Statement of J. Michael Cook
Concerning Auditor Independence Requirements
Securities and Exchange Commission Proposed Rule Amendments
Comment File No. S7-13-00
July 26, 2000
This statement is submitted in response to the Commission's proposed rule amendments concerning auditor independence.
The views I express are as an individual, based on thirty-five years' experience in public accounting practice, including two years as the Managing Partner and then thirteen years as the Chairman and Chief Executive Officer of one of the profession's largest firms, and based on my new experiences as a Board and Audit Committee member in the year or so since I retired from that firm.
I have confined my remarks today to certain of the most important issues the Commission has addressed. I will provide detailed comments on the specifics of the proposal to the Commission's staff at a later date.
The Need for SEC Rulemaking
Some will challenge the Commission's rulemaking on this subject as unwarranted or unnecessary. While I might prefer a different approach (e.g, action by the Independence Standards Board), I have concluded that Commission action is the only way to address and resolve a critical issue that has a profound effect on the credibility of auditing and financial reporting.
Auditor independence, and in particular the possible impact of non-audit services, has been a topic of extensive discussion and expressions of concern for many years. At the formation of the Public Oversight Board, its initial Chairman John McCloy expressed caution about the possible effects of the growth of non-audit services on the fact and appearance of independence. Over 20 years later, the POB's Panel on Audit Effectiveness devotes a full chapter of its recent draft report to the same subject. Current attention to this issue comes from a variety of sources; certainly including the Commission's frequent and highly-visible expressions of concern about the matter.
Over the years, the profession has put forth various proposals and taken various actions to address the issue of non-audit services. Unfortunately, however sincere and well-intended, these actions have not put the issue to rest. Today there are substantial differences of opinion between the largest firms in the profession making a self-regulatory solution highly unlikely at best. The Chairman and the Commission have often followed the approach of looking to the private sector, rather than to a regulatory response, to address your concerns about important professional issues. Regrettably, I cannot see how that approach could be successful here.
In my judgment, this issue should be addressed, and hopefully resolved, promptly. Without resolution, continuing contentious discussion in highly-visible forums will surely lead to further questions about the credibility of the auditing and financial reporting processes which are essential to our capital markets. Also, I would be hopeful that the resolution of this issue could be a meaningful first step toward restoring a constructive partnership-like working relationship between the Commission and the profession. Unfortunately, that relationship does not exist today and has not for some time; restoring it is important to the investing public which both seek to serve and protect.
Financial and Family Relationships
"Modernization" of these rules is needed and overdue, and I support the Commission's proposed changes with one exception and one caution. I do not agree that it is appropriate for any partner, regardless of location or function, to have a financial interest in an audit client of the firm of which that partner is an owner. To me, the partners and the firm are inseparable for this purpose, and no exception is appropriate.
The profession has made great progress in recent years in attracting and retaining high-talent women. This will continue to be very important, particularly so if concerns expressed about the ability of the profession to attract the best and brightest were to become reality. Although I am unaware of any gender bias in the proposals, real or perceived, others have suggested that they may have unintended gender consequences. I urge the Commission to be particularly attentive to any indications of such effects and to act promptly to remove them if they are identified.
The Four Basic Principles and Prohibited Services
I agree with the stated principles but believe that one important clarification is necessary. It is a healthy and customary part of an auditor-client relationship for the auditor to seek to assist the client in improving its business, for example, in enhancing the effectiveness of its internal controls, increasing the efficiency of its operations, lawfully minimizing the taxes it pays, etc. Such assistance should not be construed to be "advocacy" as that term is used in the fourth principle.
I am not aware of any circumstance in which an auditor's independence has been impaired as a result of providing any of the specific services the Commission proposes to prohibit. However, I do not share the view that proof of such linkage is the only appropriate basis for regulatory action. To the contrary, I believe that most independence rules today are a result of appearance-based rather than fact-based concerns. Further, I agree with the Commission that the absence of "proof" does not justify inaction, particularly when such evidence cannot be expected to be demonstrable.
Impact on Audit Quality
Concerns have been expressed that audit quality will be adversely affected by the prohibition of certain consulting services.
Some suggest that consulting services are essential to the performance of a quality audit. That assertion, in my opinion, is incorrect. The vast majority of all audits are for companies who purchase little or no consulting services from the audit firm, and those audits are of high quality and always have been.
A second assertion is that audit quality will be impaired because the skills of consultants necessary to support the audit function will not be available if the new rules lead firms to separate their consulting practices. I believe that the majority of the five largest firms have already separated consulting or are in the process of such separation. As a Board member of a number of companies served by those firms, I would expect to ask them to describe how they will maintain audit quality in view of the assertions of others that audit quality cannot be sustained in these circumstances. I would suggest that the Commission ask the same question of those firms and compare their responses to the contrary assertions of those who see the outcome differently. The Commission should then carefully weigh and evaluate this evidence - a loss of quality would be a matter of considerable concern to all parties.
A final assertion is that quality will ultimately decline because the "new audit profession" will be unattractive to the best and brightest people. I cannot evaluate that possibility but would observe that the audit-dominated firms of the future that today's leaders express concerns about are in many respects comparable to the firms that attracted them (and me) to the profession twenty or more years ago. Certainly much has changed in that time period, but I would expect the right leaders to be able to make such firms attractive once again.
If services which adversely affect audit independence are prohibited, the rationale for disclosing other non-audit services can only be that the magnitude of such services can impair the appearance of independence regardless of their nature. Accepting that rationale, the disclosure should focus on amounts only and consideration should be given to a reasonable threshold (say 25% of the audit fee) below which no disclosure would be required. This would prevent disclosure of non-essential information which might lead to unwarranted questions about independence or to de facto prohibitions by those managements and/or boards who would consider any such disclosure be an undesirable reflection on the reliability of their financial presentations.
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There is nothing more important to the accounting profession than its credibility through its reputation for independence and objectivity. In this regard there has been no professional issue in my experience more complex and perplexing than the one we are discussing today. In the end there will be honestly-held, deep differences of opinion that will not be reconciled or reconcilable - trade offs will be required. The Commission will have to evaluate these differences with due consideration for the protection of the credibility of financial reporting and, at the same time, the viability of the auditing profession. The balancing of competing views will be a significant challenge, and your decisions will be difficult. If I can assist you further in this process, I am available at your request.
J. Michael Cook
July 21, 2000