have submitted a detailed set of comments or I will on Monday, so I will try to hit the key points.
Let me lead off by saying I am a professor of business administration. I am not an accounting professor. I'm an expert on the psychology of judgment anddecisionmaking who is interested in the relationship between accounting and financial decisionmaking. In addition, I have contributed to academic research on auditor judgment and decisionmaking, both as an author and an editor.
Let me also disclose that I have been retained as a consultant by Arthur Andersen, Deloitte & Touche, KPMG and The AICPA. Also, at various times, a number of accounting firms, including all of the Big Five, have supported by research. Currently, I have a grant supporting my research from PWC.
Finally, I have a substantial ownership in a privately held software firm that competes against accounting firms for non-audit services.
My primary focus today is on the issue of audit firms supplying non-audit services and how such arrangements influence auditor independence. The underlying rationale for restricting non-audit services is a common sense argument that an auditor's decision may be affected when they have a stake in the outcome.
There is also an article that I believe you heard testimony about in July that's been published in the academic literature that argues that independence is impossible because auditors are likely to suffer from a well known psychological bias known as a self-serving bias, where auditors unknowingly process information to serve their ownself-interests. The implicit presumption is that the auditor's self-interest is aligned with client management.
What exactly constitutes an auditor self-interest?
The audit client pays the auditor. However, the fees for an audit engagement are not at risk, since contingent fees are prohibited under AICPA rules. Of course, the auditor would like to collect additional fees. However, this is true whether the fees are for non-audit services or for future years' audits. Limiting or restricting non-audit services will not eliminate this economic relationship.
On the other hand, audit firms, the accounting profession and regulators have created powerful incentives that make them accountable for their judgments to pull them in the opposite direction from management position.
These sources of accountability are both internal and external to the firm. Internally, auditors are accountable to colleagues and superiors. Like many other businesses, accounting firms have put in place sophisticated performance measurement systems. These do far more than tally up the results of revenues from client engagements.
To the extent that firms explicitly measure compliance with quality controls, professional and regulatory standards and risk management procedures, then the accounting firms reinforce, rather than undermine, independence.
There are also many external sources ofaccountability including various forms of peer review, the threat of SEC enforcement investigation, and the very real possibility of litigation.
A significant source of accountability is the anticipated negative impact of adverse publicity on a firm's reputation, which directly impacts their ability to attract and retain both clients and employees. All of these factors reinforce accountability.
This brings me to my second major point. Even if auditors do fall prey to a self-serving bias, I do not believe that the outcome of an audit will necessarily be affected. In order to understand why, it's vital to contrast the environment in which psychologists typically study human judgment with the environment in which auditors typically practice their professional judgment.
Psychologists typically conduct experiments where judgments can be completed in minutes or perhaps hours, rather than days, and the financial stakes are modest. In a typical audit, the stakes are much higher and the audit engagement goes on for weeks or months.
An audit consists of not one judgment, but an extended series of judgments, assessments of further evidence and subsequent reviews with plenty of opportunity to uncover previous errors and take corrective action.
An initial judgement error need not produceundesirable consequences, since early judgments do not irrevocably commit the auditor to a course of action.
Also, teams of professionals perform audits and other teams consult, review and provide close supervision. These extensive review and quality control processes enhance the firm's ability to catch and correct biased judgments.
Furthermore, auditors interact with both clients and with other members of their profession over extended periods of time. They are very much aware of the past history of those interactions, as well as the anticipated effect of their decisions on future interactions.
In short, reputation matters.
Given this analysis, I do not believe that restrictions on non-audit services are likely to contribute in any real way to auditor independence.
On the other hand, I do believe that there are elements of the proposed rule that will enhance independence. Proxy disclosure of non-audit services may give investors and regulators a clearer picture of the auditor's incentives.
I also welcome the emphasis on strengthening corporate governance by making audit committees directly responsible for appointment and removal of the auditor.
Finally, steps to monitor and enhance accounting firms' internal quality control mechanisms reinforce accountability and promote audit quality.
Thank you for your attention.
COMMISSIONER HUNT: Thank you, Dr. Kleinmuntz.
Mr. Anderson?
MR. ANDERSON: I'd like to thank the committee for allowing me to present my views on this ruling.
My perspective is that of an academic who has spent the past two decades studying the quality control and assurance mechanisms for professional practices and work groups, particularly those systems used in providing external and internal audit services.
The focus of my testimony today will be on two issues; first, the need to address the issue of independence from an organizational behavior and control systems perspective and, second, the misconception that providing internal audit outsourcing to an audit client, one type of non-audit service, is incompatible with the external audit.
For my first point, quality assurance and control in professional service organizations takes place at three levels: at the individual level, well recognized in the proposal; at the level of the work team or group; and at the level of the organization or practice as a whole.
The issue of conflict of interest or judgment bias such as those as the self-serving bias explicitly referred to in the proposed ruling may arise at the individual practitioner level. It may be significantly mitigated at thegroup or organizational level through naturally occurring structures or specifically designed mechanisms to address that issue.
In terms of the self-serving bias specifically, since that appears to be one of the primary arguments the proposed rule makes against the external audit firm providing non-audit services, there are a number of contextual factors as well as specifically designed mechanisms that would mitigate the potential self-serving bias effect in the judgment of individual auditors.
In 1997, an article by Bazerman et al., which also was presented as testimony before the Commission, appeared in the Sloan Management Review. This argued for "the impossibility of auditor independence" owing to the very human and rather unavoidable "self-serving bias."
At that time, I had written a letter to the journal questioning whether the authors of this article might not have overstated their case. I will now proceed to set out the key points made in my letter countering some of the claims made in that article.
Numerous factors would mitigate or neutralize the alleged effect of the self-serving bias in the context of real world audit practice. The first factor is a system of legal liability in which auditors perform their task. In determining an auditor's self-interest, it's not just whopays the auditor and who hires and fires them. Auditors, particularly audit engagement partners, are certainly aware that they are potentially liable for their decisions and that courts will hold them responsible.
The potential of legal liability arising from poor quality audits or reckless disregard of professional standards, including independence standards, affects both the individual audit partner and also his or her firm.
Given the size of the typical judgments awarded and the cost of litigation borne by the firm, including potential adverse reputational effects for the partner and the firm, it seems unlikely that auditors would ignore these considerations in determining their initial self-interest.
A second factor is the role of the audit committee. While the effectiveness of this mechanism is less than perfect, it is clearly a part of the client relationship that the auditor must manage. A displeased audit committee can replace the auditors as easily as displeased management.
Increasingly, newly adopted rules, regulations and ideal practices that have been proposed in the last few years have regarded the audit committee as the primary audit client, with the authority to name or replace an auditor.
An effective audit committee should have a significant balancing influence in shifting the auditor's self-serving bias back to the interests of shareholders andcreditors.
A third factor is that the audit firm's structure and quality control mechanisms exist. Audits are conducted by teams whose members may or may not have a collective self-serving interest. Individual auditors are accountable and can be asked to justify their judgments to others on the audit team.
Further, most audit firms, as well as all the firms in the AICPA practice sections, require concurrent partner review that is designed to specifically counter the self-serving bias.
Concurrent partner review typically discharges a quality assurance risk management role with respect to their review of work performed on SEC client engagements. Having the decisions reviewed by someone else whose interest is not in retaining the particular engagement, but in protecting the firm, at least partially mitigates any sort of bias.
Even stronger support for my belief that the Bazerman et al. article has overstated the impact the self-serving bias would have on actual practice comes from a recent study by Ron King at Washington University.
In an experiment designed specifically to examine the self-serving bias in a group setting, Professor King demonstrates that the bias can be neutralized when participants belong to groups that create social pressure toconform to group goals.
This is a relatively innocuous manipulation he performs and it quite surprisingly removes the self-serving bias.
I would like to briefly comment also on the issue of incompatibility with external audit services. Auditor independence is needed both for internal and external audit services, while the definition is a little bit different in terms of the interest. Both fail if objectivity, which is the ultimate goal of independence, is removed.
Does providing internal audit services mean that an external auditor would be reviewing their own work?
No, because if certain internal auditing standards are followed in doing their work, the providers of these services would not design or implement control systems or perform the work of operating management.
Recent proposed standards for internal auditing put out by the Institute of Internal Auditors specifically designs a chief auditor executor model that eliminates a lot of the problems associated with management responsibilities involving internal audit services.
At that point, I will thank you for the opportunity to present.
COMMISSIONER HUNT: Thank you. I notice, Professor, that in some of your testimony that you, too, have been, as Professor Kleinmuntz was, hired by Arthur Andersen, Deloitte & Touche, KPMG and the AICPA to provide insight and guidance, I think, on auditor relationships.
MR. ANDERSON: Yes. That is correct.
COMMISSIONER HUNT: Thanks.
Professor Briloff, welcome, sir.
MR. BRILOFF: Thank you. I was debating even before today as to whether I would spend a moment of personal privilege by way of full disclosure, but in view of Commissioner Unger's question to Mr. Melancon, I believe it essential that I do so, not only by way of full disclosure, but to make certain that when the Commission receives Mr. Melancon's response to her perceptive question that the Commission will understand the implications and the ramification of the numbers.
I was the subject of an ethics complaint by the American Institute of CPAs about five years ago and two years ago after a trial board hearing, I was "admonished" by the trial board because of the fact that in a peer review of my firm, A.J. & L.A. Briloff, something of a boutique with over 50 years of professional involvement, 60 years in fact, a peer review had found two defects: one, I refused --refused, mind you, not failed -- I refused to get a representation letter from the president of the Psychoanalytic Research Fund with assets of about $300,000,whereby he would say that the financial statements are his and that he takes on all responsibility. I said that's nonsense, the responsibility is my firm's, mine. Because I refused to get that representation letter, admonished.
The second involved a fund devoted to some grants for journalists research with about $100,000 of assets, all in cash, this was not an audit, it was a compilation. Merely a compilation. But because I added a third paragraph to the two paragraph prescribed letter, where I said we made some adjustments to produce a fairer presentation because we had to say this to the client because they were going to sign a tax return predicated on that very same report. Because I added a third paragraph, admonished.
So that you will see amongst the data that they will be presenting by way of disciplinary actions Abraham J. Briloff was admonished. They won't tell you why, excepting for a violation of rule whatever it is, because I did not follow the prescribed dictates.
A question was asked by Floyd Norris in one of his articles, are auditors experts or robots. Now, when you get the statistics from the institute, go through them very carefully, embezzlements, tax fraud, et cetera, et cetera, et cetera, you will even see many who were admonished for whatever it is that they might have done, but ask the same question that I asked in 1996 during one of the hearings atthe institute. Tell me where you have chastised anyone from the major accounting firms with respect to the disclosed audit failures and fiascos.
They came back after months of search, they came back with two in 1996 or 1997 by that time with respect to something that happened in 1985. And the explanation, of course, was the major firms have such extraordinary legal talent that they will drag out the enforcement process at the institute as well as, I'm sad to say, in good measure also at the SEC. In good measure, at the SEC. I have made a very careful study of the accounting and auditing enforcement releases at the SEC and I have found severe criticism with the so-called Coso report where somehow they used your releases.
But now back to my remarks, which I will outline for you even more briefly than the outline.
First is the historical perspective. I do not claim to have invented the auditor independence controversy, but I do believe that at least I am the co-discoverer of that conflict and that has been recognized in footnotes and in various ways and that was during the course of my research for my doctoral dissertation in 1964, '65.
The questionnaire identified -- repeat, identified -- the fact that there is a triage involved. The sophisticated users of the financial statements, includingregulators, mind you, members of the SEC at that time, the regulators were not fully aware and, if they were aware of the fact that the auditors were also rendering what I then called peripheral services, they would not like it.
In between, there were the local practitioners, academics and the like around, some knew, some did not know, some would like it, some would not like it, but back then in '64, '65, the Big Eight firms more than 80 percent, as the statistics show, knew about it and welcomed it. And, as a result of that particular disclosure, committees, the Devore committee was formed by the AICPA to probe and they came up with whatever answers.
Now, by way of a very personal sentimental moment, this will be very brief, that doctoral dissertation was then published commercially by Prager in 1967 and I feel particularly awed by the fact that here I am in the William O. Douglas Room and to that 1967 publication Justice Douglas provided the forward.
In there, he took note of the fact that as an incident of the multiplicity of services, I urged that those committed to the independent audit responsibility undergo a ritualistic purging so that they could prepare for this important responsibility.
He took note that I devoted an entire chapter in that dissertation for the auditor or the accountant preparingto take on a role in the audit responsibility, understanding the philosophic pressures that are imposed and parallel the corresponding pressures for the historian because I made the point rather generally that the independent auditor is the historian for the economic microcosm, just as the historian is for the political macrocosm and there is this consistency.
But I then turn to what I assert is the hubris on the part of the principal firms and the accounting establishment represented here as you saw by the chairman and the president of the AICPA and also members and principal partners of the accounting firms sitting here with $30 billion in their pockets yesterday in two cases.
The arrogance. What they are saying to you, to the users, we will tell you what you ought to know and we will tell you when, as and if we want you to know. And so it is they sit there with a deck of cards all face down, not telling us how many jokers there are. And if occasionally one of the jokers is disclosed, as an incident of discovery proceedings in litigation, they then arrange for all of the evidence to be deep sixed under a decree of confidentiality, thereby depriving us of identifying where it is that they have erred.
And I ask them and ask you, would you permit a corresponding code of secrecy with respect to persons in the public sector responsible to third parties as are independentauditors?
What is political campaign financing about?
Just because of this, there is that soft money in there that somehow or other is afflicting the judgments or potential judgments of persons in the political realm. Instead, we say those with a third party responsibility must disclose up front, openly and above board just what it is that they are doing that might, if disclosed, indicate a contamination of their principal role, whether it be the executive, the legislative or the judicial branches of our government.
And then I would point the same with respect to any industry where there's a third party responsibility, food and drug, airline, transportation, the highway safety with respect to tires. You describe any one, identify any industry where those who are responsible directly for the third party responsibility can maintain that same degree of secrecy.
COMMISSIONER HUNT: Mr. Anderson, we are going to have to ask you to conclude.
MR. BRILOFF: Well, let me say this. I appreciate the interests of time, but I do believe that just as time was permitted to those who were involved advocating their particular causes, those who have after some 30, 40 years of identification have sensed a critical problem in the publicinterests -- I will therefore conclude. Yes. I will conclude, but I want my misgivings to be known to you. I was here 9:30, 10:00.
There's the canard, perception not in fact. I have publicly back in '72 identified in fact. In 1998, I identified in fact with respect to the Price Waterhouse audit of Disney on the ABC acquisition. I have identified Arkansas-Louisiana Farmers Cooperative.
But now turning to what I call the quo vadis, where do we go from here. First and foremost, to divest. Absolute divestiture without any entangling alliances, without any of those alliances that Ernst & Young were appealing to.
And, yes, audit only firms committed to the independent audit, pointing up the importance of that audit in the public interest. And then passionately for the professors to turn to their students in accounting, to describe for them the extraordinary public interest responsibility that they have. There is an important group of our students, I know that from more than 50 years of teaching, who will be touched by that commitment and will support it.
What has been happening is that the very leadership that you saw here today are denigrating the CPAs saying instead we want a new degree, a certified XYZ degree which will somehow or other globalize all this baloney.
And then finally -- or two points. They are critically important. Transparency. I maintain that an audit committee of the corporations should take heed of what Justice Douglas said in the foreword, referring to the fact that he had been urging paid directors when he was sitting in the chairmanship of your commission, paid directors who would be totally responsible to the public. Let the independent audit committees recognize that they are committed to the public so that all of their discourse with the auditor, mainly with respect to the fees, also with respect to what the Kirk report suggested, namely, how aggressive are the accounting principles. To make them known to the shareholders because the independent audit committee should be the surrogate on behalf of the public.
And third, finally, if all of this fails, if all of these fail, then I urge and I mean it sincerely, that the Commission determine that they will abort the requirement for a so-called independent audit because it's a charade and then let the public beware because the very worst hoax, the worst charade is that they'll somehow or other engage in the perpetuation of it. We are then in pari delicto.
COMMISSIONER HUNT: Thank you much, Professor Briloff.
Mr. Maurice?
MR. MAURICE: Thank you, Commissioner. I shouldsay to commence that I come to add a European voice in support of the conceptual approach to independence issues. There is a written submission.
COMMISSIONER HUNT: We have that.
MR. MAURICE: Thank you, sir. In view of the hour, I shall try and summarize that briefly.
The Federation des Experts Compatables Europeens or FEE, translated as the Federation of European Accountants, thanks the Securities and Exchange Commission for the opportunity to testify on this important subject.
FEE, which has always supported the principal of global standards, both on accounting and on auditing, is very much concerned by the SEC's proposed rule on auditor independence, since it would be applicable to the work of European Union-based auditors who have European clients that are registered with the SEC or are subsidiaries of SEC registrants.
These European auditors are subject to independence requirements that are currently in the process of being developed by the European Union in cooperation with FEE along the same lines as those in the exposure draft recently issued by the International Federation of Accountants, IFAC, also of the U.S. Independent Standards Board.
FEE's concern is based on the fact that the approach of the proposed rule differs radically from thatbeing applied in the European and worldwide projects.
We believe that in the current and developing global economy more international cooperation and harmonization must be considered and the profession needs continually to strive for global solutions which will not be facilitated, I believe, if some regulators use a conceptual approach and others a proscriptive approach.
We share the SEC's view that independent auditors play a key role in providing assurance to investors that the financial information disclosed by issuers is reliable. Furthermore, the SEC emphasizes the importance of both independence in fact and in appearance for auditors, which is fully supported from the European point of view.
In 1998, the European accounting profession through FEE issued a policy paper called "Statutory Audit Independence and Objectivity" which sets out a common core of principles concerning independence issues. This paper has been well considered by the European Union Commission's Committee on Auditing as a basis for developing a European code of conduct and the European Commission has committed itself to a conceptual approach. A document featuring that approach is to be finalized in November.
FEE has developed a conceptual approach considering the different kinds of threats that arise with respect to statutory audit independence and objectivity and the possiblesafeguards, including prohibitions, to offset these threats. Auditors are guided as to which threats they might encounter and which safeguards they might put in place to combat them. This analysis by way of threats and safeguards assists auditors in deciding their proper course of action.
The FEE written submission summarizes the elements of our conceptual approach set out in detail in the 1998 common core of principles, including five basic threats to objectivity, together with guidance on the most common situations in which they arise, including, of course, the provision of other services by auditors.
Although the FEE submission does not in general take issue with the details of the SEC proposal, FEE does recommend the advantages of the conceptual approach to issues of other services and we disagree with the general rule that an auditor's independence is necessarily impaired by the provision of other services, provided there is no involvement of the accountant in any decisionmaking of the audit client or its management and insuperable self-review threat should not be assumed.
In FEE's view, the major weakness of the proscriptive or cookbook approach of the proposed rule is the need to have a multiplicity of detailed rules and regulations which cannot, however, cover all those situations where the independence of the auditor might be impaired. Thatconsideration is perhaps demonstrated by the catch-all provision that has been referred to earlier today.
FEE believes that the framework approach is in practice more rigorous than a detailed rule based approach and offers a number of advantages, such as the onus is placed on the auditor actively to consider independence issues for each engagement and to demonstrate that a responsible conclusion has been reached.
It prevents the use of narrow, legalistic interpretations to circumvent requirements. It allows for the almost infinite variations in individual circumstances that arise in practice in different legal frameworks. It can cope with the rapidly evolving business and auditor environment of the modern world. It provides for absolute prohibitions where, but only where, no adequate safeguards are feasible. And, finally, it can be useful, not just to the auditor, but also to other parties who make decisions about auditor independence in situations where no specific rules or standards apply.
We believe that the SEC could benefit from those advantages by investigating adaption of the rule to a conceptual approach.
Thank you.
COMMISSIONER HUNT: Thank you very much, Mr. Maurice.
Professors, would I be fair to say that both of you do not favor the proscription that our proposed rule would impose?
MR. ANDERSON: Yes, that would be the argument. The argument would be a more conceptual approach or at least not as -- an organizational approach in which you recognize the fact that there are alterative mechanisms, like the FEE approach where there may be risk and threats to independence, but those can be dealt with through other mechanisms.
COMMISSIONER HUNT: And this includes, I think, Professor, your view that it's okay for the outside auditor to do internal audits or some part of those internal audits?
MR. ANDERSON: Yes. And I believe that's one that doesn't need a mechanism because the very nature of the internal audit service is such that it's completely compatible with the goals of the external audit.
COMMISSIONER HUNT: Well, we have had, as you may know -- I hope you haven't had to sit here as long as we have over the last three days -- we have had some testimony that the internal audit is importantly a management function, for management to get a handle on where the company is, where it's going, and it's the duty of the external auditor to check those figures, but when you blend the two, it's difficult to know whether management has fulfilled its obligation. You don't see that problem?
MR. ANDERSON: No, because what about the cases where there's no internal audit? Many, many firms have no or very weak internal audit services and yet the auditor comes in and prepares an external audit on those through alternate means.
In fact, we have SAS 65 in which we talk about how the internal auditor interacts with the external auditor and one of the things they do is they can always do more work or, in a sense, almost substitute internal audit work for theirs.
Now, isn't it better to have that work done actually by the external auditor?
The knowledge that they gain from doing that, the business processes and so forth, and actually understanding the business, I think outweighs those other situations.
I would exclude what I call the management functions which the CAE approach that's outlined there says these are not compatible and in those cases I would agree you shouldn't be allowed to do that. Management needs to have somebody specifically responsible for the follow up and for the risk assessment and, to me, where most of the outsourcing engagements go wrong. They go wrong whether they're to the external audit firm or to another outsource provider because management cannot shed that responsibility.
COMMISSIONER HUNT: I think we recognize that particularly with small and emerging companies there may notbe the capability on the staff of a company to do an internal audit at the end of the year, but obviously our focus has essentially been on SEC registered companies where in the main, I think, you would have the capabilities inside to do an internal audit.
MR. ANDERSON: You could, but many do not.
COMMISSIONER HUNT: But you also said that --
You know, you mentioned the fear of litigation, Professor Anderson, being one of the limitations on what auditors will or will not do as well as the reputational risk through litigation or otherwise.
But we have had evidence from litigators, from accountants, from others, we have seen the temptations, we have seen the audits compromised. I mean, again, it's a different perception of the world, I guess, because some people see this obviously as a very real problem and some, such as you, think that the real internal and external factors prevent them from compromising that reputation and their professional duties.
MR. ANDERSON: I do think there are many factors. I think there's much evidence that indicates that the reason, for instance, people do obey the law and so forth is not just because their fear of getting caught, which is really the litigation, but also because of the group norms and the culture. So I think those are counter forces that can turnpeople to the other direction.
COMMISSIONER HUNT: I understand that perspective. All I can say is I think that some of us on this side of this table have seen accounting mistakes where we wonder what could have motivated the people to make those errors in judgment and at the highest levels, obviously, accounting is judgment calls, but for some other temptations because as little as I know about accounting, I don't think I would have made them, but I wasn't in the picture, so hindsight is always 20/20 and I don't want to judge too harshly.
Professor Kleinmuntz, you, too, I think, that the complete divorce of the auditing and non-auditing function is not necessary.
MR. KLEINMUNTZ: That's correct.
COMMISSIONER HUNT: But you think that strengthening the proxy disclosure mechanism along with increasing the strength and independence of the audit committees of the clients would do the job?
MR. KLEINMUNTZ: Yes, Commissioner. I won't rehash the discussion of statistical analysis that we heard earlier today, but I think that the point there was that we really don't have evidence to do a complete assessment of the risks. I mean, one way to say that is the incidence where everything works just fine and there isn't an audit failure, they don't end up in front of you, they don't end up in the headlines. And without the information that I heard mentioned earlier wasn't available at this point, we really can't make an accurate assessment just what the nature or cause or even frequency of failures are. And one thing that disclosure would do is that would make that evidence available.
If we knew about in proxy disclosures the audit fees, the nature of these arrangements, we would have accounting professors and students all over the country running those regressions in a flash. I mean, so fast it would make your head spin. And we would learn an awful lot about what the risk is.
My basic premise is this is about managing the risk of audit failure and you can't manage a risk until you measure it.
COMMISSIONER HUNT: I see. Well, we do have some evidence, but it's certainly non-quantifiable.
Also, I would confess that I don't think we know anything about the correlation between the size of consulting fees and the size of audit fees and whether there is a line over which the temptation becomes greater. I mean, we certainly don't have that data. All we have is we have individual, non-quantifiable cases. I don't know whether we can get that other information or not. It would be difficult, I would think, depending on what the proxy disclosure said, it may be possible to get it. But we admitthat we don't have a huge base of evidence to go on in terms of past violations, we have some but not a huge base of data. But I think you have to understand that what we are trying to do in part is regulate going forward and we think that maybe the time has come to think about whether these two functions, the audit and the consulting, with maybe very different views vis-a-vis the customer and the client, where they can live together.
I mean, for me, that's an open question but I think it's a question that's on the table.
Professor Kleinmuntz and Professor Anderson, thank you for coming. We will read your material and take it into account very much in terms of our trying to fashion along with the profession a satisfactory rule for all.
Professor Briloff, I'm sorry about your admonishments.
MR. BRILOFF: I'm not. It gave me a very important experience and a very important insight into the mechanics of the institute's disciplinary process. Don't be sorry. I wear that like a badge.
COMMISSIONER HUNT: I am delighted that you are here in the William O. Douglas Room, given your connection with him. Thank you for coming.
You also had what you called a "severe criticism" of this body, the SEC, in enforcement actions against themajor firms. I assume that's a historical severe criticism, I hope it's not a criticism of this present SEC. We have tried to be mindful of our enforcement responsibilities vis-a-vis the Big Five firms, the other large firms.
MR. BRILOFF: Just so that you understand, Commissioner, my impeachment that I just referred to stemmed as a criticism, an overt criticism, of the Cosa report, which had to do with the AARs promulgated from 1987 to 1997. So it is of recent, current vintage. And I would be prepared to sit down with anyone of the staff the commissioners request to go over and to review my analysis, a complete detailed analysis of all of the AARs and the cause celebres that we read about regularly in the business press and otherwise very, very rarely surface as an AAR. And the reason for it is that which I've explained. The star counsel for the major firms are able to attenuate and procrastinate from now to Kingdom Come. So it is, I regret to say, a recent vintage probably as much as historically.
COMMISSIONER HUNT: Well --
COMMISSIONER UNGER: We bring about a hundred cases a year for audit failure, just for statistical background. We did about 90 in fiscal year '99.
COMMISSIONER HUNT: Professor Briloff, you are one of those on the side of absolute divestment and audit only firms?
MR. BRILOFF: That is my first commitment because I maintain that we can attract all of the wonderful talent and subsume it in the audit-only firm by then philosophically those firms saying we have dedicated ourselves to the unique responsibility vested in us under the statutes which gave us the CPA degree, namely, opining with respect to financial statements. Everything else has nothing to do with a certified public accounting mandate. They are trying to make it a certified XYZ degree, but it is not a CPA degree.
Let's go back to being certified public accountants, consistent with the traditions of the firms that were represented here, by Peat Marwick, by Price Waterhouse, Waterhouse with a capital W, by Coopers & Lybrand, all of them, Arthur Young, all of them, great traditions, but they have desecrated and are desecrating them.
COMMISSIONER HUNT: Thank you, Professor.
Mr. Maurice, thank you for coming. We are very mindful, I think, having just come through issuing a concept paper on the international accounting standards after working through IOSCO on those matters, that we have to be mindful of the effect of any rule we adopt on the European affiliates of the members of our accounting profession here and I hope we will be able to address that issue.
I know it presents a very different perspective from any of the European countries than what we see here andI think we ought to be very mindful of trying to work with the European regulatory authorities to see that we don't have any unintended consequences with respect to denigrating what you are trying to do in this area to regulate your profession. Thank you for coming to give us your perspective.
You mentioned that in your view, at least, independence is not necessarily impaired by the provision of other non-audit services. Is that the prevailing European view as represented by the organizations you cited?
MR. MAURICE: That's the European view as I understand it, Commissioner.
COMMISSIONER HUNT: Well, if you were here, you unfortunately had to sit here too long. Obviously, you know there are other views in this country, so we will have to see how that works out and what kind of rule we establish.
Thank you all for coming and thank you for your contributions and your patience.
Commissioner Unger?
COMMISSIONER UNGER: Thank you.
I thought I would start with the end of the table, both of you, actually.
When did Arthur Andersen, Deloitte & Touche, KPMG and the AICPA first retain you to consult on this issue?
MR. ANDERSON: In my case, about a month ago.
MR. KLEINMUNTZ: Equally a month ago.
COMMISSIONER UNGER: And what's the extent of your services for those entities?
MR. ANDERSON: Basically, for me, they had read my response to the Bazerman article and asked me to expand on that to make sure that that view was heard. And then I also had a view that I was going to express on my own on the internal auditor services.
COMMISSIONER UNGER: So that part of your testimony -- I didn't finish reading it.
MR. ANDERSON: Yes. The internal audit testimony, they were fine with that, but that wasn't what they had initially asked me to do.
COMMISSIONER UNGER: Thank you.
MR. KLEINMUNTZ: I was also asked to comment on the psychological issues relative to the article that had appeared in Sloan Management Review and to bring my expertise in both the psychology as well as my knowledge from having worked in the area of auditor judgment and decisionmaking to bear in understanding that article because it was mentioned fairly prominently in the proposed rule. And to help them understand what the issues or problems were. Like Professor Anderson, I believe, although I hadn't been familiar with the article until it was brought to my attention by Arthur Andersen, like Professor Anderson, I believe that thatarticle overstated its case and it took a valid and very important psychological phenomenon and applied it in the auditing context in a way that I feel doesn't really capture the true nature of the issues as far as auditor independence.
COMMISSIONER UNGER: Because of this series of checks and balances that exist?
MR. KLEINMUNTZ: Well, a variety of things. One is the notion that -- the presumption in that article is that the only incentives the auditor is dealing with is the fact that they are being paid by a client and I just don't think that that's a realistic picture of how an auditor operates in a large firm. They also have to be accountable to their superiors, they have to be concerned about quality control mechanisms and so on and because of that, there are incentives that pull them in the direction of being accountable and there's actually academic literature that argues that those sorts of accountability pressures are very important and have a large influence on auditor behavior.
In addition to that, there is this notion that there are checks and balances. The psychological research that Professor Bazerman and his colleagues drew on when they wrote their article really deals with individuals making a decision on their own and doesn't deal with professionals in a large organization who are accountable. It also doesn't deal with professionals who have professional standards,ethical standards, legal requirements that they are attending to. And so from that point of view, it really didn't capture the contextual richness of the environment in which auditors operate. And so I think that their argument really just took a small valid point about the way people think and drew it to an extreme.
COMMISSIONER UNGER: Mr. Anderson?
MR. ANDERSON: Well, I certainly concur with that view and specifically that they didn't consider many of the mechanisms in place. I also would reemphasize the King paper, a very recent paper. It was presented -- I became aware of it when it was presented two weeks ago at the Illinois Audit Symposium and he has submitted -- my understanding he has submitted now that paper to the Commission, which basically shows how this self-serving bias in a simulated audit context can be removed.
COMMISSIONER UNGER: So are either of you concerned at all about the potential for conflict in the context that we've been discussing here today and in the last couple of sessions about the cross-over in services or providing non-audit services to an audit client? The independence issue?
MR. ANDERSON: Yes, of course. But the argument would be that -- the argument, the way the standard is written or the proposed rule is written, it seems to be motivated primarily by the individual auditor -- distortionof the individual auditor's judgment, rather than the audit team's or the audit firm's judgment and ignoring the group mechanism that's in place.
COMMISSIONER UNGER: And I have been in government most of my career, so I can't speak with authority on this, but even in the government there are certain philosophies or attitudes that are at all levels of management which do carry down into the firm. So if that philosophy or attitude, for example, in the loss leader engagement context, where the firm said let's go out and low bid all of our potential engagements because we're going to make it up in consulting services, which some witnesses testified does happen, what does that say, then, to the rest of the people at the firm, whatever level that's conveyed at, to those lower down?
Then it's a different sort of attitude or philosophy.
MR. ANDERSON: And if that was indeed the culture that was conveyed --
COMMISSIONER UNGER: Thank you. Culture was the word I was looking for.
MR. ANDERSON: I mean, unfortunately my audit experience as a staff auditor is some 20 years ago, but that was certainly not the culture that I ever experienced as a staff auditor. In fact, the opposite was true. I mean, errors like that were talked about and problems were talkedabout by the partners at lunch and so forth and we had a very clear impression that this is not something that was going to happen here or would ever even be considered.
COMMISSIONER UNGER: But a lot of what we're talking about, I think the reason we're talking about it is because the business has changed, not just in the last 20 years but in the last two or three years and you have to take a close look because of the mandated independence requirement and our duty to oversee it as to whether or not this change in the business dynamics has impacted the independence. And you can't help but take into account something like the Bazerman article. I have been thinking almost every day that we've had these hearings, I have a lab -- if anybody has a dog, here -- a chocolate lab and would I put a pizza on the table and leave the room? Probably not. But if I did and I came back, I would know if he ate it but I wouldn't know if he licked it. You know what I mean?
You put the temptation out there. Is this consulting business a pizza? I'm not saying accountants are dogs, but you just have to wonder about human nature and what happens when the culture changes, if it does change. What should we be looking at when we see at least externally a change in a function of what used to be primarily audit based?
MR. KLEINMUNTZ: Commissioner, could I respond?
COMMISSIONER UNGER: Please.
MR. KLEINMUNTZ: The problem I have is not the general line of thinking that you've got there, but with the notion that we go from that to immediately outlawing pizza. There may well be a problem, but I think accountants are business people and this is a problem that comes up in any business context in a number of industries. If I am a pharmaceutical manufacturer, I might be tempted for short-term profitability to do certain things or put certain products out, but in the long run, I have a public responsibility to put out products that are safe and effective and not only that but it's in my long-run interests as a business person to do that because I will avoid other problems, I will build trust with my customers and so on.
And I see the situation as being comparable for the accounting firms. I don't believe that the accounting firms -- well, let me say it differently. I don't have any particular personal knowledge about what the culture is inside the various accounting firms, but to the extent that you are concerned about that, I think the appropriate thing to do would be to start asking questions about the culture and about how the accounting firms are managing those issues, rather than simply saying this is unmanageable and so therefore by fiat we have to remove the source of temptation.
COMMISSIONER UNGER: Well, I think I have askedthose questions, but I haven't really gotten very informative answers and maybe I'm asking the wrong people.
COMMISSIONER HUNT: I don't know whether you were here yesterday or not?
MR. KLEINMUNTZ: No, I was not.
COMMISSIONER HUNT: Because we did have some testimony about the issue that you and Commissioner Unger are discussing. That is, the change in the culture, given the drive for the more rapidly increasing income and profits from the consulting side of the house, one former partner of a major accounting firm and similar testimony from, I guess, a litigator who had been in a lot of accounting cases, not a lot, but there had been some, the culture of these firms has gradually evolved.
Thank you.
COMMISSIONER UNGER: No, I appreciate that. I don't think I was here for that testimony, so that was helpful for me, too.
Did you want to add something to that, Mr. Anderson or anybody else?
MR. ANDERSON: One point is that the internal audit services, the outsourcing of internal audit services, I view as different than the consulting services because the point I was trying to make was that there is no incompatibility, that if your internal auditor is not in total communication withthe external auditor, the external auditor would be very upset. I mean, they should get all the reports, they should get the work, they should have access to everything that the internal audit person does. And the actual of the work in internal audit is the same type of work, same mechanism, same objectivity standards and so forth that the external auditor goes through, so I don't see where doing that work would undermine the external audit in any way because I don't see from an audit committee's viewpoint -- I mean, you have basically internal and external audit and internal is starting to move more toward serving the audit committee to get controls and governance in place. And that seems very compatible to me with the external audit.
In fact, from an audit committee's viewpoint, I would say that, you know, I look at what I spend on audit resources, whether they're internal and external, I'm just trying to control the company and then part of that control is to get accurate financial reporting in place and whether I do it using the internal audit resource I've got or the external audit resource doesn't really matter to me to achieve that goal.
COMMISSIONER UNGER: Mr. Briloff?
MR. BRILOFF: May I comment on the testimony of the last few minutes of my two colleagues on the right?
COMMISSIONER UNGER: Please.
MR. BRILOFF: There's a certain naivete there. On the one hand, you talk about the other controls that prevail, litigation, reputation, et cetera. They're there, I recognize that. But I ask you very directly, yesterday we had testimony from Ernst & Young, they anteed up 400 million as a result of their failures in the S&L. Last year, they anteed up -- or was it even this year -- 300 million in connection with their dismal failures in the CUC Cendant audit. And I ask you very sincerely if it were Abe Briloff who was thus found out, would I be so presumptuous as to say I will now tell the Commission how the Commission ought to act in terms of its relationship to the accounting profession?
Therefore, this concern about litigation, of course, it's real, but they insure against it with the result that it's a socialized responsibility.
And the colleague at the right referred to the fact that when he worked for an accounting firm 20 years ago, a major firm, they told him very overtly about the discipline responsibility that you have and they told it to him very sincerely and he took it to heart very sincerely. But then I ask him to go and review the publicly available documents in the Cendant CUC matter, where you can see overtly -- publicly available documents, in which Arthur Andersen ripped into Ernst & Young as to what it is that they -- where they fouledthe nest. You will see smoking guns in there. Smoking guns which were brought to the attention of the partner in charge. But you realize that psychological pressures on that partner in charge when the merger between CUC and HFS was then in process, could he say halt, the numbers are fake, let's go back to the drawing board? You tell me how any partner in charge would respond.
Tragically, I'm sorry for Mr. Rabinowitz. I know he was caught, just like the auditors in National Student Marketing 30 years ago. Yes, 1970. Same situation. They had gone beyond the point of no return. It's the tone at the top, the way they act.
And I agree with you, they told you very importantly this is a firm where you're going to be responding to the reputation. But the partner in charge of an audit has his own ego and purposes to protect. If he said I gave up three clients because of the fact that I was committed to being more Catholic than the Pope, you know what would happen to that particular partner.
COMMISSIONER UNGER: Thank you.
Well, actually, we have heard testimony from witnesses who go beyond this new part, new dimension of the auditing firm's relationship and say that there's the inherent conflict that starts when you pay for your own audit and I do think there is a little bit of that. And so howmuch more can they sustain without the conflicts becoming more apparent?
But I am not so sure we can ever figure that out. And I know even when we sit in a closed room and talk about our enforcement cases involving audit failures and the level of scienter, it's very hard to know. It is very hard to know. And I think it's something we don't want to be in the position of secondguessing. So if we remove the conflict before it exists and has the opportunity to take place, I think that's all the better for the investors and for the accounting profession as a whole.
But I'll move off that. The only thing I had wanted to ask of Mr. Kleinmuntz was did you think that the proxy disclosure, you had mentioned that you thought that that would be a positive rule.
Is that because you think that would modify behavior or because you think we need the information?
MR. KLEINMUNTZ: I think that it would make the information -- it would provide information that both investors and regulators could use. It would shed light on what the arrangements are. To the extent that there are people that on occasion may be tempted, if the nature of the temptation is out there, it becomes a lot clearer and it may well lead to audit committees taking a harder look at what they're doing with respect to these sorts of arrangements. Iknow you've heard testimony along those lines.
COMMISSIONER UNGER: We have heard that. We have heard that.
My only concern is that will it detract from the integrity of financial reporting as a whole if we say there could be conflicts and the investor has to go look and see what the fee arrangements are.
MR. KLEINMUNTZ: Commissioner, if that does occur, that would create an incentive for companies no longer to hire their auditor for these sorts of non-audit services. And maybe the market would help correct that on its own
COMMISSIONER UNGER: Mr. Briloff?
MR. BRILOFF: Just a brief note. I appreciate Professor Kleinmuntz's suggestion. I would like for all of us to remember that exactly 20 years ago, 1980, under the chairmanship of Harold Williams, the Commission promulgated accounting series release 250 which would have done nothing more, as I recall, than do that which Professor Kleinmuntz suggested.
The profession resisted that so aggressively and they waited long enough until 1981 under a different administration where the Commission promulgated accounting series release 264 to abort 250, saying let the private sector make their judgment call. And I can't help but feel that some of the persons sitting in the seats along here overthe past several days or weeks, whatever it is, were hoping that there would be an instant replay of that come January 2001. I am hoping they will be disappointed.
COMMISSIONER UNGER: It's so tempting to respond to that, but I'm not going to.
MR. BRILOFF: Please do.
COMMISSIONER UNGER: As the only Republican Commissioner -- I'll talk to you off the record.
Mr. Maurice, I wish I knew more about the European standards and everything and I profess my ignorance up front, but do you have the same kind of independence standard that the U.S. does with respect to the audited financial statements?
MR. MAURICE: In essence, yes. Well, the FEE guidance, which is indicated in the principles, does in quite a number of instances identify a situation at the wrong end of the spectrum, prohibition is effectively the only course that can be taken. But short of that, the threats and safeguards approach should be valid.
COMMISSIONER UNGER: Well, you say that you think instead of laying things out, making a list, I guess, of prohibitions, you think that we should approach it from more of a conceptual perspective?
MR. MAURICE: As far as possible. But there will still be a need for some prohibitions.
COMMISSIONER UNGER: What about all the people who say -- and it's very hard to reconcile everyone's testimony, I understand, but what about all the people who criticize the proposal for being too ambiguous and too difficult to comprehend and will be too difficult to follow, if we had a purely conceptual framework, do you think that would make it more difficult?
MR. MAURICE: For the members of the profession to come to terms with?
COMMISSIONER UNGER: Yes.
MR. MAURICE: Well, I speak perhaps with a different hat on as an employee of the Institute of Chartered Accountants in England and Wales. We have had a concept based independence statement in operation for over four years now. And there is no evidence of which I am aware that the profession is not able to cope with it.
COMMISSIONER UNGER: Do you have something sort of like the AICPA? God, I hope not, sometimes, but something like the AICPA that sets standards for the industry?
MR. MAURICE: Yes.
COMMISSIONER UNGER: So are they able to interpret -- is that how it works, they interpret --
MR. MAURICE: Yes, the discipline and policing and so on is in the hands of the individual professional bodies in the United Kingdom, but FEE is a federation of which theyare all members and therefore they are expected to accord their own guidance with the FEE requirements as a sort of highest common factor.
COMMISSIONER UNGER: And that's enforced by FEE or by --
MR. MAURICE: That will be enforced by each of the individual regulators of professional bodies. FEE isn't an enforcement agency.
COMMISSIONER UNGER: Just a standard setter? Okay.
How do you deal -- what are the specific prohibitions, if any, that deal with potential independence issues?
MR. MAURICE: There is, for instance, an indication of a specific prohibition in relation to participation in the accounting records of a public interest company. That's one that springs to mind. There are other prohibitions in relation to the provision of particular services in particular situations. I think the idea is the prohibition is not just that it should represent a situation where the appointment can't be accepted or continued, but also that it should indicate a framework within which the practitioner operates.
Of course, if he or she undertakes the exercise, weighing threats against safeguards, and they get it wrong, then they are vulnerable to complaint to their professionalbody. And if they get it wrong, then the burden of showing that they reached a reasonable decision will probably lie on the firm.
COMMISSIONER UNGER: So their first line of analysis is at the firm?
MR. MAURICE: They should -- yes. They should. Well, in relation to a reserved area like audits, reserves in the U.K. to specific bodies.
COMMISSIONER UNGER: And do the firms in the U.K. have a substantial amount of non-audit revenue, as in the U.S.?
MR. MAURICE: Well, yes. The large firms in the U.K. are the same as the large firms here.
COMMISSIONER UNGER: When I was in Australia, actually, for the IOSCO meetings, I had the occasion to meet with a lot of firms, law firms, who didn't like the accounting firms being in the legal business. They sort of drew a distinction as to the type of services that were provided. I don't think they really talked about conflicts, I think it was more of a competitive issue, but that's obviously not the issue that we're looking at today specifically.
But does the way you approach this involve the audit committee to any extent?
MR. MAURICE: Consultation with the audit committeeis a safeguard and most indicate it as being effective or being relevant in many situations, many if not most.
COMMISSIONER UNGER: So short of the conceptual approach versus the specific prohibition approach, which I guess is more like ours, do you have any other advice for how we should go about solving this problem?
MR. MAURICE: About solving which problem exactly, Commissioner?
COMMISSIONER UNGER: The independence issue. I think there's only one. The independence problem.
Do you think there is an independence problem?
MR. MAURICE: I think there has always been an independence problem because I think in my time in the profession, I'm not an accountant, I'm a lawyer, but I've been working for the profession for 18 years. The evolution of guidance on independence, rules on independence, and so has been a constant preoccupation. In the U.K., we now have a rolling review which goes on over two years in relation to all independence guidance and aspects.
Because we have moved, I think, from essentially a prohibition based approach to a conceptual approach, I think that we have avoided certain dangers. I have always been wary of categorical prohibitions, of including them in drafting. I can understand well indeed the requirement. The requirement is to draw an enforceable line, but I fear thatin seeking to draw a definitive and enforceable line, the ease of enforcement becomes an issue and therefore rough justice may result.
COMMISSIONER UNGER: And what caused you to make that switch?
MR. MAURICE: I beg your pardon?
COMMISSIONER UNGER: The switch from specific prohibitions to the conceptual approach.
MR. MAURICE: What --
COMMISSIONER UNGER: What prompted that?
MR. MAURICE: Well, why did we undertake that? Yes. Well, I've said that the U.K. bodies were regularly revising their guidance. That's a recent requirement. But we were previously -- we were also regularly revising our guidance in response to issues which were raised by the U.K. regulator, the Department of Rate and Industry. It seemed that every six to nine months there was a new issue that required addressing as to the implications. There was low balling, there was opinion shopping, phenomena I think which were first identified on this side of the Atlantic and very often the subject of ethical and technical guidance. Because they had arisen in the U.S., it was certain that they would arise shortly in the U.K. And we seemed to be dealing with, as it were, a new and additional situation every time.
The framework or conceptual approach was intendedto produce a regime where even if you haven't been sharp enough in identifying a particular situation or threat to independence, if you had to approach and address it as a practitioner on the basis of analyzing the threats and the seriousness of the threats and then contemplating which accepted safeguards can be employed to negate the threats or to reduce them to acceptable levels, that you would reach the right conclusion without the need for specific guidance.
COMMISSIONER UNGER: Well, one of the -- I promise this is the last question.
One of the criticisms that we've heard, though, over and over about our proposal, one of the criticisms, is that there is no smoking gun, there is no direct evidence of lack of independence. And I was wondering if you ever came across a smoking gun or any direct evidence of a lack of independence.
MR. MAURICE: No, there are quite frequent referrals to the institute's investigative and disciplinary committees in relation to independence aspects, but I have to say they tend to be the more blatant ones, the more obvious ones. On the other hand, following a recent problem on this side of the Atlantic where a number of failures to accord with guidance had been identified, we, that's to say the English Institute of Chartered Accountants, asked our joint monitoring unit which monitors the observance of technicaland ethical standards on the part of member firms who are, for instance, registered auditors. We asked the joint monitoring unit to carry out a review across the profession and of all major firms as to whether similar breaches were identifiable in the U.K. and they gave us a clean report in general terms.
COMMISSIONER UNGER: Well, thank you very much. I appreciate all of your time in waiting and in enlightening us with your testimony.
COMMISSIONER HUNT: Gentlemen, do either of you have any questions?
MR. TURNER: Just a couple of quick ones.
COMMISSIONER HUNT: Make it quick.
MR. TURNER: Mr. Maurice, with respect to continental Europe, aren't there some countries that do have prohibitions on services, consulting services, by auditors?
MR. MAURICE: In the case of Italy and, I think, Greece, there are statutory prohibitions and, indeed, in Germany, statutory limitations on other services being provided by the auditor. In Italy, virtually no other services can be provided by the auditor.
MR. TURNER: How about France? Are you familiar with France?
MR. MAURICE: France has an approach which is more comparable with the United Kingdom. They tend to avoid outright prohibitions.
MR. TURNER: Thank you.
MR. BECKER: I wouldn't dare.
COMMISSIONER UNGER: Can we mark this? So closes the testimony.
COMMISSIONER HUNT: I'd like to thank you all for coming. This closes the second day of the third and last session of our hearing on --
COMMISSIONER UNGER: The fourth.
COMMISSIONER HUNT: They counted this the second day of the third session, is the way they headlined it.
COMMISSIONER UNGER: Okay.
COMMISSIONER HUNT: And thank you. You have all provided valuable testimony and we hope we will be able to fashion a rule that's satisfactory and workable.
COMMISSIONER UNGER: And especially thank you to the staff who has sat here way beyond us coming and going. Thank you.
(Whereupon, at 2:44 p.m. the hearing was concluded.)
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http://www.sec.gov/rules/extra/audmin4.htm
