Under the federal securities laws, public companies are required to file financial statements that have been audited by an independent accountant. Over the past several years, the major accounting firms have expanded their business beyond the traditional auditing practice into areas such as consulting, broker-dealer operations and financial programming and software applications. Traditional auditing firms now receive approximately 70% of their revenues from services other than auditing.
As this shift continues, questions have arisen as to the independence of these firms. Specifically, the SEC has begun to question whether these and other various relationships with an audit client compromise or potentially compromise the integrity of a public company's financial statements. Earlier this year the SEC sued PriceWaterhouseCoopers for violating the independence rules due to the fact that members of the firm owned stock in companies that the firm was auditing.
The issue is whether independent auditing firms compromise or potentially compromise their statutory duty of independence by engaging in certain relationships with audit clients.
From a market standpoint, there is probably no issue that is more important than the validity of a company's financial statements. While there have been scandals and frauds since the enactment of the federal securities laws, the market as an integral part of American society has survived and prospered.
This is not necessarily the case in countries that do not require auditor independence. In recent years scandals undermining the entire market have occurred in Russia, Japan and the Philippines - just to name a few. Auditor independence provides confidence to investors that, for the most part, what they read is in fact the truth. This confidence encourages investors to invest in the capital markets and while it sounds like a cliché, the capital markets are the lifeblood of the United States economy.
Requiring auditor independence promotes stability and integrity in the market. It is this stability and integrity that makes the markets so important.
In addition to the issues of market integrity and market stability, the issue of auditor independence is consistent with The Fool's mantra of "do your own homework, make your own investment decisions". In order for investors to adequately do their homework so that they can make informed decisions, investors must have access to all material information. In other words, we believe there needs to be complete transparency in the market place - everyone should have access to all material information. This need for material information and market transparency is what made the passage of Regulation FD so important. No doubt the need for unbiased financial information about a company is necessary for investors to be able fully and adequately vet every investment decision. At its core, the issue of auditor independence is no different from the purpose of Regulation FD - creation of market transparency and a leveling of the playing field.
Investors should know whether the auditing firm that has formed and published and ostensibly independent opinion about a company's financial statements has a relationship that would or would appear to compromise its independence. The presence of this information is something that an investor would in all likelihood include in the "total mix" of information about a potential investment. In its simplest terms, compromising auditor independence is a conflict of interest that investors should be aware of.
In order for investors to do their own homework and make their investment decisions they need all material information. Whether an auditing firm has a relationship that does or potentially biases the independence of a company's financial statements is an issue that investors should be made aware of.
The Motley Fool believes that market transparency is an absolute requirement for the market to function efficiently. We can think of three ways to promote this goal:
We believe that auditing firms should be required to disclose the nature and scope of their entire relationship with a public company. Once this disclosure is made it is up to the individual investor to determine whether they believe that a company's financial statements are truly independent. This is a free market approach that forces auditors to earn the trust of the investing public. Mistakes will impugn the integrity of that auditing firm and will compromise its ability to function. Disclosure is the first and best step that can be taken at this time.
The approach currently favored by the SEC restricts the relationships between public companies and their auditors. Disclosure alone does not solve the problem because there still exists the appearance of impropriety. This appearance is enough to make the capital formation process that much more difficult. In turn, as this capital raising process is made more difficult, the stability and integrity of the market is brought into question.
Forcing auditors to forgo a line of business impinges on their ability to generate revenue. If restrictions are imposed it could lead to sale of the consulting operations of auditing firms. This forced sale could require auditing firms to receive less than market value in exchange for their assets. As such, auditing firms should be compensated for their loss of business.
As noted above, we believe that disclosure is the first best step that the SEC can take to solve this problem. Do we believe that there is a problem with the current practices? Yes. Are we sure with the approach that should be taken? No. We believe that the solutions outlined above do a good job and are a good start to promoting market transparency while protecting the integrity of the public markets.
Testimony of Thomas M. Gardner
Before the United States Securities and Exchange Commission
On September 13, 2000
Good afternoon. My name is Thomas Gardner and I am co-founder of The Motley Fool, Inc. of Alexandria, Virginia. I would like to thank the Commission for affording me the opportunity to testify today about the issue of auditor independence.
In 1994, my brother, David, and I started The Motley Fool with a mission "to educate, amuse and enrich the individual investor." Today, we employ more than 350 Fools and have offices operating in the U.S., the U. K. and Germany. We have an internationally syndicated newspaper column carried by more than 190 newspapers and The Motley Radio show syndicated in 145 markets. In addition, we have five NY Times best-selling books, a line of self-published books and research, and a community of Fools more than 2.5M strong who visit us online at Fool.com, Fool.co.UK and Fool.de. On average, each month across the globe, The Motley Fool is reaching more than twenty-five million investors with its original mission "to educate, amuse and enrich the individual investor."
Our work is driven by our belief that average people - you and I - ought to take a vastly more active interest in our management of money than we have heretofore. And in order for individual investors to effectively manage their own money, they need education, information, and opportunities for open dialogue. That's what we provide. We teach people the fundamentals of long-term financial management; we highlight online and offline information resources for them; and we manage a 24-hour open network of communication on money between people in more than 100 countries around the globe.
In a world that severely lacks financial instruction of any form, at any educational level, we at The Motley Fool have been reminded every day of the extraordinary value for individual investors of nothing more than simple information - information about Einstein's miracle of compounding growth, information about the real (after-fee and after-tax) rates of return of managed mutual funds, information about any public company's quarterly earnings result. And I know that it is vital for every stock-market participant to have access to the same corporate information at the same time.
This idea, the need for complete public market transparency, is the source of the integrity and stability that make our markets the envy of the world. For example, the Securities and Exchange Commission's passage of and commitment to the enforcement of Regulation FD, requiring corporations to release material information simultaneously to all investors - regardless of their geographic location, their professional standing, or the size of their brokerage account - is a powerful affirmation of the critical necessity of market transparency.
With that as a backdrop, I'd like to discuss why I think the issue of auditor independence is important to individual investors. For business investors, at the heart of making good investment decisions is the need to assess company performance by analyzing financial statements. And embedded in that process is a natural reliance on the truth and accuracy of the financial accounting. It's unrealistic to expect even the most seasoned investor to regularly sniff out accounting irregularities in advance of the SEC doing so. Accordingly, there must be a mechanism or process whereby investors can take comfort in the veracity of the financial statements.
Congress recognized this need when they confirmed federal securities laws which required that all public companies regularly file financial statements audited by an independent auditor. Nowhere else do federal securities laws require a third party to confirm the performance report of a public company.
Unfortunately, commercial activity over the past decade has served to weaken the definition of an otherwise simple word "independent." We're losing its prefix. The array of relationships that exist between public companies and their auditors today are moisturizers down a slippery slope toward dependent audits. And when the objectivity of financial audits is compromised, we lose ground on achieving the transparency that is fundamental to a robust public market. Again, without transparency, individual investors - far and away our market's largest constituency - will, with each abuse of the system, withdraw their funds for years, perhaps decades, perhaps never to return.
The SEC's congressional mandate is to protect investors and defend the openness, clarity, and visibility of the marketplace. The present state of corporate audits - with auditing firms inking substantial consulting and business-service contracts with companies whose financial performance they are tasked with objectively inspecting - is at odds with that SEC mandate. It violates the protection of individual investors. It violates the openness, clarity, and visibility of the marketplace. And it violates existing federal securities laws.
Now, do I have the cure-all solution for corporate auditing? Unfortunately, I don't. The best I can offer today is that independent auditing is critical to the security and opportunity offered by our equities markets. No one on any side of this issue can disagree with that. But there is no simple remedy to the problem. I have two possible solutions that I'd like to share, but they're the thoughts of an individual investor, the manager of a private company, a layman without formal accounting training, and a guy who calls himself Fool. Weight what follows accordingly.
These two ideas have the same goal - to create clarity in the market and to provide investors with the information they need to make informed investment decisions. Both ideas support our belief that the U.S. market will be strengthened by the attraction of hundreds of millions of individual investors from around the world to our well-policed free-market system. To that end, our "do your own homework, make your own investment decision" mantra at The Motley Fool relies upon full informational disclosure. That also happens to be the basis of our federal securities laws.
Therefore, I think that the first best step the SEC should take is to, without delay, require public companies to disclose the nature and extent of their relationship with auditors, in its entirety. This disclosure is not currently required. It should be. A complete, detailed disclosure would give investors the opportunity to decide for themselves whether or not accompanying commercial relations were impacting the purity of the audit.
Requiring disclosure would serve to force public companies and auditors to earn the trust of the investing community. If a public company maintained a consulting relationship with its auditor, disclosed it fully, and the financial statements were never brought into question, either by a government body or a private lawsuit, then I would see no reason to be any more or less distrustful of the validity of the financial statements.
Likewise, if another public company extended commercial relations with an auditor, disclosed it, and then the financial statements proved inaccurate, this could permanently damage, even destroy, the reputation of both company and auditor. The risks are immense: shareholder lawsuits; civil actions by the SEC and other regulators; criminal prosecution; and of course, the loss of investor confidence in the company and the auditor. Total and continuous disclosure might well introduce risks substantial enough to deter unhealthy, conflicted business relationships between public corporation and independent auditor.
Disclosure is also consistent with free market thinking. Confidence in or skepticism of a company's financial statements will be factored into the market's valuation of that business. When companies and their auditors want to pursue ancillary business relationships, requisite disclosure will help insure the integrity of the audited financial statements but it will also become a factor in company valuation.
The most important point of a disclosure-based approach is that investors be given the opportunity to receive, digest, and analyze all information material to their investment decision.
A second and more severe form of regulation is to restrict certain relationships between auditors and public companies. This approach seeks to protect investors by upholding the United States Supreme Court's position that auditors be watchdogs for investors with a duty of independently certifying the financial statements of a public company. The High Court has made it exceedingly clear to the auditing community that its responsibilities are to a company's shareholders not to its executive team.
However, the problem with untying the meaningful and existing commercial ties between auditing businesses and public corporations is that doing so would act as a strike against value creation for auditors. Any restriction, which in effect forces an auditor to scale back or sell its consulting business, will result in a loss of value. And that loss in value extends not just to executives at auditing companies, but throughout the entire industry. This sort of decline in the value of the auditing function would, no doubt, then repel the best certified public accountants from working as auditors. The net result of that would be a lower quality of auditing and, thus, an increased risk to market transparency.
Therefore, I believe that if we move to restrict these relationships in order to protect investors, we must then consider compensating auditing firms for their loss, similar to the theory pursued in eminent domain cases. Subsidization of the auditing function - a policing watchdog of our open public markets - should not be ruled out.
I close where I began. This issue is extremely complex. Both sides present viable arguments in support of their position. Unfortunately, none of the solutions I have proposed are a cure-all for the problem. Nonetheless, there is no compelling argument against disclosure here. I urge the SEC to immediately require auditing firms to disclose the full, detailed extent of their relationship with public companies that they audit.
And while I do think that the extension of commercial relations beyond auditing opens investors up to additional risk, nevertheless without any empirical evidence that such relationships actually harm investors I am reticent to support immediate restrictions. However, if evidence can show a correlation between these relationships and the undermining of the integrity of the market - and I am open to the possibility that such evidence exists - I believe we should consider subsidizing tighter restrictions against auditor partnerships.