Date: 08/17/2000 2:47 PM Subject: Attention Lynn E. Turner: re File No. S7-13-00 ATTENTION: Lynn E. Turner August 16, 2000 Lynn E. Turner Chief Accountant United States Securities and Exchange Commission Washington, D.C. 20549 Dear Mr. Turner: Thank you for your transmittal of August 11, 2000 regarding the Commission's recently published rule proposal addressing auditor independence issues: "Revision of the Commission's Auditor Independence Requirements." I have read through the materials, including the testimony, press releases, and speech transcripts with considerable interest-having previously read the proposal itself, when it became available on EDGAR. I am pleased to provide these comments regarding the rule proposal and related issues. First and foremost, I believe that direct financial interest in all audit clients should be proscribed for all employees of a professional firm providing auditors' services. This is a bonding mechanism by the profession to the public which states directly that there is no direct financial interest in the auditee. This direct financial interest proscription should likewise apply to the employees' household, i.e., those under the same roof. This addresses the ownership by the auditor (considered to be the professional auditing firm and its employees) and by those who clearly share joint investments and outcomes of such investments. Beyond the household, I believe that the confidentiality restrictions upon auditors should preclude the public concerns regarding other parties' investments, in other than enforcement actions associated with breaches of confidentiality and insider trading. As an aside, I believe all arguments about new economies mandating that capital be acquired through non CPA owners, investments by working spouses be permitted, or such holdings in the past being "merely technical" violations--not leading to lack of independence in fact--miss the point and are vacuous. We are dealing in capital markets that make accessibility to capital through diverse instruments easier as opposed to harder, the ability to tailor holdings to avoid conflicts is likewise easier in the Internet setting than in yesteryear's hard-copy world, and a violation of a bonding arrangement cannot be argued to be de minimus based on magnitude. The entire point of proscription is that none is permitted. It removes the choice and sets aside magnitude as irrelevant. To argue that a pension plan of a spouse should not have to bother to avoid holding a particular company's stock if a husband or wife works for the auditing firm of the auditor of that company is tantamount to saying that the auditor should be able to hold that auditee's stock. If the latter is deemed to be unacceptable, so should the former. The fact is when professionals choose career paths, there are certain commitments undertaken, and for those associated with auditing firms and benefiting from the credibility that such firms have built up over time from their bonding arrangement of no direct financial interest in auditees, all members of the household share in that career choice commitment. To try to blame a new economy or a frequency of working spouses as the reason for weakening a clear bonding with the public by the profession is again vacuous and ill-reasoned. Second, I believe that the outsourcing of internal auditing to the firm conducting the external auditing should never have been permitted. I simply observe "it's about time" that such a practice is to be proscribed. I would suggest entire proscription of outsourcing by the external auditors of their firms' auditees' internal auditing. Third, I would totally reject the Commission's concept of defining direct financial interest proscription at an individual employee level, based on involvement in or affect on an audit engagement. Moreover, the concept of having spin-off firms, subsidiaries, or entities of nonauditing services bearing the same or related name as the auditing firm should not be accepted as solving any promulgation on the independence of auditors. Substance versus form should be the focus, and the clearness of the bonding signal to the public in exchange for the public covenant implicit in the auditor's public accounting franchise, must be emphasized. In other words, if one works for firm A and firm A audits client X, then no employee of firm A should hold any direct interest in client X, period. The corporate structure of associated firms does not alter the direct interest of employees of firm A. Note that one of the good results in the recently announced arbitration findings involving Arthur Andersen and Andersen Consulting was the requirement of a name change by the latter as the total separation occurs. Complete divestiture and no name identification with the audit firm is the substance of compliance with the direct interest rule by all employees of the firm doing the audit. As I have read past discussions of independence violations and the proposed response, I become concerned about the "signal" being sent to new professionals. Consider the scenario of two professional firms' employees, one of whom broke the rules, participated in a stock market which had substantial returns in recent times, and now has been "caught," relative to a second professional who honored the rules of his profession. To suggest that professionals did not know they were in violation should be impossible to accept for those entrusted with auditing public corporations: after all, direct financial interest is very easy to define and understand. To treat the setting as simply an occasion for improving the firm's controls in the future with no real penalty to those doing the transgression would seem to reward the 'wrong-doer,' much as amnesty programs have done in the past. In my judgment, those who blatantly broke a clearly set forth direct financial interest proscription are not individuals who should be considered able to carry the public trust forward. Yet, not only are the punitive consequences unapparent for this group, but the current proposals seem to suggest a "mea culpa" by regulators that suggest-if you want the rules changed, break them on a sufficiently large scale that we have to change them. I see no reason to alter the direct investment proscription rules. The proposals to focus on individuals rather than firms, degree of involvement rather than firm employment, and amount of affect rather than recognizing the sharing in firm viability and profits implicit in being an employee and/or partner, are inviting gamesmanship, blurring very clear signals, and rewarding past bad acts. Fourth, the SEC should decide what really must be proscribed (e.g., outsourcing of internal auditing to that firm acting as external auditor) and what is not to be proscribed as a separate matter from disclosure. If an activity is deemed conflicting with independence, then it is the activity that should be explicitly proscribed. I believe the source of the problem goes back to the hotly debated question of commissions and contingent fees. If we all agree that being paid contingent on the result creates, by design, an interest in the outcome, then that cannot be tolerated in any forum, be it mergers and acquisitions, litigation settings, tax services, or other so-called joint alliances with auditees. The question of focus must be the objectivity of the service performed and the clear distinctiveness of remuneration for such service from the results of the accounting, auditing, tax, or dispute setting. The auditing firm should not become a seller or intermediary where a fraction of a sale to an auditee reverts to the auditing firm. Note that this calls into question recent developments at the AICPA, the referrals being promoted by a variety of companies through CPA firms, and similar issues. The point is that the CPA's name should not be "for sale" but rather should be a "reputation signal" of objective, quality, reliable, professional services. Fifth, the magnitude of the remuneration or its percentage relationship to auditing fees should not be used in setting independence guidelines or even implied to signal some issue concerning independence or objectivity. Anyone familiar with professional services understands that auditing fees by their nature tend to be recurring over time and often similar in magnitude, whereas many consulting fees are episodic. Indeed, the average corporation is reported to refinance its large debt sources only once in seven years. The notion that some have suggested that if a service is requested that exceeds some artificial threshold of an audit fee, it ought to be proscribed is in my opinion without any justification. Is one suggesting that auditors have less independence for large clients than small clients since the former pay higher auditing fees? Are small clients not to be privy to related accounting and auditing services merely because their audit fees are small? Think through the arguments with care, and the non-sequitur nature of the debates becomes apparent. Sixth, dramatically opposed arguments have been offered by the same voices: (1) we have more qualified professionals and produce better audits because of other services provided, yet (2) we have "split" these staffs through firewalls or spin-off arrangements and that ensures their lack of conflict. These two diametrically opposed positions unveil the essence of the real issue. Conflict should be directly addressed in the form of proscribing direct financial interest and specific proscribed services, and then the professional staff in a single firm should not only be subject to a consistent set of independence standards but should likewise share information on engagement services performed for a single client and benefit from that synergy. I believe that professionals who have an opportunity to participate in accounting, management consulting, turn-around experiences, tax settings, and dispute resolution are more prepared to be effective professionals, including when they are placed in auditing settings. However, the important point is independence and objectivity hallmarks, as well as the "tone at the top" of the professional services firm. The message cannot be one of salesmanship first or service to clients' management as being foremost. Instead, the message must be Certified Public Accountant, objective competent professional, and here are the results of our services. Remember, research indicates that a top-valued attribute of CPA firms that has been reported as triggering both choice and retention decisions has been that auditing firm's backbone and independence. How many times have you heard a CEO state, "I expect the CPA to help keep me out of trouble..." A cheerleader can be found in many quarters, but a trusted advisor that helps you gain a reputation in the market for credible reporting and performance is neither plentiful nor undervalued. In a sense the entire attention of the SEC and the profession to the questions at hand is a sign of real past success. The reason auditees approach professional accounting firms is not generally to "influence their audit" but rather to access professionals whose experience, competence, and objectivity would seem to be positive traits in addressing the other needs of the company. The SEC should walk very carefully in determining how to draw the line on proscriptions and service limits. In a sense, a restoration of the pre-contingent fee/commission era is sought, restoring the concept of objectivity of services and removing the sales aspect that might blur technical substance from being accorded appropriate weight. This is best accomplished by removing the contingent/sharing/commission framework from all services provided by a public accounting firm to the auditee. Similarly, work within the public accounting firms to ensure a structure that rewards objective competency and independent performance, to achieve the appropriate tone at the top. It should be in the interest of each of those firms not to create an incentive system that by design would be described as creating conflicts with its auditors' independent relationship to auditees. Yet, this is an area where joint efforts of self-regulation and regulation can be combined with the firms' management to proscribe the practices that are the real culprit. We all understand that performance evaluation systems tend to drive performance. They can be designed to be compatible with the independence of auditors. Seventh, care is needed in the disclosure area. Remember the conflicting considerations. When the auditing standards prescribed disclaimers for lack of independence, the point was emphasized that the reason for lack of independence was not to be reported, because it was feared the user might second-guess the decision and discount the reason for the lack of independence and choose to rely on the financial statements. Instead, it was recognized that the auditor was responsible for determining his or her lack of independence under the standards and then reporting the result of that decision. Somewhat similarly, the "plain English" push in the international standards and other forums, as well as the information overload arguments, all challenge whether excessive details inform or camouflage. On the other hand, efficient markets have often argued that as long as the information is disclosed, the market participants can reflect it and resource allocation is improved. I believe the disclosure idea of other services provided may well be an avoidance of important decisions regarding proscriptions, modes of payment and compensation, and firm-wide standards, rather than informative value added. For you to tell me that the auditing firm performed a service in one year that was ten times the audit fee, in my judgment, gives me no information on independence. If that service was objectively provided in an area in which the auditor had expertise and there was synergy in learning about that area of operations when evaluating the overall risk of the audit setting, I would not only believe the service was a positive signal but also a value-added signal. Indeed, one could consider the positive quality signal as follows: a one-time need arose which was a large-scale project and the auditing firm competed in the market place and was selected, with the governance structure's full consideration of independence considerations, and that auditee still believed the task could best be performed by its auditors. I believe the complement to proscription of services is governance. If disclosure is to occur, then it should be done as information on expenditure patterns rather than emphasized as necessarily relevant in any way to the independence question. As a researcher who benefits from public information being accessible in order to do systematic study of various empirical phenomena, I should probably embrace additional disclosure as an opportunity to explore some of the assertions made in the standard-setting and regulatory processes. Yet, I have to hasten to point out a cost-benefit context and an implicit suggestion that information rather than data is being sought. If it is information on independence being sought, then I fail to see the causal link of dollar amounts or proportions. Note that prior to your communication, I drafted a commentary which I have been informed is forthcoming in Accounting Today (probably the next issue). While some of my points herein relate to that article, rather than repeat its content herein, I would simply direct your attention to the source. If you have any questions about these comments or those that appear in my article, don't hesitate to contact me. I hope these perspectives will be of use in your deliberations. Sincerely, Wanda A. Wallace, Ph.D., CPA, CMA, CIA