Before the SEC on July 26, 2000

My perspective is long-term and unique: Auditor/Educator at large CPA firm, Chief Accounting Officer of several large international public corporations, Professor with research interests in ethics, corporate governance, and auditing, also investor concerned with recent financial reporting problems.

Need for CPA to avoid ethical lapses and improve audit performance is urgent. Generally agree with SEC approach. Not why so fast, but what took so long? AICPA training materials for supervisors and managers I used in the 70s and 80s emphasized "selling more services to existing clients"

Pressures on auditors result from increasing reliance on stock option gains for larger portion of compensation as well as Wall Street expectations.

II C 2 Scope of Services (b) Recent Developments (p 7)

SECPS report of firm fees may not portray accurate picture of the proportion resulting from other than financial statement audits. SECPS says they do not provide guidance on what to put in which bucket. "Accounting and auditing" which the firms now call "Assurance and Business Advisory Services" includes outsourcing of internal auditing and a variety of advisory services.

II C 2 Scope of Services (d) Measuring Independence Impairments (p 9)

In addition to the MicroStrategy case, SEC files no doubt contain numerous examples that would demonstrate an association between consulting services and audit failures, but these of course must remain confidential. No empirical evidence exists because no empirical studies have ever been undertaken. It is unreasonable to expect to "prove" cause and effect relationship exists as in a laboratory experiment in the physical sciences.

A broad definition of "audit failure" would undoubtedly disprove the contention that audit quality has never been diminished by ethical lapses such as those possibly associated with providing certain non-audit services.

III B General Standard for Auditor Independence (p 13)

Appearance measurement should refer to reasonable investors and other stakeholders knowing all publicly available relevant circumstances. Stakeholders in addition to investors rely on the assurance provided by auditors. Appearance should be measured by public information. We should not expect persons to dismiss apparent independence impairments when they have no access to relevant information.

Need a fifth governing principle that would determine when an auditor is not independent. It should be a behavioral principle that encompasses a number of conditions so it would not require frequent change. Language: . . when the auditor has any relationship or engages in any activity that gives the appearance that independence may be impaired. The existingethics rule forbidding acts discreditable to the profession is an example of a behavioral rule. Behavioral rules can be enforced.

Agree that auditor independence means that the auditor shall never subordinate his or her judgment to that of others. This is another behavioral standard that should be reinstated in the rule.

Disagree that accounting firms should be permitted to lobby for an audit client.

III C Specific Applications of the Independence Standard 3 Business Relationships (p 26)

Through the SROs, the Commission has just implemented stricter criteria for determining the independence of directors as members of an audit committee. It would seem that equally strict criteria or even stricter criteria should apply to independent auditors.

Using my suggested fifth principle, none of the listed business relationships would be appropriate since they certainly give the impression that the interests of the auditor and client are aligned. ie, designed to help make the client more successful.

III D Non-audit Services 1 The Proposals (p 27)

I am pleased that John Biggs, the Chair and CEO of TIAA-CREF, the world's largest pension fund and a recognized leader in corporate governance, has chosen to publicize their policy of avoiding use of their external auditor for any other services. (TIAA-CREF holds the largest portion of my family's net worth.)

The argument that providing consulting services enables a firm to provide a better audit seems appealing. However, I doubt that knowledge gained by consultants can be effectively utilized by the auditors who are actually performing the audit. One of the firms testifying at the POB hearing stated: "we tried to [combine audit and systems skills] and it didn't work."

III D 1 (b) Specific Non-audit services that impair independence (v) internal audit outsourcing (p 30)

Perhaps the term "services specially arranged and individually approved by the audit committee" (the exclusionary rule) should be substituted for "nonrecurring." A client might wish to regularly utilize the external audit firm for the internal audit of a particular location because of knowledge of language, local customs, saving of transportation cost, and the like. I agree with the objective of prohibiting in substance total or nearly total outsourcing of the entire internal auditing function.

The AICPA Ethics Executive Committee has not well stated these issues. Its use of the term "be responsible for the internal audit function" allows for a figurehead arrangement. Instead, the client should be required to provide "active management" of the internal audit function.

III D 1 (b) Specific (vi) Management Functions (p 31)

Need to clarify that "functions as management" is not limited to senior management, but extends to many levels. Further, it should be made clear that management decisions may involve tactical as well as strategic matters.

III D 2 Alternatives (p 35)

My survey of bank auditing costs in 1995 showed that for respondents with over $3 billion in assets, fees for services other than the annual audit amounted to more than 60 % of the audit fee in 43% of the cases. In one case, other fees amounted to 4 times the fee for the annual audit. Undoubtedly, the proportion of other fees has grown since 1995.

I favor the philosophy of sharply limiting non-audit services to some inconsequential amount (more like 10 - 15 % of the audit fee rather than 25%). Circumstances undoubtedly exist where the best interests of all concerned do favor using the in place external audit firm. Perhaps some shortcuts in the administrative aspects of the exclusionary rule should be allowed for truly insignificant amounts.

Presence of cross selling or marketing, profit sharing, a "holding entity", or commonality of names would negate the appearance of independence the Commission is attempting to achieve. I doubt whether the general public would understand a firewall. I doubt whether the analyst community would have confidence in the effectiveness of a firewall.

III E Contingent Fees (p 37)

It is hard to comprehend how acceptance of any fee that is contingent upon occurrence of a result that the auditor determines or controls does not obviously result in a conflict of interest with the public and thus trigger an impairment to the auditor's independence

III F Quality Controls (p40)

The proposed rules on quality controls appear to focus almost entirely on independence impairments resulting from ownership issues and should rather cover a broader spectrum of causes and encompass a behavioral framework.

It is this section where I believe the proposed rules should be significantly expanded to require all firms to have ethics programs that would meet the requirements of the US Sentencing Guidelines. (See my articles: "CPAs must forge ahead on setting up ethics controls" September 1996, "Big Six lags in embracing internal ethics programs" August 1997, "Does Firm's Conduct Code Widen the Ethics Gap?" May 1998.

It seems incongruous for firms to be required to evaluate a client's ethical control environment or corporate culture as a part of every audit engagement, yet with one exception have no counterpart control mechanism themselves.

Clearly, maintenance of professionalism that protects the public's interest is too important a subject for firms to continue to ignore the control mechanism that has been made a part of US jurisprudence, is the keystone of the Defense Industry Initiative, and has been adopted by an overwhelming majority of large public corporations.

The one Big Five firm presently known to have a formal Ethics and Business Conduct program should be commended. However, the values contained in its previous conduct code How We Do Business are totally incompatible with those a CPA firm should live by and proclaim tothe world. I am told that a new code of conduct has been issued to replace this document, but was told by the firm's top ethics partner that it was a "private document" and not available to me or to the public.

As a counselor in the Institute of Management Accountants ethics program, I receive hot-line calls from IMA members who are facing ethical dilemmas. Several of these have involved fraudulent financial reporting in public companies. I urge the CPA profession to consider the public interest and provide formal alternative communication channels as provided for in the Sentencing Guidelines or an ombudsman who could initiate corrective actions at an earlier stage while protecting the interests of informants.

III G. "All Relevant Circumstances" (p 40)

As noted in my discussion of the General Standard, I recommend a fifth or behavioral component be included. For example, firms seem to go out of their way to denigrate their auditing services. Millions of dollars are being spent to create the image of CPAs as valued confidants, yet not a penny is earmarked to convey professionalism or any concern for the public interest. These current advertising campaigns that are designed to make CPAs into "financial service providers" diminish the appearance of independence and should be proscribed. Under the "clean break" alternative, this could be easily accomplished.

1. I urge the SEC to couch at least one independence guideline in behavioral terms. This will encourage ethical decision-making processes rather than just setting forth ever increasing numbers of detailed and legalistic rules that will foster the mind set that anything not specifically prohibited is acceptable. Legalistic rules foster efforts to rationalize evasion of the essence of the profession's ethical objectives. These are already very well stated in the six articles of the AICPA Principles of Professional Conduct.

Europe and Canada seem to be ahead of the US in focusing on behaviorally-oriented compliance programs. The Canadian Defence Ethics Program is an example.
2. I recommend that the proposed rules encourage the CPA profession to assume a leadership position in ethical behavior by developing and implementing a world-class exemplary ethics and business conduct program under the oversight of the hopefully soon to be reinvented Public Oversight Board.

My own research shows compelling evidence that a variety of favorable outcomes are associated with a strong management commitment to an organization's code of conduct. Other researchers have found similar results.