Statement by Mauricio Kohn, CFA, CMA, CFM
For
The Association for Investment Management and Research (AIMR)
Before the
Securities and Exchange Commission
September 20, 2000
Introduction
Good afternoon, I am Mauricio Kohn, Principal of Kohn Financial Consulting.
I am a holder of the Chartered Financial Analyst® (CFA) designation and member of the Association for Investment Management and Research (AIMR). AIMR is a global, nonprofit organization of over 43,000 investment professionals in 90 countries. Through its headquarters in Charlottesville, Virginia and more than 95 Member Societies and Chapters throughout the world, AIMR provides global leadership in investment education, professional standards, and advocacy programs.
I am also a Certified Management Accountant and Certified in Financial Management. I am here today to testify on behalf of the Audit Subcommittee of the AIMR United States Advocacy Committee of which I am a member.
The AIMR U.S. Advocacy Committee is a standing committee of AIMR charged with reviewing and responding to major regulatory, legislative, and other developments in the United States that may affect AIMR members, the investment community, the efficiency and integrity of financial markets, and ultimately all investors. The Audit Subcommittee focuses on issues related to auditor independence and audit effectiveness, not only how audits are conducted but also on corporate governance issues and the oversight responsibilities of corporate audit committees.
Members of the Audit Subcommittee have worked with the Independence Standards Board (ISB) and have participated on several ISB task forces on auditor independence. As a subcommittee, we have been, and will continue to be, active in responding to ISB and other proposals on these issues. Most recently, we responded to the O'Malley Report issued by a special panel of the Public Oversight Board, regarding the effectiveness of audits. All of our comment letters are available to the public on the AIMR web site under - http://www.aimr.org/professionalism/advocacy/commact.html.
General Comments About Auditor Independence
We believe that external auditors, who are independent and objective, play a critical role in maintaining the credibility of the financial information disseminated by enterprises within the U.S. capital markets and used by market participants in making investment decisions. Consequently, independent auditors are integral to the overall stability and strength of these markets. Users of financial statements rely on the independent auditor's opinion to ensure that an enterprise's audited financial statements represent a fair and faithful depiction of its performance and financial condition in accordance with generally accepted accounting principles (GAAP). Credible and reliable information is essential for the efficient operation of financial capital markets, insuring that capital will be allocated to those investments that create the greatest returns commensurate with the risks and uncertainties of the investment.
Specific Comments on the Commission's Proposals
We support a proposal that will improve auditor independence and, in turn, give investors confidence that audited financial statements and accompanying disclosures fairly present an enterprise's performance and financial condition in accordance with U.S. GAAP in the case of domestic enterprises or other GAAP in the case of foreign enterprises filing with the Commission. We believe that updates to current rules and standards regarding auditor independence are needed to appropriately reflect the current business environment in which accounting firms not only conduct audits, but also provide consulting services to audit clients. Most importantly, the proposed changes address the needs and concerns of all stakeholders in these enterprises, regarding the appearance of conflicts of interest and impairments to independence.
To facilitate our deliberation and discussion of the Commission's proposed changes to auditor independence requirements, AIMR conducted three separate surveys of AIMR members and CFA candidates who are identified in the AIMR database as analysts or portfolio managers. Data was collected separately for respondents in the U.S. and outside of the U.S. In combination, the surveys asked a series of questions about whether certain relationships would likely impair or compromise auditor independence. Each survey addresses one of the following issues:
(1) Financial ownership and interests in audit clients held by audit firms, partners, and other audit professional staff;
(2) Non-audit services provided to audit clients; and
(3) Employment relationships involving personnel within the audit firms and audit clients.
In addition, all three surveys asked whether auditors could advocate or lobby on behalf of their audit clients without impairing independence. A total of 2,985 individuals responded to the three surveys (or 11% of those surveyed) comprised of the following: 970 (733, U.S.) responded to the survey on non-audit services; 875 (673, U.S.) to the survey on financial interests; and 1,140 (867, U.S.) on employment relationships. Any significant differences between U.S. and non-U.S. responses will be noted in the results I present.
The following are highlights from the results of these surveys and positions taken by the Audit Subcommittee regarding some of the Commission's proposed changes to auditor independence requirements.
Advocacy Role
We believe that the facts and circumstances of each situation involving an advocacy role should be considered when evaluating potential threats to auditor independence. It is not always obvious to us under what circumstances those who rely on the auditor's work might consider the auditor's independence impaired. This general uncertainty about advocacy roles is evident from the survey results.
As I mentioned earlier, all respondents, regardless of which survey they received, were asked whether an audit firm should be permitted to advocate or lobby for its audit clients before regulators and standard setters on auditing or accounting issues. Close to 3,000 individuals responded to this question. They were divided almost evenly as to whether such "advocacy" would cause impairment of independence - 44% said Yes, independence would impaired, 45% said No. The remaining 11% were "not sure."
We believe that certain advocacy roles, such as that of an attorney providing legal services, should be prohibited. We strongly believe that a lawyer's advocacy role is incompatible with an auditor's independence role because:
(1) The attorney-client privilege conflicts with what must be the auditor's focus: the protection of investors through proper public disclosure; and
(2) Legal advice often fulfills a management role through participation in management discussions resulting in a representation that is, in turn, relied upon by the auditor.
(3) An attorney is obligated to act in the best interests of its clients and do no harm to its client which conflicts with an auditor's role of maintaining objectivity and remaining independent from its client.
On the other hand, auditors advocating on behalf of clients regarding tax and accounting issues, do not, in our opinion, represent a strong threat to auditor independence.
The survey results support our position. The results of a specific question in one of the surveys about the appropriateness of an auditor providing legal services to audit clients were clear: 65% of the 733 U.S. respondents (62% of total respondents) indicated that auditor independence would likely be impaired or compromised by providing legal services. Only 37.3% believe assisting with tax compliance would be likely to impair independence.
We are aware that audit firms are currently permitted to provide legal services to audit clients in Europe, South America, Australia and other countries. The survey responses from the 237 respondents from outside the U.S. indicated more acceptance of this practice - 50.2% of respondents believe impairment would occur compared to 49.8 % who believe it would not. This explains the drop from 65% to 62% I noted above.
Financial Ownership and Interests
We also support the general thrust of the Commission's proposals to "modernize" auditor independence requirements relating to financial ownership and financial interests in audit clients held by the audit firm's partners and professional staff, as well as held by their extended family members. We believe that changes in regulations are needed because (1) traditional family structures have changed and audit personnel and their families, often dual income households, are widely dispersed geographically and (2) audit firms must be able to compete effectively in recruiting and retaining professional staff, especially in today's labor market. However, we believe that the audit firm itself should be prohibited from having any ownership interest in an audit client, unless this interest is held in trust by an independent trustee, such as a pension plan managed by a third party or mutual fund. Likewise, an audit client should be prohibited from having an ownership interest in its audit firm. Our positions on these issues are fully supported by survey responses.
Table 1 contains the combined survey results from 875 responses to the following question: Should an audit firm, its partners or audit professional staff be permitted to have financial ownership or financial interest in the firm's audit clients
Table 1
Financial Ownership of Audit Clients
(n=875)
No, ownership should be prohibited |
Yes, Up to 5% |
Yes, Up to 10% |
Yes, Up to 15% |
Yes, percentage
| |
Audit Firms |
85.3% |
9.4% |
1.1% |
1.1% |
3.1% |
Partners involved in the audit engagement |
85.7% |
10.4% |
.6% |
.7% |
2.6% |
Professional staff involved in the audit engagement |
77.5% |
14.7% |
2.4% |
.9% |
4.5% |
Partners not involved in the audit engagement |
50.3% |
27.3% |
4.2% |
2.3% |
15.9% |
Professional staff not involved in the audit engagement |
32.7% |
33.0% |
6.7% |
2.3% |
25.3% |
Non-Audit Services
As previously mentioned, we have issued comment letters to ISB on its proposals for auditor independence standards, including legal services and appraisal/valuation services. In those letters, we recommended that auditors be prohibited from providing legal services to their audit clients and that appraisal/valuation services should be limited in scope. In addition, adequate safeguards must be in place to segregate the audit practice from non-audit services. Such safeguards would include establishing effective firewalls or forming a separate subsidiary that only provides audit and tax services.
A primary concern we have with an audit firm providing other non-audit services, such as asset valuations and appraisals, is that in the process of performing those additional services, the audit firm might uncover information about an audit client that would raise concerns about the viability of the business or the reliability of the records, and such concerns are not disclosed. We believe that auditors should be held to a higher standard than those providing other services. If an auditor uncovers this type of information while providing non-audit services to their audit client, they should be required to disclose that information.
Another conflict occurs when auditors perform work for an audit client that eventually feeds into or becomes part of the financial statements of the firm or a representation of management. In those instances, we question whether firms can objectively evaluate their own work. In addition to the conflicts we observe when firms provide legal services to their clients, we believe that there are also inherent conflicts of interest when firms provide the following services to their clients:
The following Chart 1 shows the results from 970 respondents, comprised of 733 U.S. and 237 non-U.S. respondents, were asked: Which of the following services, if provided by accounting firms to audit clients, would likely compromise or impair auditor independence and judgment?
Chart 1
Non-Audit Services Provided to Audit Clients
Note: Percentages shown on the above chart represent the respective percentage of respondents who believe independence would likely be impaired if the firm provided that service to its audit client.
Potential threats to auditor independence, resulting from audit firms providing non-audit services to their audit clients, are troublesome to many of the respondents. A few respondents indicated in written comments submitted with the survey that audit firms should not be allowed to offer any non-audit services to their clients. We believe that this approach would be too severe and would eliminate some beneficial synergies gained by having certain audit-related affiliations such as internal control and system designs, tax planning and compliance.
However, we are concerned with the extent to which the audit firm has evolved into a multi-service business advisory firm, one that provides consulting and management advisory services in addition to audit and tax services. This trend has shifted the emphasis of the firm's practice away from their primary purpose, audit and forming an opinion on financial statements, to other services that are often more profitable for the firm. As a result, we have observed changes in the audit firm's culture and primary business drivers that place more value on non-audit services than performing audits. This paradigm shift in value was noted in the recently published exposure draft of the O'Malley Report1 (page 91 under Findings):
"Focus group participants often indicated that not only clients, but also engagement partners and firm leaders, treat the audit negatively - as a commodity. Some respondents to the Panel's survey and engagement teams interviewed in the Quality Peer Review process expressed similar views..."
This change is also reflected in statements made by Barry Melancon, President of the AICPA, who has indicated his desire to change the definition of a CPA from "Certified Public Accountant" to "Certified Professional Advisor". In addition, I have found in discussing these issues with practicing CPAs that they often view the audit as a "loss leader," a service that they provide to create access to providing other services to the client and not their primary responsibility.
The frequent use of the audit as a "loss leader" to obtain engagements for non-audit services further cements our views that those who provide audit services must be separated from those who provide non-audit services. At a minimum, there must be disclosure of any non-audit services provided by auditors to their audit clients. Therefore, we strongly support the Commission's proposal to require registrants to disclose in their proxy statement the non-audit services provided to them by their audit firms. This strong support was evident in the survey results. Of 970 respondents - 83.5% indicated Yes, the Commission should require registrants to disclose a statement of all non-audit services including, at a minimum, (1) the percentage of the total non-audit fees to total fees paid to the auditor and (2) the percentage of non-audit fees to total fees for each non-audit service provided by their external independent auditors.
We recommend that the scope of the disclosure be expanded to include, in addition to fees paid during the reported period, the total value of outstanding service contracts or arrangements by type of service, the fees billed, paid and unpaid for these contracts, as well as any current proposals or bids for future services as of the reported period. In addition, if such arrangements are not prohibited, we suggest that any compensation that has been or may be earned by the audit firm from any contingent or success-fee arrangement, especially related to financial and/or advisory work, should be disclosed.
As a general rule, we oppose a "bright-line" approach to determining disclosure or accounting treatment. Therefore, it is important that qualitative, as well as quantitative, elements of the non-audit services should be considered in determining whether disclosure is necessary. Our recommended approach to this disclosure is consistent with the Commission's Staff Accounting Bulletin No. 99, Materiality. An example of a qualitative factor would be the nature of the work and impact on the financial statements, in addition to the quantitative relationship to total fees paid.
The accounting industry has gained its reputation by being thorough and providing investors a reasonable assurance of accuracy and reliability of financial information. It has done so with auditing services as a cornerstone to its foundation. When the "other services" that the auditor performs overshadows the audit, a question arises as to whether that reputation will remain intact.
Employment Relationships
For many of the same reasons we cited for updating the rules for financial interests, the Commission's rules governing employment relationships should also be updated to reflect the current business environment. We do not believe it is necessary to impose a mandatory "cooling-off period," prohibit clients from hiring audit firm professionals, or stipulate that an audit firm's independence is impaired when its professionals accept key positions with current clients. We believe that such restrictions would unduly impair an audit firm's ability to recruit high quality candidates with the desired skills and knowledge as well as the client's ability to benefit from a former audit professional's industry expertise and knowledge of the client's business.
Instead, we strongly recommend disclosure of any post-audit firm employment by the firm's current audit clients shortly after there is an offer and acceptance of employment for key positions, such as CEO, CFO, and president. Also, should any employment issue arise either prior to the commencement of the audit or during the audit this should be disclosed prior to the issuance of the audited financial statements or within 10 calendar days on Form 8-K. Our survey results showed strong support for such disclosure: 62.3% of respondents indicated this disclosure should appear in Form 10-K (or other annual reporting document) and 45.1% indicated it should appear in a Form 8-K. as well. (See Chart 1 below.)
Chart 1
Disclosure of Post-Employment in Key Positions
with Audit Clients
With respect to other employment relationships, majority of 1,140 respondents did not believe that a firm's objectivity and independence would likely be impaired if one of the professional staff, who is not assigned to the audit engagement, had a close family member employed by the audit client. This response changed for a professional staff, who is assigned to the audit engagement: 43% of 1,140 respondents believe that independence would be impaired if the family member holds a key position with the audit client, and 35% of 1,140 respondents believe this would be the case if the family member holds any management position with the audit client.
Closing Remarks
The following are our key positions on the Commission's proposals for auditor independence requirements:
We believe that fair and full disclosure is warranted for various relationships between an enterprise with publicly-traded debt or equity (audit client) and its external auditors - business arrangements, non-audit services, financial interests, as well as post-employment relationships involving key positions in the registrant. Therefore, in updating the Commission's rules on auditor independence, at a minimum, we recommend that a separate section be added to the Annual Report on Form-10K (or Form 20-F for foreign registrants) for the purpose of disclosing such relationships to both current and prospective stakeholders of these enterprises.
AIMR appreciates the opportunity to express its views on the Commission's proposals to revise auditor independence requirements. Georgene Palacky of the AIMR Advocacy Program or I will be glad to elaborate on AIMR positions and the results of the surveys and entertain any questions that the Commission or its staff may have regarding our comments.
1 Special report issued by The Panel on Audit Effectiveness, a panel formed by the Public Oversight, dated May 31, 2000.