UNITED STATES SECURITIES & EXCHANGE COMMISSION
HEARING ON AUDITOR INDEPENDENCE
Wednesday, September 13, 2000
PROPOSED AUDITOR INDEPENDENCE RULES
Securities and Exchange Commission
New York, New York
Wednesday, September 13, 2000 8:45 a.m.
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner
JONATHAN G. KATZ, Secretary
DAVID M. BECKER, General Counsel
LYNNE E. TURNER, Chief Accountant
Opening Statements by the Chairman and Commissioners
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner
LAURENCE H. MEYER, Governor
PAUL A. VOLCKER, former Chairman
Board of Governors of the Federal
Board of Governors of the Federal
BEVIS LONGSTRETH, former Partner
DAVID A. BROWN, Chairman
Debevoise & Plimpton
Ontario Securities Commission
JOHN C. WHITEHEAD, retired Chairman
Goldman Sachs & Co.
GARY M. PFEIFFER, Chief Financial Officer
JUDY LEWENT, Senior Vice President and
E.I. DuPont DeNemours and Company
Chief Financial Officer
Merck & Co., Inc.
KAYLA J. GILLAN, General Counsel
ALAN P. CLEVELAND, Special Legal Counsel
California Public Employeees'
New Hampshire Retirement System
RALPH WHITWORTH, Managing Member
Relational Investors, LLC
JACQUELINE K. WAGNER, Chairman of the Board
WILLIAM G. BISHOP, III, President
The Institute of Internal Auditors
Institute of Internal Auditors
DAVID COSTELLO, President and Chief Executive
National Association of State Boards of Accountancy
DENNIS PAUL SPACKMAN, Chairman
National Association of State Boards of Accountancy
JO ANN GOLDEN, Vice President
New York Society of Certified Public Accountants
NANCY NEWMAN LAMATA, President Elect
New York Society of CPAs
TOM GARDNER, Co-Founder
BERNARD BLUM, Blum Shapiro Financial
The Motley Fool, Inc.
DOMENICK J. ESPOSITO, Chief Executive Officer
THOMAS S. GOODKIND, formerly with Arthur Andersen & Co.
Grant Thornton LLP
ROBERT M. MORGENTHAU, District Attorney
County of New York
JAY W. EISENHOFER, Grant & Eisenhofer, PA
CHARLES R. DROTT, CPA
ROBERT K. ELLIOTT, Chairman
American Institute of Certified Public Accountants
BARRY MELANCON, President and Chief
American Institute of Certified Public Accountants
HAROLD L. MONK, JR., Chairman
PCPS Executive Committee
GORDON A. VIERE, Chairman
Practice Group B Advisory Committee
GARY S. SHAMIS, Chairman
PCPS Management of an Accounting Practice Committee
ROBERT FOX, CPA
LARRY GELFOND, CPA/CV/A/CFE
New York State Board for Public Accountancy
Colorado Accountancy Board
BAXTER RICE, President
California State Board of Accountancy
ANNE ROSS, past Chairman
South Carolina Board of Accountancy
ROBERT WILKES, South Carolina Accountancy
GRAHAM WARD, President
ELISE NEILS, Director
Institute of Chartered accountants in England and Wales
Brand Finance plc
THOMAS C. DeFAZIO, Executive Vice
RICHARD J. STEGEMEIER, Chairman Emeritus
President & Chief Financial Officer
of the Board of Directors UnoCal Corporation
RAJIB DOOGAR, Visiting Assistant Professor
DAVID DASGUPTA, former Manager
Department of Accountancy
Media Relations, AICPA
P R O C E E D I N G S
CHAIRMAN LEVITT: I'd like to welcome everybody to this second public hearing, the Commission's proposal to modify the rules governing the auditor independence. Can we have it quiet, please?
Today we will hear from a broad array of market participants, investors, institutional investors, lawyers, academics, state, federal and foreign regulators, corporate management and accountants. Accountants for the small firms as well as the Big Five.
The independence of the accounting profession is vitally important to all of these parties, and a broad public dialogue can only be good for the profession and ultimately our markets.
Since the Commission proposed this rule-making in late June, we've received over 700 comment letters in response to testify at our hearing. It's been completely strong. We take seriously our obligation to give everyone an equal voice in this process.
Some in the profession have asked for additional time to make a presentation to the Commission. We obviously realize that these ruleproposals would affect directly the major firms and we're happy to honor their requests. The Commission intends to make additional time available to these presentations on September 21st at the Commission.
I'd like to thank Pace University for their hospitality today, and I look forward once again to an informative day.
Before I introduce the first panel, I would ask the Commissioners if they have any opening comments.
COMMISSIONER HUNT: I just want to join you and my colleagues, Mr. Chairman, in welcoming everybody to this second day of hearings. This is, as you said, a critically important issue that's been around for a long time.
As you also said, we want to give everybody a chance to speak who wants to speak who has something relevant to say.
I don't know how much time it's going to take, how many more days it's going to take to get everybody in the world to speak, but take as much time as is necessary, so then, thank you.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: Thank you, Mr.Chairman. I want to thank all the witnesses who are appearing here today and the witnesses who appeared in Washington.
It is a crucial step in informing the Commission's decision-making process on this very important issue.
I also want to single out staff for having put so many hours into this series of field hearings, and I look forward to today's testimony.
COMMISSIONER UNGER: Thank you, Mr. Chairman.
I join my colleagues in welcoming the witnesses, and I look forward to building a record that we are looking so hard to build on this important issue, and I really look forward to and hope that the witnesses today, if you're here, could focus on the practical implications of the rule, because I think that's something for the proposal that we really need to hear something about, and that's sometimes the hardest judgment to make when you're attempting to change some things such as this, so I look forward to hearing the testimony and it's going to be a long but informative day.
Panel 1 (Morning)
CHAIRMAN LEVITT: First panel, we have twodistinguished presenters, Dr. Laurence Meyer, Governor of the Federal Reserve System. Dr. Meyer is recognized as one of the nation's leading economists having received numerous awards for his conmetric forecasting and the author of numerous articles and a textbook on macroeconomic modelling, and our good friend, Paul Volcker, former chairman of the Federal Reserve Board from 1979 to 1987.
Following nearly 30 years of service, Paul is currently the chairman of James D. Wolfson Incorporated, a Wall Street investment firm, and is Frederick Schultz professor of economic policy at Princeton University, his alma mater.
Gentlemen, Dr. Meyer.
DR. MEYER: Thank you. Chairman Levitt and Commissioners, thank you for the opportunity to speak at today's hearing on rules governing auditor independence that have been proposed by the Commission.
The principal concern of the Federal Reserve is the efficiency and stability of financial markets. By extension, we take a keen interest in issues that underpin the functioning of markets, because information is a key support for financial markets.
The Board has long believed that highquality accounting standards and disclosure requirements are essential to the efficient, rational allocation of capital.
For the banking industry, we believe high standards aid market discipline, and good management. Banking regulators find such standards helpful in meeting their responsibility for supervising safety and soundness among financial institutions.
Independence enhances two important aspects of financial reporting. A setting of accounting standards and enforcing conformance with these standards.
Both the SEC and the accounting profession have important roles in fostering independence. Accounting standards have improved markedly as a result of steps taken over the years to strengthen independence.
High quality accounting standards, however, can potentially be nullified if there is a perception that auditors lack independence and objectivity in their enforcement role.
In my testimony this morning, I will focus on one aspect of the SEC proposal, the prohibition of outsourcing the internal audit function to the firm's external auditor.
We strongly support this aspect of the proposal. This reflects the importance to be attached to both the external audit and the internal audit, as critical checks on banking organizations' risk management and internal controls.
As regulators of banks, the Federal Reserve is very interested in external audits of institutions it supervises. Large banks are required by statute to have an external audit.
Recognizing the value of an external audit, we encouraged small institutions to engage public accountants. External audits give us greater assurance of the integrity of the financial information we receive.
In addition, we believe that banking organizations benefit from an outside opinion of the quality of their financial reports, and assessment of their internal controls.
Moreover, our ability to supervise institutions is enhanced by competent and objective external audits. We have been very wary since the trend began of internal audit outsourcing.
Our concerns are twofold. The potential to blur the accountability of bank directors and management for internal controls and diminishedeffectiveness in the internal audit's ability to monitor controls.
In 1997, the Federal Banking agencies issued a policy statement that serves as a framework for the internal audit function and related outsourcing arrangements.
On outsourcing, the policy seeks foremost to warn management and directors that outsourcing the internal audit does not in any way relieve them of the responsibility for internal controls.
Institutions can delegate the technical work, but not oversight and accountability.
The policy does not prohibit all outsourcing, because efficiencies can be gained and specialized talent brought to bear.
These arrangements must be carefully structured so as not to weaken overall the processes for identifying and fixing internal control deficiencies. The banking agencies considered prohibiting a bank's external auditors from acting as an outsourcing vendor, because we were concerned about the effect such arrangements could have on external auditor independence.
As we finalized our guidance, we decided such a prohibition was premature.
The banking agencies were reluctant to set a standard different from other industries, which of course are not subject to our safety and soundness policies.
Second, we believe the issue is more properly addressed by the SEC, who has broader jurisdiction over the auditing profession.
We ultimately chose instead to have our examiners monitor arrangements among supervised institutions and evaluate auditor independence case by case, and to encourage individual organizations to consider looking for firms other than their external auditors.
The SEC proposed rule would not eliminate outsourcing in its entirety or prohibit public accountants from offering all internal audit services.
Instead, it would exclude the external auditor from performing internal audit services for the same client. There may be efficiencies in providing internal and external audits, since the work can serve a dual purpose of inspecting internal controls and expressing an opinion about the financial statements.
These efficiencies, however, may come at the cost of the external auditor's appearance of independence. Our view is that auditor independence is more valuable than these asserted efficiencies.
We are pleased the SEC is addressing this issue on a cross-industry basis. From our perspective as a banking supervisor, we support the SEC's proposal to limit the external auditor's role in the internal audit function of its clients.
CHAIRMAN LEVITT: Thank you very much.
MR. VOLCKER: Thank you, Mr. Chairman, I have done a lot of testifying in my day. This is the first time before the SEC, and I am particularly conscious of the importance of full disclosure and accuracy, and I have to tell you the SEC must have an old prospectus of my current activities, because I'm no longer with Wolfson. It doesn't exist and I no longer teach in Princeton, but I am very conscious and interested in this subject.
COMMISSIONER CAREY: You're still tall.
MR. VOLCKER: I still talk. I don't think I'm senile.
COMMISSIONER CAREY: No, I said tall.
MR. VOLCKER: I am not obviously an accountant, auditor, I am not a professional in thatsense, but I have been a consumer in various guise of my career, and have a great interest in the importance of the accuracy and reliability of accounting statements, and as I point out in the statement that I gave to the Commission, this is important, not just for the United States, it's important for the world, this globalized world and we are very fond of preaching the Americanized approach towards accounting and auditing to everyone else.
And I think that makes it particularly incumbent upon us to maintain the highest standards.
I have great admiration for the work that auditors do. I view it with admiration, but sometimes with frustration, because I think there is evidence that we fall short of what we preach and standards that we should uphold too frequently.
Part of that, I think, is the sheer complications of the present world and global world, and certainly the complications of financial markets.
I read about the Morgan Chase prospective merger in the paper this morning. Knowing I was coming down here, one of the things that occurred to me was still another challenge for the auditors to keep track of such a large, complex institution involving so many different businesses and people andcontrol systems and all the rest.
So there's a constant emphasis on making sure that the auditing profession, among other things, I think has ample revenues and training and all the rest, but what you're addressing in your proposal I think is kind of a philosophical point, a point of principal that raises a question of whether there is an insidious bias or lack of objectivity in accounting by the way accounting firms are organized.
There's more than one source of a conflict of interest, but I do think you have put your finger on an important conflict of interest that is real and not just a conflict in perception, and that is the increasing amount of activity, resources, revenues, profits, that accounting firms are seeing and consulting services unrelated to their auditing responsibilities, which inevitably raises the danger of insidiously, maybe unconsciously biasing the attentiveness, discipline, that they applied to the auditing statements of the company, the accounting statements of the company when they are looking to that same company for large revenues and other directions of activity.
I am very aware that this has become enough of a problem in practice, enough of a conflict withinfirms, that there is a strong tendency to provide the consulting and auditing practices, and in that sense, my understanding of what you're trying to do is to introduce a regulation that in fact reinforces what many of the firms are doing anyway, and doing it in a way that makes the borderline clear and more effective, and I think that is a correct approach and I support what you are trying to do.
I am also conscious particularly in recent days of the number of accounting and auditing friends that have told me your particular proposals are sometimes difficult to interpret. Sometimes they may be more sweeping than they need to be.
We certainly need to pay close attention as to their practical application, so while supporting the general thrust, I do agree with what Commissioner Unger just said, and I'm sure the Commission and its staff is alert to anyway, the purpose of these hearings, the purpose of this review is to make sure that in the final application of the rules and regulations about separating auditing from other activities within the accounting firms, legitimate concerns about the details can be reviewed to see whether they are in fact legitimate, but I certainly urge you to go ahead and put this in practical, final,effective form.
CHAIRMAN LEVITT: Thank you very much. I am deeply grateful, all of us are, for your distinguished presence here. I might ask you several questions.
Mr. Volcker, you made clear that as guardian of the public trust, the obligation should be to the shareholders.
Given the growth in the auditing service in providing a broad range of services to clients, are you concerned that with the meltdown in emerging economies, that the preservation of the status quo in this area might send the wrong message internationally?
MR. VOLCKER: Well, I certainly think the kind of action you're proposing will send the right message internationally, but this is supportive of all that we've been saying in terms of the kind of accounting practices that ought to be common around the world, and the United States has an image of being in the forefront in that effort, and that may sometimes be exaggerated, frankly.
We have problems there, too, but I certainly think that what you're trying to do is consistent with the image and the policy that we are proclaiming.
In that sense, the absence of action Isuppose would be reversed.
CHAIRMAN LEVITT: Do you share Dr. Meyer's concerns about the outsourcing of the internal audit on the part of banks, particularly smaller banks?
MR. VOLCKER: I certainly share his concern that you can't have the outside auditor reviewing its own internal audit. That seems to be quite obvious.
This issue about whether there should be any outsourcing of the internal audit at all is one I have not thought about deeply.
I know that when we, when I was chairman, there was still a question of whether banks had to be audited, and they are, of course, examined and many of the banks complain that it would be very costly and they didn't have the resources for decent internal auditing efforts, so maybe in some cases there are justifications for outsourcing an internal audit, but I certainly do not think that changes the need for an objective outside audit.
CHAIRMAN LEVITT: The critics of this proposal focused most directly and dismissed the notion of perception as being relevant. I know Dr. Meyer touched on this, but I would appreciate both of your comments with respect to the importance of perception, both domestic and internationally.
MR. VOLCKER: Well, that I can tell you, I have a paragraph in my statement about this, and I know people say, well, it's just a perception and it's wrong.
I don't think it is just a perception. It's a reality. The perception is there because there is a real conflict of interest. You cannot avoid all conflicts of interest, but this is a clear, evident, growing conflict of interest, given the relative revenues and profits from the consulting practice, and a conflict of interest is there.
How much it affects the audit, of course, is an elusive, difficult subject, but since the conflict is there, I think it is a kind of black and white issue that ought to be ruled on.
CHAIRMAN LEVITT: Dr. Meyer?
DR. MEYER: Even the perception of a problem undermines investor confidence in data and it also reduces the reliabilities that the supervisors can have in the investment firms and may therefore encourage the duplications, the burdens, as the supervisors do more work, because they don't believe they can count upon or aren't convinced they can count upon the reliability of external auditors.
I think if the perception didn't have anybasis in reality, it would not necessarily last very long, so there has to be some interconnection between them, but the perception is an important one.
CHAIRMAN LEVITT: I think there are some areas in our society where perception becomes the ultimate reality. I suspect this is probably one of them.
To what extent, Dr. Meyer, do you think that banking organizations today are outsourcing their internal audits and is this an increasing trend?
DR. MEYER: Yes, well we, since the 1997 effort and guidance, we've been doing ongoing monitoring, and we actually did a survey in the summer of '99, and we found out that for large bank holding companies with assets in excess of five billion, about a fifth of them outsource internal audit functions and about a fifth of state member banks do.
About half of these cases, the outsourcing is to the external auditor of the firm, so it is, now, you can decide whether or not that 10 percent is small or large, it's a significant number, it is something that has been growing over time as well, it has particularly been growing since about 1996.
The fact that we did this survey is a reflection of our ongoing concern and the necessitythat we feel to monitor this, and to talk to our examiners and see what level of concern they have about the practice, and they indicated some level of concern and some concern about the competence of the internal audit function when it does get outsourced to the external audit, so it is an issue.
CHAIRMAN LEVITT: Has the Board considered implementing their own regulations in this regard?
DR. MEYER: We did very much consider that in 1997, but we decided at that point to do it on a case-by-case basis and handle it through monitoring, mainly because we were reluctant to set a standard on major accounting and auditing issues that was different from other industries, partly in deference to the SEC, who has broader jurisdiction and authority in these areas.
We think our patience is being sort of rewarded by your turning to this issue, and we think this is something which will be very helpful to us.
CHAIRMAN LEVITT: Mr. Hunt?
COMMISSIONER HUNT: Again, thank you for appearing, gentlemen.
Dr. Meyer, do you think there's any difference in the outsourcing of the internal audit to the outside auditing firm and vis-a-vis to anotherauditing firm?
DR. MEYER: I think there is a difference, but there is some common issues as well.
We think it's a problem to outsource to anybody. I mean, there is that issue, because it sort of develops a mindset that the managers and directors of the bank can transfer responsibility for risk management to an outside vendor, and whether that transference is to the firm's external auditor or to some other external firm may not be that important.
Now, we think that there's -- that the problem is compounded when you're outsourcing to the external auditor, because then you get the potential of conflicts of interest, lack of independence in the external audit, and I think that's a much worse outcome, so we think that the prohibition on the outsourcing to the external auditor is justified.
On the other hand, we're still going to have ongoing monitoring whenever there's outsourcing to any vendor, for the reasons that I indicated.
COMMISSIONER HUNT: Because you think that it might allow the officers and directors to appear to advocate their responsibility for risk management?
DR. MEYER: I think there are sort of two issues here.
One is that mindset that's created that they had somehow transferred that responsibility and focused less on it, and that's certainly not a mindset that we want in banking organizations.
But in addition, our experience with outsourcing is that while you might think that the whole purpose of this is to increase the competence of the internal audit, the result seems to be just the reverse.
It's a very cumbersome process to have that internal audit carried out by some external firm. It's not constantly around, walking around, seeing what's going on in the ground and having that familiarity with the operations of the firm.
And that's a problem whether it's outsourced to the external auditor or some other auditor.
COMMISSIONER HUNT: Well, your last comment raises an interesting question that was raised in our first day of hearings, which is that some accounting firms indicate that when they do consulting work for their auditing clients, they become so much more familiar with their clients, that in fact the existence of the nonauditing work makes for a better audit.
DR. MEYER: Of course, this is not an issueof nonaudit work. This is audit work on both sides, but it seems to me in this case the world is still a trade-off. Okay, we appreciate that.
That's not an argument that I would completely dismiss out of hand. There's some justification, there's some duplication, there are some synergies involved here.
I don't dismiss that argument, but in a world of trade-offs, you have to weigh the lack of the conflict of interest and the implications of external auditors reviewing their own work, the potential deterioration, the competence of internal audit and the transfer of responsibility for internal risk management, and it seems to me that from our perspective it's not really a close call, that the costs are just too high.
COMMISSIONER HUNT: Thank you.
Mr. Volcker, you mentioned that there's a concern that the auditing firms have ample revenues to enable them to perform their auditing function, particularly in light of the mega mergers of today, such as the one announced in the paper this morning, a fast-growing part of the revenues of the auditing firm is from this nonauditing consulting business.
How do you envision them making up for thatlost revenue if the firms are divided and they cannot do the consulting work for the audit clients?
MR. VOLCKER: Well, they obviously don't have to make up for the lost revenue in terms of compensating all the employees that are involved in the consulting side of the business. That should be the bulk of those revenues.
But I do think it may put some pressure on companies to make sure that they are willing to compensate their straightforward auditors devoted towards the audit and not other services adequately to provide a reasonable attractiveness of that profession, and I think that is happening and will happen.
I think there is enough work to be done in auditing, and all these complexities show the professional, technical talent that is needed these days and that needs to be compensated.
COMMISSIONER HUNT: Thank you both.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: Thank you, Mr. Chairman.
Chairman Volcker, there's a point you touched on that has been repeated by many critics of the proposal, which is the issue of compensation andthe issue of the type of experience you get to have if you go to work at an accounting firm, and they, their assertion is that they cannot continue to make the audit experience or the auditing profession an attractive one and be able to retain and attract talented young people without giving them the ability to do some consulting work and that's a, it's for me a regrettable state of affairs, but what would you say to that?
MR. VOLCKER: Well, I suspect that many of the traditional professions are feeling under some pressure from the lure of Wall Street incomes, and the dot com world, and I suspect the Federal Reserve feels that, and auditing firms feel it. It is a fact of life.
I don't think you cure that problem by creating a conflict of interest in your own firm.
Those high-priced people have obviously created a lot of turmoil in the accounting firms by all the contests of who is going to receive all the revenue and how is it shared and they've ended up in something short of armed conflict, I guess.
But considerable conflict, quite obviously in some of these accounting firms doesn't strike me as very healthy in terms of the auditing practice.
The reason I mention this compensation thing, it's clear they do have talented people, there are lots of challenges in auditing these days by all these technical complications and companies, encouraged I'm sure by SEC surveillance are going to have to be willing to pay for straightforward auditing and a job which is adequate.
I've had enough experience with banks and other companies that I have been involved with that when they get in trouble, the auditing function certainly becomes more important, and they're willing to pay a somewhat higher fee to make sure they're adequately audited, because they realize the enormous expense of lack of sufficient diligence and independence when they get in trouble.
COMMISSIONER CAREY: I just want to say I share your view as well as Commissioner Unger, about the practical applications of this effort, and the need to be mindful of unintended consequences.
MR. VOLCKER: Part of the problem if you were talking about it, as I view it, conflicts in the auditing profession, is the way they're paid in the United States. You're not taking on that particular problem, but it obviously exists.
COMMISSIONER CAREY: Do you mean crossselling?
MR. VOLCKER: No, I mean the fact that a firm makes a bargain with an auditor, and there is competition among auditors, and one of the criteria for choosing an auditor may be trying to do it as cheaply as possible. It's just inherent in the situation, you're not dealing with that at this point, and I don't know how to deal with it, I haven't got any advice for you, but it is a problem.
CHAIRMAN LEVITT: One of the ways that other industries that have that conflict deal with the problem is by having an effective self-regulating organization.
Unfortunately, up to now the profession lacks that oversight discipline.
COMMISSIONER CAREY: No further questions, thank you.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: Thank you.
Chairman Volcker, you talk in your testimony or mention in your testimony a sense that auditors aren't challenging management enough and that may be one of the causes --
MR. VOLCKER: In some instances.
COMMISSIONER UNGER: Right, and that one ofthe causes of the failures could be the conflict between the management and auditing services.
Do you think there are other things that we should be looking at or other areas?
MR. VOLCKER: Other areas of conflict?
COMMISSIONER UNGER: Other areas.
One of the areas of failure or lack of diligence is because of this conflict.
Could you think of any other motivations?
MR. VOLCKER: There's always a human problem, not entirely the way that they're compensated, you audit a company, you become familiar with their problems, you become familiar with their management, you become psychologically part of management in some sense that's a danger, you shouldn't.
An auditor always has to resist that temptation. It's very insidious, but it's part of human nature.
I think all you can do is try to build some areas of principle. What you're trying to do here is to minimize, put it the other way, maximize a sense of independence of the auditor.
COMMISSIONER UNGER: It's interesting, because Dr. Meyer's testimony talks about how theofficers and directors should be more accountable, and that outsourcing impedes that, and yours says that the accountants aren't challenging the management enough, so I guess we need to find the right balance between the company challenging the auditors and the auditors challenging the company, so that you do have the integrity of the financial reporting system.
How do we do that?
MR. VOLCKER: With difficulty.
COMMISSIONER UNGER: Apparently.
MR. VOLCKER: Obviously there is no magic answer to these things. You don't want antagonistic relationships obviously between the auditors and the management either.
All you can do is draw some broad principles, count on the profession and there's a lot of reasons to count on the integrity of the auditors, but what's happened here is a relatively new development. There's heavy emphasis on consulting.
It didn't exist before automation, I guess, in the electronic age, anything to the same extent. I just think there's enough evidence within the firms themselves, that this has run into a problem to make it timely that you try to draw this line.
COMMISSIONER UNGER: Interesting you shouldraise that, because in the first day of hearings, I think when we asked, or I asked what the revenue of nonaudit income was, it's about 60, 50 to 70 percent, depending on the firm, and another question I have is, do you think that our proposal could drive firms out of the business of auditing and wholly into the business of consulting?
MR. VOLCKER: Well, some people might choose that route, but there's going to be a need for auditors because you're going to need audited statements, and the fewer people that offer that service, the price will go up.
Maybe it should go up, but I think you will reach a balance where the auditors are adequately compensated for doing what they do, and given complications of today's world, probably cost more than it used to cost, relatively speaking, if they're going to do a good job.
This as a result of to some degree increasing the costs of audits, I don't think that that is any way a reflection on the value of this proposal.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Thank you very much, gentlemen, for really superb testimony. Thank you fortaking your time to be with us this morning.
Panel 2 (Morning)
The next panel will include D. Bevis Longstreth, who served an SEC Commissioner from 1981 to 1984, is a retired as partner from the law firm of Debevoise and Plimpton. Mr. Longstreth recently served as a member of the Panel of Audit Effectiveness that issued its final report on August 31, 2000.
Mr. David A. Brown, chairman of the Ontario Securities Commission, and a former senior corporate law partner at Davis Ward & Beck for nearly 28 years.
Finally, my long-time friend, mentor and associate, John C. Whitehead, former deputy Secretary of State, retired co-chairman and senior partner of Goldman Sachs & Company, and Mr. Whitehead most recently co-chaired the Blue Ribbon Panel to Improve Corporate Audit Committees and his recommendations have been implemented by the New York Stock Exchange, NASDAQ, the SEC and the accounting profession.
MR. LONGSTRETH: I'm very grateful for this opportunity to testify.
I want to first, having followed this closely, I want to first congratulate the Commission and particularly its chairman for the vision and boldness embedded in the release and the rules it'sproposing.
To many it may seem strange that boldness and even personal courage may be required for the SEC to propose such an obviously praise-worthy rule, but yet I'm convinced that's exactly what it took to propose the rule and that plenty more of the same is going to be called for to adopt it and implement it.
This battle, and I think it is clearly a battle, pits a legally created monopoly dominated by five global accounting firms against the SEC.
Some of these firms representing solely their private business interests, reject further restrictions on the free play of those interests, as with many businesses.
The SEC acting upon the need for greater independence, a need long recognized by virtually every group that considered the issue, and there have been many, has proposed a rule to meet this need.
Given the sharpness of debate and the transparency of private versus public interest, there is more at stake than just the independence o auditors.
The independence of the SEC itself is being challenged.
As the accounting firms do all they can onCapital Hill and throughout the business community, to bring pressure, political and other kinds of pressure to bear against a proposal that in my opinion cannot be defeated by argument on the merits.
As the New York Times put it in an editorial supporting the Commission, "The SEC has proposed nothing Draconian, only common sense rules to make sure that outside auditors perform and appear to perform independent audits."
In the tumult of the moment, leaders of the accounting profession seem to have forgotten their origins as a profession granted rights and reciprocal duties to perform a vital public service.
Although affected by the public interest as much as any public utility, the profession seems to want freedom from serious oversight or constraint. It won't wash, not in a country where check and balance is king.
Before I turn to the proposal itself, let me also congratulate the SEC staff led by Lynn Turner in turning out such a thoughtful, well-considered and thorough set of proposed rules.
The details are always important and in this release there are no lack of them. And not all of those details I claim to have digested, but therelease is good on explanation and inviting of scrutiny, comment and ideas for improvement.
Overall, I'm a strong supporter of these rules and I'm going to limit my comments to the area of nonaudit services.
After a lot of thought, I've concluded that an exclusionary rule for nonaudit services is the best approach in addressing the independence problem.
This rule would have limited exceptions. Rather than repeat the case for an exclusionary rule here, I have attached to my written testimony the statement in the support of this kind of rule contained in the Report and Recommendations of the Panel on Audit Effectiveness.
This statement was written and supported by some panel members of which I was one, of whom I was one. The proposed rule takes a more complicated approach in seeking to prohibit only certain types of nonaudit services, those considered to be especially threatening to independence.
I have one major comment.
Under the proposal, an impermissible nonaudit service is one that meets one or more of four governing principles. These principles declare an accountant not independent if during the period ofaudit engagement the accountant has a mutual or conflicting interest with the audit client, audits the accountant's own work, functions as management or an employee or acts as an advocate for the client.
The list of nonaudit services determined by the Commission to be impermissible under these principles is extensive and the principles by which the litmus test is informed are sound.
Nonetheless, I think the approach is seriously incomplete, because it ignores a principle as important and arguably more important than the four listed above.
This principle is the auditor's vulnerability to economic pressure from audit clients.
The governing principles do not address this risk at all.
As the release acknowledges, as auditing becomes a smaller percentage of a firm's business with its audit clients, the auditor becomes increasingly vulnerable to economic pressures from those clients.
But it is not only the magnitude of nonaudit service fees that creates the problem. It is the fact that a conflict of interest, which you heard at a previous panel, a conflict of interest arises from the provision of virtually any kind of nonaudit service toan audit client.
This conflict derives from the fact that in performing these two kinds of services, the audit firm is really serving two kinds of clients.
Management in the case of nonaudit services, which typically are commissioned by and performed for management, and the audit committee in the case of the audit, which now is by rule commissioned by the audit committee and performed for that committee for shareholders and public investors at large.
And here I'm talking only about good professionals, not venal ones, but these are good professionals trying to serve two masters, the firm is a fiduciary in respect of each of these two very distinct client groups, duty bound to serve with undivided loyalty.
It is obvious and a matter of common experience that in serving these different clients, the firm will be regularly subject to conflicts of interest. These conflicts tear at the heart of independence, which is the freedom to exercise undivided loyalty to the audit committee and the investing public.
Where other loyalties tug for recognition, and they come from those in a position to enlarge orshrink one's book of business, the freedom necessary to meet one's professional responsibilities as an auditor is curtailed and sometimes it becomes eliminated all together.
Now, the proposed rule in addressing disqualifying financial and business relationships between an accountant and its audit client, declares an accountant to lack independence for even small investments in the client or any direct business relationship with that client.
One can imagine many financial and business relationships with an audit client that would, by these definitions, render an accountant not independent, yet be insignificant to the firm when compared to the revenues, past, present and future, generated and expected to be generated from nonaudit services performed for that client.
Yet the financial and business relationship of nonaudit services is given a complete pass in the proposed rule.
My point is not to suggest that the finely textured concerns over the independence impairing effects of various financial and business relationships are misplaced.
They reflect legitimate, albeit immeasurableconcerns, but they pale in significance when compared to the potential for impairment that comes from a financial and business stake that an audit firm will still be allowed to develop in an audit client through provision of permissible nonaudit services.
One of the premises on which the exclusionary rule argued for in the panel's report was based is the superiority of a clean rule over a complex finely textured one.
The problems of interpretation, misunderstanding, avoidance and even evasion, now so commonplace within the tax thickets of our land grow large as the complexity and detail of the rule increase.
Here, as in most cases, effectiveness is best achieved through simplicity.
CHAIRMAN LEVITT: Mr. Brown?
MR. BROWN: Thank you, Chairman.
I am pleased to have the opportunity to present the perspective of another North American securities regulator on the important issue of auditor independence.
I thought I would highlight a couple of the key points made in my written submission, elaborate onone or two of them and then hopefully leave some time for questions at the end.
A key element of the Ontario Securities Commission's legislated mandate is to foster a fair and efficient capital market and confidence in that capital market.
In recent months, we've seen a growing erosion of public confidence in the reliability of the audited financial statement.
We are told that sophisticated investors and analysts now place far less reliance on audited statements, preferring instead to develop their own independent views of a company's prospects.
But the resources necessary to conduct such exercises are far beyond the average investor.
Although the reasons for this erosion in confidence in the audited statement are likely complex, I believe that a significant factor is the loss of the confidence in the auditor as a figure sufficiently independent of company management.
Auditor independence is a significant concern to the OSC for the same reason that it is a concern in the United States.
The investing public must have confidence in the auditor's ability to exercise objective andindependent judgment in difficult situations.
Objectivity is fundamental to the integrity of the external audit. The auditor must avoid both real and perceived impediments to his or her ability to say no to management.
Anything that dilutes either the reality or the perception of objectivity undermines the whole system.
In Canada, for example, the rules of professional conduct for auditors require that they avoid any situation that impairs professional judgment or objectivity, or in the view of a reasonable observer would impair professional judgment or objectivity.
Thus in the Canadian rules, the reality and the perception of independence are given equal prominence.
And so the importance of the perception of auditor independence and objectivity cannot be overstated.
Audited financial statements are the cornerstone of our disclosure system, and the public has come to place a large measure of reliance on them in part because of the credibility lent by the report of an independent auditor.
This is particularly important in the context of Canadian accounting standards, which place great reliance on a framework of sound principles rather than the more detailed and specific rules commonly found in the U.S. GAAP.
The inevitable scope for auditors to create a necessary judgment increases the need for independence both in fact and appearance.
As public confidence in the role of independent auditors erodes, investors will be less inclined to rely on audited financial statements and will continue to seek other sources of information in which they believe they can have greater confidence.
Unfortunately, no matter what steps we take as regulators, we can never know with certainty that an auditor will be prepared to say no under pressure.
The reality of independence is difficult, if not impossible. Perceptions of independence, therefore, become almost equal to reality in importance.
When it comes to perceptions, I am concerned that consulting relationships and audit responsibilities can be seen as fundamentally at odds with each other.
In most circumstances, consultants are hiredby management of the corporation.
Management works on an ongoing frequent basis with consultants, determining their assignments, critiquing their work, reaching agreement on recommendations and approving their fees.
The result can be a relationship of consultant loyalty, a commonality of interests and potentially an element of financial dependence.
Firms may become beholden to their clients in areas that are far more lucrative than the basic audit functions. I am concerned that the audit may become little more than a loss leader, as accounting firms leverage the audit relationship to cross-sell higher margin services.
In these circumstances, it seems only natural for shareholders to question whether they can have confidence in the audit when it is carried out by a firm that spends much of the year taking direction from the same managers they are supposed to scrutinize.
A second issue involves the evolving structures of the accounting firms themselves, and I'm referring to the interrelationships within the accounting firms between the audit and the consulting practices.
As accounting firms have become large, multi-disciplinary businesses, and audits have become comparatively less lucrative, it seems likely that auditors will less frequently play the lead role in the partnership.
This has two effects: First, the partners from other divisions of the firm are more likely to be driving the partnership and making strategic decisions about client relationships.
And second, if this trend continues, firms will continue to have difficulty recruiting new talent for the audit department, particularly if new recruits get a sense that other areas of the firm are more highly valued by firm management.
Much has been said in the course of this debate about the difficulty of recruiting on the audit side of the firms, and I think that's a very real issue, but I think the issue is clearly exacerbated by the messages being telegraphed to young recruits, and that is that there's a faster partnership track on the consulting side.
For more than a year the OSC has publicly raised concerns about the issue of auditor independence.
We have discussed our concerns withindividual firms and the profession's regulatory associations, and we've challenged them to find a solution that addresses these issues.
So far the industry has not produced a proposal for consideration.
Although we've not begun to frame a regulatory solution, it has become increasingly evident in Canada that some form of regulatory involvement in a solution will be essential.
Since most of Canada's large public accounting firms are affiliated with major U.S. firms, the SEC's auditor independence rules will likely shape the corporate governance structure and the codes of conduct of their Canadian counterparts.
Therefore, we are following the SEC's proposals with great interest and will formulate our regulatory response based partly on your experience.
There's one further issue, Mr. Chairman, that I would like to raise.
I suspect that our regulatory counterparts in most of the other developed countries are following a similar process to ours, and I know that you, Chairman Levitt, and Commissioner Hunt have been leading a discussion on these issues with our colleagues in IOSCO.
I believe it's important to build an international consensus on a sound approach to these important issues which are not unique to North American capital markets.
This is particularly important because of the extent of direct and indirect participation of foreign companies in U.S. capital markets.
Independence standards established by the SEC will have significant implications in other countries.
It's also important to identify structural differences in the profession in other countries.
I have recently been aware of a potentially significant feature of the Canadian business model that perhaps is different in the U.S.
In Canada, the accounting firms provide the major portion of the bankruptcy and insolvency services.
This is a historical relationship the firms have by their own rules of professional practice not been permitted obviously to offer these services to audit clients, but they have not been prevented from offering those services where other clients of the firms perhaps are creditors, and this is particularly important in Canada because the major banks, there areonly a few major banks and a few firms, so all of the firms have banks as their clients.
The accounting firms then provide trustees in bankruptcy, receiverships and monitors for the courts in the insolvency relationship.
My understanding of your potential proposed rules is that this may affect the way in which the profession is evolved in Canada.
Having just become aware of these issues a few days ago, I haven't fully gotten my mind around them, but our staff would be quite willing to work with yours to explore these further and I suspect that there are other issues that we may find evolving.
So, Mr. Chairman, we strongly support the initiative that the SEC is taking. We believe that a regulatory solution is necessary, and we will be following with interest and likely adopting many of your proposals.
CHAIRMAN LEVITT: Thank you, Mr. Brown.
MR. WHITEHEAD: Thank you very much, Mr. Chairman, for allowing me to be here today to speak my views on this important issue. I don't have prepared testimony, but I would just like to make some off-the-cuff remarks.
I feel as if I've been dealing with these issues all my life. It was in 1947 that I started to work at Goldman Sachs, more than fifty years ago, where I was involved in their investment banking activities.
During 37 years there, I was co-chairman of Goldman Sachs the last ten years, and during that period, I was on the boards of about a dozen companies, not all at the same time, and I think I was on the audit committee and often chairman of the audit committees of probably all of those boards.
I was also chairman of the Securities Industry Association, and during that period, and on the board of the New York Stock Exchange, and I was one of the founding members of the Financial Accounting Foundation which was organized back, I don't remember how many years ago, to establish the FASB and appoint the original members of the FASB.
And as you said, most recently, I was co-chairman of the Blue Ribbon Commission that studied the functioning of the audit committee, so I feel as if I have some credentials to have opinions on the subject.
I am a big defender of our capital markets. I think they're unique, and I think that they have never been as strong or as deep or as liquid as they are today.
I think a great deal of credit for this remarkable continued prosperity without interruption that the country is now having is very largely a function of the wonderful capital markets, which permit our corporations to raise capital for growth in unheard-of amounts, both equity capital and debt capital; which permit our new companies and growing companies to raise money more quickly than has ever been possible in the past.
Indeed sometimes it would seem maybe even too quickly, but they're a wonderful engine of our great prosperity in this country and very important to protect and maintain without interruption.
Financial statements are at the very heart of our capital markets. They're the basis for analyzing investments. Investors have every right to be able to depend absolutely on the integrity of the financial statements that are available to them, and if that integrity in any way falls under suspicion, then the capital markets will surely suffer if investors feel they cannot rely absolutely on the integrity of those financial statements.
The development of advisory income by the accounting firms, and particularly the leading accounting firms in recent years, has thrown some suspicion on their independence as auditors, as you know, and I believe it's reached the point where the separation of the functions is really essential.
Now, I think it's most unfortunate that the raising of these issues somehow casts some kind of aspersion on the integrity of accounting firms.
I know of no profession that has a higher level of integrity than the accounting profession.
They are, but the suspicion that's cast on them as a result of the growing fees in relation to the fees received for the auditing function does begin to cast doubt on a very honorable group of firms, and I have searched my mind for other ways to do it than the separation that you are proposing.
I find no other way to remove that growing suspicion, and I think it's important that that be done and I hope you stick to the rules.
I would make one other point to those accounting firms that have feared that these rules will upset their businesses in a major way and they can lose very substantial amounts of revenue.
I don't think that's the case. For everydollar of revenue that an accounting firm needs to give up as a result of these rules, some other firm will also be giving up just as much, and the opportunities to add new clients for their advisory services is also there for clients for which they are not the auditor.
I do not believe there will be any net reduction of fees to accounting firms on an industry-wide basis, and the better firms that have the best reputation for ability in these advisory areas will I think have a chance to grow rapidly by taking on more new business than they lose.
So I would urge the accounting firms to take that attitude and develop a means of growing as a result of these rules, and not necessarily of seeing their business shrink back.
So I think the rules are not as bad as it might look at first analysis, but I think there's no other way to assure the continued integrity of financial statements and the continued success of these wonderful capital markets that we now have here.
CHAIRMAN LEVITT: Mr. Longstreth, you mentioned the fact that accounting firms in fighting for freedom from serious oversight or constraint arerepresenting their private business interests.
What we've heard from the firms is that consulting services make for a better audit.
How do you view that argument?
MR. LONGSTRETH: Well, I think I've heard that, too, a number of times during our panel discussions, and I can't argue that it isn't the case in some circumstances.
In some circumstances, it may be strongly the case and in others a slight improvement. These are immeasurables, but it's just entirely plausible and sounds correct that the more you know the company, the more, the better you're equipped, let's say, to serve the company.
Now, this would apply equally well to independent directors, and John's Blue Ribbon committee issued a report, an excellent report that's been widely implemented, I think by now, in which it concluded that independent directors to be independent and to serve on the audit committee as independent directors must derive no compensation from the company other than their director's fees.
It's perfectly obvious to me and I think to anyone who thinks about it, that an independent director who had contractual relationships with thatcompany, that made the director intimately familiar with the operations of the company, could be arguably a better independent director.
He would know more or she would know more about the company, and yet that argument, if it was made, was rejected in the interests of assuring that an independent director serving on the audit committee had no connections to the company other than the director's fee, and I think the point is there are trade-offs, as I think the Honorable Mr. Meyer said earlier, or Paul Volcker said or they both said, there are trade-offs, and in this case, there is a trade-off.
So I wouldn't argue against the point, I would just say the point pales in significance to the need to shore up the independence.
CHAIRMAN LEVITT: When you were a member of the Commission, did you deal with this issue?
MR. LONGSTRETH: You're trying to embarrass me.
I have said that the worst decision I made, the worst decision I am today aware of that I made as a Commissioner was to vote to essentially repeal the disclosure rule which was put into effect, I think by the Williams Commission, requiring disclosure in theproxy statement of nonaudit services.
And if I knew now what I knew -- I mean, if I knew then what I know now, I would not have voted that way.
I think the arguments for repeal were lightweight and wrong, and I think we might not be in the position we're now in if that rule had persisted.
However, I do not, I strongly think that disclosure is an inadequate tool today to deal with this problem.
CHAIRMAN LEVITT: You were a member of the O'Malley Panel on Audit Effectiveness, and the opponents of this rule continually quote from that group's report to show that we really should not adopt any restrictions on audit services.
You mentioned that you were among the members of the panel that had a different view. I wonder if you could briefly tell me how the O'Malley group approached this issue?
MR. LONGSTRETH: We approached the issue first by debating whether independence was relevant to audit effectiveness at the outset.
It was put on the agenda after vigorous debate. It then became a subject of continuing vigorous debate as to whether nonaudit services posed a problem ornot, and the -- I think the most powerful argument that one keeps hearing about this subject is that from those who do not want any restriction; is that there are no smoking guns.
I mean, we don't have a major case revealing that nonaudit services caused an auditor to effect a bad audit or to indulge management in something that was really not right under auditing principles and accounting principles.
But there was plenty of debate over that, and we ended up with basically two points of view, and Mr. O'Malley I think as chairman took the decision which was supported by the panel, to lay out the two arguments in the panel report, and those two arguments are laid out in the report, and people can judge for themselves.
Those who are opposing your rule and quoting the report must be very selective in their choice of argument.
CHAIRMAN LEVITT: Mr. Brown, you mentioned professional expertise, and some in the profession contend that without being able to provide internal audit outsourcing or IT design, auditors won't be able to perform high quality audits.
I suspect you disagree with that line ofthought?
MR. BROWN: I do, Chairman.
Those who take the position that the audit is of higher quality where they are also doing other consulting services, are also quick to say, however, that in circumstances where they're not doing other consulting services, the audit is not inferior.
I suspect they're right on both counts, because I think what has to happen is the scope of the audit when they're not performing other consulting services may have to be greater than it otherwise would be, but I think the audit firms do that, and so I think it's an issue of cost, not of quality of the audit.
CHAIRMAN LEVITT: Your remarks concerning the likelihood of some kind of self-regulatory mechanism to be created by the industry is not very high, and you, you know, I found that over the years the profession has been reluctant to address this issue, and I wonder if you have any views on why you think that is, self-regulation works so effectively in other areas of the financial community.
MR. BROWN: I'm not sure that it's a reluctance to address the issue. I think the issue has been addressed, is being addressed, but I thinkthere's an inability for the profession itself to find answers, and I think that's for a couple of reasons.
The strongest is that the very business models that they themselves have developed see them pouring vast resources into the consulting side of the business. I think they believe that that's where most of the growth potential goes, where it's coming from, although I'm pleased to see that some of the firms now are talking about expansion of the assurance services and there may be some hope there that some of the pressures from the business model will change.
I also think that they're being pressured internally. I think that companies and perhaps audit committees have done a disservice to themselves in the past by forcing audit fees down.
There haven't been the same pressures on the consulting fees, and so I think that the consulting revenues have been more lucrative on a per person hour basis.
So I think that the firms, frankly, will be unable to solve the problem because of those pressures, and that it will be up to us as regulators to have a large role in that solution.
CHAIRMAN LEVITT: Mr. Whitehead, you were chairman of the Blue Ribbon Panel on CorporateGovernance, and there was a lot of skepticism at that time as to whether a nonregulatory approach, at least insofar as the panel was concerned, would do at all, and this was followed up by action by the various SROs, and my own observation and those of my fellow Commissioners has been that the dialogue raised by your panel has created nothing short of a cultural change on the part of audit committees.
I cannot tell you how many audit committees I've heard from personally who have said that the Blue Ribbon Panel has made their jobs much easier, and that it's empowered them.
How would you view our rule proposal in terms of helping audit committees to do their job even better?
MR. WHITEHEAD: I think it would help audit committees do their job better.
I think it would help auditing firms do their job better, too. I'm sure that every one of the auditing firms, at least both those that favor the new rule and those that are opposed to it, recognize that there is here a growing problem, and they're searching for ways internally to help.
I think this will push them in the right direction at a time when the problem is getting worserather than better, as these consulting fees continue to grow proportionate to the growth in the auditing fees.
CHAIRMAN LEVITT: Thank you.
COMMISSIONER HUNT: Thank all of you, gentlemen, for being with us today.
Commissioner Longstreth, or former Commissioner Longstreth, I'm sure you're glad to be a former Commissioner and not having to sit with us all day today.
COMMISSIONER UNGER: You're not staying?
COMMISSIONER HUNT: You mentioned in your testimony that you were concerned about, and your written statement submitted for the record as well, that some of the battle over this issue may be eroding the independence of the Commission.
Do you think that's actually going to happen?
MR. LONGSTRETH: No, I don't. I mean, that's a --because of the, I'm aware of the extent to which a major effort by the firms has been undertaken.
I've been, I don't know how many lawyers are left in Washington who aren't working in one way or another.
I have this on hearsay, not direct evidence, but I have it from some highly placed sources, so I recognize there's a battle going on, and it seems to me that as many people have said, including The New York Times, but as the gentlemen who preceded us, the distinguished gentlemen on this panel, I mean, this is not, this need not be a big deal.
As Mr. Whitehead points out, which is a simple and brilliant observation, there's no shrinkage of the business.
For every audit client that you have to cease serving, there's one other client opened up for you, and the percentage of business today, the genie is not yet out of the bottle, but it's coming out of the bottle, and the question is whether the SEC will be able to withstand, in my view, anyway, I'm putting myself in your shoes, will withstand the heat that will come from many different places to make sure the genie doesn't get out.
By "genie," I mean that there is only about 70, well, for the Big 5, 75 percent of the SEC clients do not use their auditors for nonaudit services, but that percentage is shrinking. It went down from 80 percent a few years ago, so there is a trend and it's probably a powerful trend, so that's all.
COMMISSIONER HUNT: Well, you know the argument on the other side of course, which is there's synergism here and it leads to better audits and all the rest of it, that the Chairman, mentioned a few minutes ago.
I guess none of us know the definitive answer to that question at this point in time, but I think the conflicting views at this point are clearly understood.
Again, thank you for coming.
COMMISSIONER HUNT: Chairman Brown, you mentioned that you see an erosion of confidence in auditors.
Some of the comments we have received from our proposal are to the effect that professional analysts don't necessarily use the audited statements anymore.
I think you mentioned this, but are using new technologies, audited statements or documents are using new methodologies to evaluate the work and prospective work of companies.
If that's the case, and I suppose it is, do you think that makes our concerns about auditor independence any less important?
MR. BROWN: Commissioner Hunt, no, I don't.
As I said, I think that the reasons for the erosion of confidence are complex.
I clearly think one of the reasons relates to the diminishing independence of the auditors, and I think that the approach of the analysts is quite different, depending on the type of company, whether it's a so-called new economy company or old economy company, whether historical financial statements give a better or not as good a picture.
So I think there are a number of reasons. But we have been told, and I believe just from my own observation, that the independence issue is very much part of that trend.
COMMISSIONER HUNT: You mentioned our work in IOSCO, and as you know better than I, until now we've been focused on adjusting and adapting a set of standards for cross border uses, but I agree with you that we ought to in IOSCO give some attention to these independence issues now, and I'm sure we will, under your brilliant leadership of the Technical Committee.
MR. BROWN: Thank you.
COMMISSIONER HUNT: Mr. Whitehead, this was mentioned in our earlier hearing, too, that the way to solve the problem is to do audit work for audit clients, and consulting work for your competitor'saudit clients and you well know that the answer or response of some of the firms is that doesn't allow us to do as good an audit as if we were doing the audit work and consulting work.
MR. WHITEHEAD: Yes, I think there is probably something to that view, but I think the disadvantages of a firm doing both are greater than the advantages that come, and I think that the disadvantages of the lack of familiarity with the details of the company's business systems should be no handicap to an auditor in doing his professional job.
I must say that I appreciate, if I were the auditing partner, the partner of a leading accounting firm responsible for relationships with a company client for which I was doing the auditing work for, say, a million dollars, and doing $5 million of other services for that company, and there arose a disagreement between me and the chief financial officer about the treatment of some matter, accounting treatment of some matter in the company's business, I would be hard put to it, and I would feel some pressure to help my firm continue to maintain this relationship and keep those consulting contracts.
And that puts the auditor in a difficult position, and I'm sure every partner of everyaccounting firm that does both functions has felt the pressure of that decision.
I think it's better to remove the pressure, and as I tried to point out earlier, I don't believe an accounting firm necessarily loses business on a net basis as a result of this change.
They just do different kinds of businesses with different clients.
COMMISSIONER HUNT: I think we all have a perception that that kind of pressure is real and existing and growing, and obviously we have to find a way to solve it.
So thank you all for your opinion.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: Thank you, Mr. Chairman.
Commissioner Longstreth, I just want to say that if each of us up here had to defend each and every vote we've taken, I think we'd all find some stinkers.
COMMISSIONER UNGER: Speak for yourself.
COMMISSIONER CAREY: But I want to say we'll view your thoughts and your enlightened views on these matters in toto, but I want to thank you for your testimony.
I want to ask a question of Mr. Whitehead. Holman Jenkins is a columnist for the Wall Street Journal editorial page, which as a Democrat I don't often find myself agreeing with, but at the time of the PWC case he came out with the observation that if you have one firm with 8,100 violations, does that say more about the people or about the rules?
And I want to ask you, and I think there's much in this rule that addresses exactly that type of concern, but having run an organization as large and complex, with as many competing interests as Goldman Sachs, how do you -- as these firms get more and more complex and there are more intersections of interests, how do you address that?
MR. WHITEHEAD: Well, it's a good question and it would take a long answer, and I'm not sure I have it.
I'm glad I'm not running Goldman Sachs today, because it is much more complicated and much larger. It was easy in my day, and it's certainly not at all easy today, and with the steady stream of mergers of financial institutions, and of accounting firms, I think it's going to get more and more difficult.
I think it further argues for theimplementation of this kind of rule, that you have to give industries some guidelines, and I think that's the function of the SEC.
I think micromanagement of rules, and you have some rules that I would consider to be micromanagement, are not constructive and probably should be reviewed and maybe changed, but the guidelines of the principles behind these rules are the important things that will help accounting firms treat everybody, all the accounting firms equally, so that the competition within the industry will continue to remain and I think that's a healthy thing.
So I think the greater complexity of the industries now affect capital markets does make it more difficult, but that these, this kind of rule, these kinds of rules will be constructive in helping them run their firms more effectively.
COMMISSIONER CAREY: Thank you.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: Thank you, Mr. Chairman.
I wanted to follow up briefly on what Mr. Whitehead and Commissioner Hunt were talking about in terms of the synergies of the business between the auditing and nonauditing or consulting services.
Thinking about what you've said and that business will just move to another firm, and you will just pick up the other auditing clients, but I have a feeling it's just not so simple, because if that were the case, then why would the accounting firms be concerned about this loss or potential shift in business, not a loss in business.
Don't you think there's something more to it in the so-called maybe marketing of providing these services to your clients, in that there's a greater efficiency of the firm providing you with these consulting services, we already know a lot about you because we perform the audit, therefore it's just another step in our relationship and we can do it cheaper or more efficiently than competitors X, Y and Z and could the industry be concerned in fact if there is a prohibition on consulting and auditing being provided by the same firm, that there will be a whole new industry that springs up that is not an accounting firm, that has nothing to do with the auditing functions of that particular client, and that that's the real competitive issue, not that it will go to another firm and that they'll all share the auditing clients of each other in terms of providing consulting businesses, but that there will be a whole new sectorof the business that grows up in the economy.
MR. WHITEHEAD: That whole new industry already exists in a variety of forms.
Consulting services on these issues are available from a lot more than the accounting industry itself already and the accounting industry in effect is competing with the management consulting industry, with investment banking who are supplying now a variety of consulting services, so there's loads of competition, but I think my point would be that if an accounting firm really performs excellent services, better than others, that it need not fear losing some business as a result of the new regulations, because it will be able to take on more than it loses.
And I think this will be upsetting because it will be a period of transition in which they will be meeting new clients for their consulting services, and losing old clients for their consulting services and there will be a shuffling of personnel and management within each of these organizations which of course is disruptive, but when it's all over, some firms will come out better and some firms will come out worse, but the net result on the industry will not be negative.
COMMISSIONER UNGER: But they will have tocompete more on the strength of the services as opposed to the synergies achieved by providing both services.
MR. WHITEHEAD: I find it very dangerous that an accounting firm would be arguing that because we are your auditor, you really ought to do this advisory stuff with us and not with McKinsey. I don't think that's happening very much.
COMMISSIONER UNGER: But then what is the competitive issue, then? Why aren't people going to McKinsey more than they are to their own auditor?
MR. WHITEHEAD: They each have their own sales organizations and they each perform somewhat different functions. It would be a complex question.
COMMISSIONER UNGER: Very diplomatic answer.
MR. LONGSTRETH: Could I try, just add one footnote to this discussion.
Your numbers in the release are impressive. You mentioned the 75 percent.
In other words, 75 percent of the audit clients do not use their auditor for any services that are not related to the audit, and yet over the past six or seven years, the growth rate among the Big Five for nonaudit services is 26 percent, far exceeding the growth rate in audit services.
So the business, I mean, there is a business there and it's growing very rapidly, and it has nothing to do with the audit client.
COMMISSIONER UNGER: The other question I wanted to ask, and I think probably all of you are able to answer it, is the, improving the audit committee's role, strengthening the audit committee's role.
Is this conflict something that the audit committee could do more about?
MR. WHITEHEAD: Yes, I think this is a subject that the audit committee can certainly do something about, but I think the audit committee, too, is likely to welcome this change.
The company will have to find other purveyors of these advisory services, if that's the part of the business that the auditing firm decides to give up, or they will have to find other auditors, but I think the auditing committee is certainly concerned about the appearance, or possible appearance of a conflict of interest.
I'd like to make a comment, if I may, on outsourcing of internal auditing functions, which I heard discussed in your earlier panel.
I've always believed that internal auditingis the function of management.
It's not the function of some kind of separate thing; that management should be responsible for managing, for auditing its functions internally.
It's a legitimate function of management, but the internal auditing staff and the internal auditor should be made to feel by the audit committee and the Board that if he uncovers something which seems to be a serious problem, that he then is expected to report to the board of directors through the audit committee, through the chairman of the audit committee immediately, and not feel bound to only report to the chief financial officer.
So that there is, the Board has a function here in the audit committee, in insuring the integrity of the internal auditing process, but I think the management should pick and choose the people that are on their staff and not rely on an outside firm.
COMMISSIONER UNGER: Thank you.
COMMISSIONER HUNT: I have a follow-up question to you, Mr. Whitehead.
Given your experience on audit committees for many corporations -- I'm sorry, did you want to say something?
COMMISSIONER UNGER: My question was for Mr.Whitehead. I didn't mean for the rest of you to --
MR. BROWN: I was just going to add a brief point to Commissioner Unger's question.
I've been told by the chair of one of our major multinational corporations that it's the loneliest job in the world, and I think it takes a very strong, confident personality as the chair of the audit committee, to be able to understand and if necessary push back on some of the relationships that have grown up between the auditors or the accounting firm and management of the company.
So I believe that there is a stronger role for the audit committee to perform, and the recommendations of the Blue Ribbon Panel that have now been adopted at in the U.S. and that we're looking at in Canada will give them added strength and hopefully added confidence, but I don't think that we can stop there and ask the audit committee to solve this problem by themselves.
I do think that we need a regulatory solution.
MR. LONGSTRETH: Can I add two points to that?
I'm the chair of an audit committee of a large public company, and I've tried, I've thoughthard about the independence issue of necessity because of the panel's work and I've tried to talk to the auditor, have the committee talk to the auditors about independence.
It's extremely difficult for an audit committee to challenge the independence of the auditor.
You end up, basically, it's a challenge of the integrity of the auditor, and that's a very uncomfortable thing to be talking about, but the -- so that's point one.
It's not realistic to say, are you sure you're independent? How do we know you're independent?
That's a very difficult dialogue to contemplate.
The next point I'd like to make --
COMMISSIONER UNGER: That's the dialogue we're having.
MR. LONGSTRETH: The audit committee is essentially blind to this question and has to rely on the auditor itself to explore the question, and you cannot expect the auditor to determine its own independence.
So there is, I think it would be, while Iagree there's been an enormous shift, cultural shift, very positive one as a result of John's Blue Ribbon Committee recommendations, it simply is not enough to assure that the job can be done, in my view, for those two reasons, and the others that have just been set out.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Thank you very much for a superb presentation.
We have fallen somewhat behind schedule, so I would ask succeeding witnesses and my fellow Commissioners to be concise in our questioning and concise in the presentation and to try to stay on target.
Panel 3 (Morning)
The next panel is reflective of what I believe is a very subtle but important change that is taking place as a result of this debate and a result of this dialogue, and that is that some of the best companies in America are thinking more about this issue than they ever have before, and some of the best audit committees are beginning to focus on this.
We have two witnesses, I've spoken to the chief executive officers that each of them represent, but in their own right, Gary Pfeiffer and Judy Lewent are among the most distinguished financial people inAmerica today.
Gary Pfeiffer represents E.I. DuPont. He joined the company in 1974, he holds a Bachelor of Arts degree in political science, an MBA from William and Mary in Virginia.
And Judy Lewent is chief financial officer of Merck, responsible for financial and corporate development functions.
Prior to that, she was vice president and CFO responsible for financial functions of the Merck Foundation.
We are honored to have your companies represented by two of the most distinguished financial officers in America today.
Gary, could you be the lead off?
MR. PFEIFFER: Thank you, sir.
I appreciate the opportunity to share my views as the CFO of DuPont on this important issue.
In the brief introductory remarks, I'd like to make three points.
First is we are in agreement with the intent of the proposal to reinforce the integrity of financial reporting by insuring the independence of external auditors.
Second, we agree fully that both the realityand the appearance of independence are very important parts of the proposal's intent, and that we believe independence in this area is best regulated with a rigorous oversight process by audit committees operating from a principle-based set of guidelines.
Before I expand on these three points, let me acknowledge up front that we are a firm that in 1999 requested and received substantial nonaudit services from our independent accountant.
Shortly I'll cover how we did so and maintained both the reality and appearance of independence.
Let me describe how these nonaudit services came about. I think that may be instructive in the application of the guidelines.
Several years ago, DuPont outsourced the administration of our employee benefit plans to both employees and pensioners to Coopers & Lybrand.
Subsequently, PriceWaterhouse, our independent auditor, merged with Coopers & Lybrand and suddenly the number or amount of nonaudit services performed by our external auditor doubled on that merger because of Cooper's work that they had done before the merger.
The second piece is that in 1998 to 1999,DuPont had some very substantial mergers and acquisitions and divestitures in our portfolio of businesses totalling more than $40 billion during that period.
We turned to our external auditors during this time for audit and attestation services and due diligence work.
We turned to them because they knew our businesses, they knew our values and we could count on their professionalism and their objectivity.
With this background, let me go back to where I started. The integrity of financial statements is extremely important to DuPont.
We at DuPont are both a preparer of financial statements and a user of financial statements.
Our life is clearly significantly easier when our investors and our prospective lenders have a high credibility in the integrity of our financial statements, but our life is also significantly easier if we can have the same credibility in the integrity of the financial statements to the customers to whom we extend billions of dollars in trade credit terms and in the statements of the companies in which our $18 billion pension fund invests. Confidence of theindependence of the external auditor helps build independence and integrity.
At DuPont, we strive for the appearance and the reality of independence of the auditor and that depends on our boards and our committees operating within the context of the Blue Ribbon panel. The audit committee sets the policy and the parameters for independence.
I, as chief financial officer, am accountable to execute within those policies and parameters as is our independent auditor, and the audit committee is then accountable to make sure that we both do our job.
The process that we use internally is supported by regular reviews of the audit committee, written reports on audit and nonaudit services, routine meetings between the audit committee and management without the independent auditor and routine meetings between the audit committee and the independent auditor without management.
All parties within this process take independence very, very seriously.
Within this control process, we are in full agreement of the four governing principles that the Commission is proposing.
We would recommend that the complexity of today's business world suggests that those four principles might be of better use as guidelines for audit committees and management and independent auditors rather than rules.
Pragmatism and materiality we would suggest need to be considerations in the audit committee's decision to insure the reality and appearance of decisions are maintained without compromising quality and effectiveness.
Let me give you a few examples from DuPont's perspective. First, we believe that internal audit work and external audit work are something of a continuum.
Where the exact line is drawn between the risk models of the independent auditor and the internal audit group is best set, we believe, by the audit committee annually as they review the scope of the important work of both those organizations.
Second, we believe it is appropriate and useful and effective to engage external auditors to insure that appropriate financial controls are embedded in information systems as those systems are developed by others, whether they be developed by company personnel or other consultants.
We would suggest that the audit committee can best determine how the independent auditor can best do that maintaining their independence and their separateness from the development of the system.
Third, we believe that using external auditors in financial due diligence in mergers and acquisitions is an effective assistant to management and the Board and is a service to shareholders.
We have found that in these engagements the professionalism and the objectivity that our external auditors bring support their role as advocate for shareholders and the Board.
Finally, we agree that shareholders should be made aware and need to know about the audit and nonaudit fees an independent auditor is paid by the company.
We have voluntarily disclosed these amounts since 1992. We would suggest the proposed exposure rule in its level of materiality would be overlong for a company like ours and could disclose some competitively sensitive information.
We would suggest a reasonable materiality test would be appropriate.
Let me close my remarks by stating we fully support the intent of the proposed rules.
Independence in reality and in appearance is very important to us both as a preparer of and a user of financial statements and financial reporting, and we believe that the four principles are excellent.
It would be most excellently used by the audit committees in its guidance in their rigorous oversight to insure the intent and purpose of full and complete independence of external auditors.
Thank you very much.
CHAIRMAN LEVITT: Ms. Lewent.
MS. LEWENT: Good morning. I do appreciate the Commission's offering Merck the opportunity to participate in these hearings on auditor independence.
My comments will primarily describe Merck's approach towards our auditors which is designed with a view to maintain an independent perspective while evaluating our financial statements. I will focus primarily on the principles and practices associated with the use of nonaudit services provided by our audit firm.
The approach which Merck developed more than twenty years ago, discourages the use of nonaudit services by our audit firm, but preserves the flexibility to use those services in the limited instances where the use of such services is clearlywarranted.
In general, the auditor's role is to act as a third-party provider of assurance on the overall prior presentation of a company's financial statements.
Clearly, it is necessary for the auditors to be independent.
Their unbiased guardianship helps assure the financial statement and provides solid footing for investor statements.
It is critical for the management and the public to have full faith in the integrity of those statements.
The perception of auditor independence is vitally important to that faith and is an important element of a sound financial reporting framework and efficient capital markets.
We are all aware of the difficulties in ascertaining whether certain auditor activities such as providing nonaudit services to audit clients, has in fact impaired auditor's objectivity and fairness in performing audits.
The answer is unclear in light of the vast number of particular circumstances in which the question can be considered.
There may be circumstances, however, where there is increased risk that independence could become impaired.
Even more likely, an outsider could perceive particular situations as impairing an auditor's independence.
We therefore manage the auditor/client relationship based on a set of principles and practices designed to minimize this risk.
A number of elements comprise a solid framework of independence. Some are exercised solely by the audit firm and others by client management.
Audit firms, for example, regularly participate in self-evaluation and peer review programs in which an auditor's work is scrutinized by other auditors inside and outside the firm.
Through some programs an audit firm can see shortcomings in its processes including adherence to independence and other professional standards.
At Merck, specific practices have been put in place over the years to reinforce our auditor independence.
First, consistent with common practice, the outside auditor has full access to the audit committee or the board of directors.
Second, Merck has established a practice of rotating its lead auditor every five years, two years before the AICPA practice rules would require.
It is also customary for us, for the partner to not have served on the Merck audit and in other capacities when assuming the role of the lead partner.
We believe these practices strike an appropriate balance between continuity and objectivity.
Third, based on a belief that our auditors should not provide nonaudit services except in limited circumstances, a rigorous evaluation process determines when to engage the external auditor for nonaudit services.
The standard for selecting our audit firm for nonaudit services is based on our auditors demonstrating superior expertise when compared to another provider and providing that service at a competitive cost.
The audit committee of Merck's board of directors must then approve each such request to use our outside audit firm for nonaudit services.
If the proposed services could impact the audit committee's view of auditor independence then it is obligated to deny this request for services relatedto the audit function, but outside the scope of the audit such as due diligence services or compliance audits, approval by our corporate controller is required.
To date, this process has resulted in the use of our audit firm for nonaudit services only in limited circumstances, and all of these processes have not been a burden to Merck in terms of fees or quality of results.
Management judgment is a key element of this approach.
Let me share an example of where we have used our auditors for nonaudit services.
Merck will occasionally engage the expertise of our auditors Arthur Andersen to support a compliance audit that is the responsibility of our internal audit function.
While our internal audit function is viewed as an important management responsibility, there are circumstances where it is appropriate to supplement their work with resources from our auditors.
For example, in Brazil, Korea, Japan and some other locations, we have used Arthur Andersen auditors with relevant language skills to support Merck auditors charged with completing the audit.
The framework Merck has in place to help preserve the fact and appearance of auditor independence is appropriate for our company and has not affected the quality of audit service we expect and have received from our audit firm.
Over the years of service, as our auditor, we have depended heavily on Arthur Andersen's competence, integrity and advice to insure that Merck prepares and presents high quality financial statements.
We will continue to rely on high quality audit professionals to provide that assurance in the years ahead and would favor a regulatory environment which serves to continually strengthen the expertise of the audit profession.
We believe the approach towards auditor independence that Merck developed many years ago with its focus on audit partner rotation and very limited use of nonaudit services is effective in addressing potential issues of independence.
Clear principles and a practice of evaluating each use of nonaudit services against a rigorous standard are the underpinnings of our management in this issue.
We have concerns about the potential resultsof a process which would substitute a detailed set of rules and regulations for Merck management and audit committee oversight.
Again, thank you for the opportunity to address the Commission.
CHAIRMAN LEVITT: I'd like to thank both of you, and observe that your CEOs and the audit committees are among the most noble and constructive in America and are representative of the kinds of companies that really care about the public interest.
In that connection, I'd like to ask both of you the question as to the argument made against this proposal that perceptions really don't count very much.
Certainly, your CEOs and the actions of your audit committees would suggest they have a different view of that, but I'd like to hear from you what you believe the attitudes of your CEOs and audit committees are with respect to perception in this arena.
MS. LEWENT: I think others before us made some excellent comments.
I guess I would only add that across the board, I know how DuPont feels as well as Merck that one's reputation is sacrosanct and your actions haveto make sure that perceptions are supported by reality, so that any violation of any, any potential jeopardy, you put that knowledge of the credibility of, let's say, independence in this case, is not worth, is really not worth the risk, and it's very hard to repair those perceptions once they develop, so we feel that taking these kinds of procedures and putting them in place, allows us to eliminate any potential risk that a perception might exist in that regard.
CHAIRMAN LEVITT: And you do think it appropriate for the Commission to address this issue of perception?
MS. LEWENT: I absolutely do.
MR. PFEIFFER: I would just add, Mr. Chairman, that in this area, I would agree with Judy that perception is reality in this area, because what we're talking about is the sense of integrity in the field, that they have when they read the statements.
CHAIRMAN LEVITT: What do you think the impact of the Commission's rule proposal will be upon the work of your audit committees?
Do you believe this will reinforce a practice that apparently has been in place for some time and may spread it to other audit committees thatperhaps have not focused on these issues?
MR. PFEIFFER: I think that the intent of the rule and the four principles will certainly reinforce the work and strengthen the framework within which our office exercises its accounting work.
As I mentioned in my remarks, I think using those principles as guidelines for the audit committee's pragmatic judgments will support their work.
I do have some concern about them having imposed upon them the administration of a very detailed set of rules.
CHAIRMAN LEVITT: Ms. Lewent?
MS. LEWENT: I guess I really don't have very much to add to what Gary said, except that we really do practice policies that are, I would say, quite representative of the rules that you're proposing.
I think that would only serve to reinforce what the committee practices are, and I guess our only concern is about the complexity that some of the specifics might present.
CHAIRMAN LEVITT: Commissioner Hunt?
COMMISSIONER HUNT: Thank you both for appearing before us.
Mr. Pfeiffer, do I understand from your remarks that you think the present rule is too detailed?
MR. PFEIFFER: Yes, sir, I do. I think the complexity of business models that large companies operate in around the world and across dozens and dozens of different businesses and industries is best measured and metered by guidelines and principles that audit committees who are independent of management, and rigorous management process, I think I've described this morning and Judy has tried to describe, are the best way to do that.
COMMISSIONER HUNT: Do you agree with that?
MS. LEWENT: I would add a perspective on the complexity and detail of rules, you've often appreciated when any of us attempt to lay out and anticipate any eventuality, it's a daunting thing.
That's one concern.
The other thing is we do live in a fast-changing environment. So I think not just the situation we live in today, but having something that is evergreen in reality, I think is a reality.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: I'd like to ask a question that was raised in your testimony.
How does Merck determine whether the nonauditor services are unavailable from another provider?
MS. LEWENT: I always put things out for competitive bid, so we would never take just a proposal from our own audit firm in any instance.
COMMISSIONER CAREY: So is it driven by price, is that what you're saying?
MS. LEWENT: What I'm saying is it's a combination.
Clearly you have to look at both aspects of stewardship, so we have to take cost into consideration, but the primary driver would be quality of service.
Some have particular superior capability, and it's really that standard that our own audit firm would have to demonstrate clearly superior capability to another competitor to cross that hurdle to have us engage them.
COMMISSIONER CAREY: All those lines, how can it be determined that nonauditor services are materially more cost effective if provided by the auditor?
And couldn't cost effective nonaudit services still impair independence?
MS. LEWENT: Could you just elaborate on the question, just so I appreciate --
COMMISSIONER CAREY: Isn't it possible that cost effective nonaudit services still pose a threat to independence?
MS. LEWENT: I guess what I was trying to say in my comments, that cost was one element, but clearly, our standard is basically we will not use our audit firm for nonaudit services until both expertise and cost come into play or demonstrate clear superiority, so I think it's pretty high standards.
So this is not a cost-driven exercise.
COMMISSIONER CAREY: That's what I was trying to get at.
Thank you very much.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: You set that question up for me perfectly, because I wanted to ask, how many times in making that determination do you end up using the auditor?
MS. LEWENT: Rare would be a fair word to use. Very rare.
COMMISSIONER UNGER: How would you qualify rare?
MS. LEWENT: Now you get into definitionissues.
COMMISSIONER UNGER: Percentage-wise.
MS. LEWENT: Well, by that I meant in terms of definition, just being clear, if I sweep up say due diligence services, in other words, taking the broadest definition of nonaudit services, so again, not even talking about issues like information systems and things like that, but just the broadest definition, our use would run under 10 percent.
COMMISSIONER UNGER: And what percentage would that be, then, of the total revenue or outgoing revenue to the firm's --
COMMISSIONER HUNT: Expenditure.
COMMISSIONER UNGER: -- expenditure, thank you.
So 10 percent would be nonaudit services and what percentage of the money you pay, I guess, to accountants or to the firm would that represent?
MS. LEWENT: Oh, I'm sorry. We don't usually get into the specific numbers, but just at sort of competitive levels, I'm just saying that of the total fees we pay to Andersen, basically less than 10 percent of those go for nonaudit, any kind of nonaudit service.
COMMISSIONER UNGER: Oh, thank you. I thinkit sounded, and I apologize, I missed most of your testimony, but it sounds like you have in place very effective measures to determine the independence of the auditors, yet you still think that the SEC should put into place specific rules.
Why is that?
MS. LEWENT: I guess some of the spirit of at least my comments were that we have been well served by some guiding principles, and that it's that we support you in terms of the mission and intent of what the SEC is about here.
The concerns we raised would be the implementation of those principles and the choice between having those guiding principles and allowing management and the audit committee to execute on those within those parameters versus having sort of a very detailed list to operate from.
CHAIRMAN LEVITT: I gather you would support the notion that the ultimate proposal taking cognizance of a number of commentators who were concerned with the complexity of some of the guiding principles, for instance, and their breadth, if they were narrowed and simplified, as the process of rule-making and the reason for these hearings would suggest, that you would be supportive of such afocused approach?
MS. LEWENT: I think that's very much in the spirit of the comments.
For example, I'd also reference the Blue Ribbon committee that was discussed earlier as a good model for that, because that really was a very positive process and gave audit committees a lot of guiding principles to operate under and I think it's been very effective.
CHAIRMAN LEVITT: And the ultimate finding of that panel was the result of very focused rule making by the Commission, which I would expect would be a process similar to one to be employed by this Commission.
COMMISSIONER UNGER: Thank you very much.
CHAIRMAN LEVITT: Thank you very much, both of you.
Panel 4 (Morning)
The next panel includes Kayla Gillan, general counsel of the California Public Employees' Retirement System, Alan P. Cleveland, legal counsel to the New Hampshire Retirement System, and Ralph Whitworth, managing member of the Relational Investors, a private investment manager specializing in strategic block investment in publicly traded U.S. companies.
MS. GILLAN: Thank you. I am honored to be here today, to represent the views of the California Public Employees' Retirement System, also known by the acronym CalPERS.
CalPERS is the largest public retirement system in the United States with assets exceeding over $175 billion, and while this asset size may be somewhat impressive, I may never leave California without mentioning the purpose of this money, and that is to secure the retirement of the over 1.2 million people who depend on our system to pay the retirement and the disability, both for themselves and for their families and its need to protect the financial security of our members and their families that brings us here today.
First let me clearly state for the record that CalPERS is not in the accounting industry and we profess no expertise in that field.
CalPERS is, however, one of the largest and most significant and sophisticated investors in the financial markets both within and without the U.S.
Although we are also a significant large customer of accounting and consulting services in our own operation, I come to you today to reflect ourinvestor role and our key interest in the integrity of the markets in which we participate.
It is for this reason CalPERS applauds the efforts of your Commission, Chairman Levitt, in your bringing this complex issue to public awareness.
We are aware of the high visibility as well as the high number of comments that the hearings have produced, and CalPERS appreciates the opportunity to provide its perspective.
I have read much public testimony submitted thus far and I will not duplicate what others have had to say, so for the sake of time I would just like to leave three points for you today.
The first, this rule-making effort is necessary. It seems universally accepted that an independent audit committee is an essential feature of a fully accountable corporate governance structure.
This Commission's most recent work regarding audit committee independence and disclosure has cemented this principle.
It's also well accepted that an independent audit is necessary for the committee to perform its function and we're here today because there is such a vast difference of opinion among providers, users and ultimate beneficiaries of the audit as to whatindependence means.
Recognizing the increasing complexity of the accounting business model, it's CalPERS' view that well-defined standards, principles and rules must be adopted, and while we support the work of the Independence Standards Board only, this Commission has the authority and the effective ability to weigh the competing public interests that are represented in this area and reach conclusions about the best way to protect shareholders and the integrity of the financial markets.
We know that some have suggested this rule-making is not necessary because of a lack of empirical data precisely linking each of the independence issues identified in the proposal to some financial harm to the company or its investors.
A decade ago, this was also said about much of what has been well accepted by this time in the corporate governance arena.
The concept that an auditor who has a greater financial incentive to please management than to criticize it will tend to find ways to avoid negative comment is intuitive and obvious.
I can offer some anecdotal evidence.
As part of CalPERS' own investmentoperations through our corporate governance program, we annually identify those few select companies that are the poorest performers within our over 1,500 U.S. companies and we use screens that look for the conveyance of poor performance with regard to stock performance, economic value added, and corporate governance practices.
At least during the past two years when CalPERS ourselves have been focussing on audit standards and auditor independence in each of these companies that we've identified as having the biggest problems with regard to performance, they've also had problems with regard to the quality of their financial statements and a seemingly meek auditor.
This is not proof that the poor performance was the result of the nonindependent auditors, but it certainly feeds into the investment community's concern about this issue.
It's not only the reality of biased auditing, but also the perception that a biased practice is possible that erodes investor confidence.
The second point.
The SEC should look to but not be limited by the ISB independence standards.
We've noted some testimony before youalready that the ISP standards in some respects provide even greater independence in areas of employment with audit clients and financial and family relationships, and we would urge you to look at those and seek to include them in your own proposal.
Third, the SEC should consider simplifying its proposal and drawing a bright line test. No nonaudit services to an audit client.
And in this comment, we join with the statement that you previously received from Mr. John Biggs, chairman and chief executive officer of TIAA-CREFF.
The nature of prescriptive lists such as those included in the current proposal is to invite the creative to find ways of escape.
As an attorney, much of what I do and my colleagues do every day is to find ways not to be covered by legal restrictions.
We in the bar have trained to do this and we do it quite well.
The current proposal I fear would benefit the attorney community through increased fees but at the cost of investor confidence.
A clear, simple and bright line standard will avoid this tendency, and moreover I have notheard anyone suggest that there is some absence of qualified and cost effective alternatives to the auditor performing nonaudit consulting services to the same client.
Thank you for your attention in allowing CalPERS to be before you today and we will be submitting written comment and I'll be happy to answer questions.
CHAIRMAN LEVITT: Thank you very much, Ms. Gillan.
I would note that you took the red eye to be with us this morning, and we are deeply, deeply appreciative.
CalPERS has long stood for doing what's right for individual investors. They've been a beacon in terms of leadership on difficult issues, and we take very seriously your interest and your commitment.
Alan Cleveland, on behalf of the New Hampshire Retirement System.
MR. CLEVELAND: Thank you, Commissioner.
The New Hampshire Retirement System is happy to be here. Ours is a retirement system on the east coast just under 500,000 in assets, 70 percent invested in domestic securities. However, those assets are absolutely critical, and what will fund thepension benefits of over 50,000 fire, police, teachers and public workers in the state of New Hampshire.
These monies are vitally important to us.
Ours, as most funds, is a trustee plan in that it is governed by future principal.
Often we hear comments about institutional investors. It sounds very antiseptic and one has a vision of high-rise buildings and blank facades.
In point of fact, these should probably be more accurately described as fiduciary investors, because approximately 55 percent heads up today of public securities are invested by public pension funds in this country.
These are fiduciary governed funds, and for that reason auditor independence is especially important.
The promise of the pension benefits of these funds very much depends on the integrity, transparency and accountability of the publicly traded companies in which our members are invested.
The trustees of pension funds have an undivided fiduciary duty to their beneficiaries.
They must act solely in the interests of the beneficiaries of these funds in the investment of trust assets, so again the trustees of approximately55 percent of these publicly, as holders of these publicly traded companies are fiduciarily governed and invest as fiduciaries under precepts of loyalty.
For that reason, they are particularly sensitive to the independence and loyalty of the auditors in which those companies invest.
Like the fiduciaries, we have a duty to the lenders and shareholders of the company i.e., the fiduciary lenders of the governance. This undivided fidelity to the investor can only be satisfied if the auditors are independent of company management.
We regard the concurrent performance by the company's external auditor of nonauditor services at the direction and under the control of management to be inherently corrosive and fundamentally incompatible with the duty of independence and fidelity owed by the auditor to the investing public.
We find unpersuasive the proposition that consulting and other nonaudit services provided by the auditor will not impair his or her independence.
To accept that proposition asks the investing public and particularly the fiduciaries of public pension funds and private pension funds to suspend just plain common sense and the lessons of life experience to enable the accounting firms topursue additional business opportunities in connection with the engagement.
For the trustees of pension funds to describe their duties of loyalty and prudence in holding the stock and debt of publicly traded companies, the auditors of those companies are necessarily relied upon to discharge their duties of fidelity and independence to the investing public.
Again, we fully concur in a prophylactic rule of strict independence as proposed by the Commission.
The appearance issue, okay, much has been discussed about appearances. It simply misses the point to argue as some do in opposition to the proposed rule that there is no empirical evidence proving a demonstrable loss of auditor independence in providing management consulting and other nonaudit services.
Independence, of course, is essentially a state of mind.
Trustees of pension funds are very familiar with the notion of independence. They are keenly sensitive to the notion of duty of undivided loyalty to their beneficiaries and they expect no less from the external auditors of the companies in which theyinvest.
Appearance counts a great deal in matters of trust. Not fidelity alone, but the appearance of independence is necessary for the relationship. The burden of preserving the implicitness of that trust falls wholly on the fiduciary. Any competing relationship that reasonably casts a shadow over the auditor's independence and felicity to the investing public is per se improper.
Stated simply, an auditor to be truly independent needs to be a person whose audit engagement constitutes his only connection to the company.
Again, another issue that has been touched upon often this morning is the auditing committee.
We will submit that it is impossible in the real world for an audit committee to impose a standard of independence with respect to the company's auditors if in point of fact the Commission is unable to affirm this rule of independence.
The auditing committee is properly charged to control the external independent auditor.
However, if that auditor or auditing firm in point of fact looks to management for the bulk of their fees and services, there's no means by which theauditing committee could control that external auditor. It undermines corporate governance and external controls of the company to expect the audit committee to compete with management.
So again, in conclusion, the investing public and creditors will look first and foremost to the independent auditor process to gain the assurance and confidence in the reliability of financial statements as prerequisite in holding of securities.
We applaud and confirm and concur and hope that the Commission stands by and in fact finalizes its proposed rule of independent accountants.
Thank you very much.
CHAIRMAN LEVITT: Thank you very much.
MR. WHITWORTH: Thank you, Chairman Levitt, and members of the Commission, for giving me the opportunity to testify before you.
I commend you for holding these hearings, and for the related proposed rule-making, the effort flows logically and necessarily from your earlier commendable work on audit committees, and your staff's work on the phenomenon of managed earnings.
I come to you today as a member of five public company boards beyond my role as managing member of relational investors. Four of those are New York Stock Exchange companies, one of which I am the chairman of the board.
I also chair an audit committee of one of those boards as well as chairing compensation committees and nominating committees. Hopefully I can bring some of that practical experience to bear here as well.
As others have, I will summarize my testimony and the body of it has been submitted to your staff to be included in the record.
It's been said before, but I think it's worth restating, that auditor independence goes to the very essence of our capital markets, and it's linked inextricably to the efficiencies of our capitalist system.
I absolutely believe after having traveled some of the world and spent the last fifteen years in corporate America that we do have the very best system in the world of financial reporting.
It's not the envy of the world, though, as many other features of our system are.
In fact, there are many companies that I've spoken to their officers that say gee, we would just love to be listed in America and avail ourselves ofour capital markets, but we just can't swallow your audit requirements and your financial reporting requirements.
Well, I think that is very good and I'm very proud of our system for that, and I'm proud of you in your effort to maintain that integrity and the strength of our system, because I think it goes to our cost of capital and the vigor of our economy, so there's much broader, there's a very broad public interest at work here today.
We've heard a lot about perceptions, whether that's important or not. That's a very simple thing for me to conclude, because I go straight to the annual report, and I see that the auditor's letter in the annual report every year is titled, "Report of the independent auditor."
I also note that on the proxy statement of most companies every year, there's a line where they ask the shareholders to approve the independent auditors, so I think beyond that, it goes without saying that someone in corporate America believes that the perception of independence is important.
The problem is that both of those statements should have a giant asterisk next to them for many companies, because unbeknownst to the investors whoare reading them, there may be financial and economic interests between independent auditor and the company that may threaten that independence.
Now, I've long subscribed to Justice Brandeis' quote that sunlight is the best of disinfectants and that's generally been my approach as I have reviewed proposed rules from your body, but I think in this case that that just does not suffice.
I think both the fact and appearance of auditor independence is essential. And coming from a perspective where I have a strong bias towards unfettered markets, I think this is one area when balancing the interests, these broader interests that I've discussed and my bias towards unfettered enterprise, that prophylactic solutions are indicated.
And we have to remember that it's the audit profession that places the imprimatur of trust on the conduct of their services, and not just with public companies, but in other services that they provide.
Every year at the Oscars, we hear about how one of the Big Five auditing firms is responsible for counting the ballots, and I think that's very important to all Americans, so it is their profession that places this trust into the relationship, and I believe that because of that, it's appropriate to drawanalogies to other areas of public trust, as in our judiciary system and in government, as you're fully aware, where appearances are as important as fact.
And because of this importance that I place on that, I come from the--I draw a presumption that all nonaudit services should be prohibited.
And then I move to an analysis that says, if we're going to allow external auditors to provide nonaudit services, it should only be in cases where there's an overriding, where there's an overriding belief is that they are uniquely situated and qualified to provide it, and that's independent of cost and convenience.
And that's where I think your rule gets a little bit complex, because in my testimony that I've provided, I've gone through each of the points that you've asked us to comment on, and what I found myself as I went through those that it is difficult to draw lines in certain areas.
I've had experience where we have these auditors for nonaudit services and I believe they were best qualified. So there is a proverbial devil in the details here.
So I would recommend you to those specific comments, and some ideas that I have there, and now Iwould just like to move to an alternative scheme briefly that I have--
CHAIRMAN LEVITT: Your time has expired.
MR. WHITWORTH: I'm sorry.
CHAIRMAN LEVITT: So in the interests of moving this along --
COMMISSIONER HUNT: Your suggestions are in your written statement?
MR. WHITWORTH: Yes, they're all there.
CHAIRMAN LEVITT: Ms. Gillan, I have heard, the Commission has heard over and over again from those that oppose this proposal that there is no smoking gun.
How would you respond to that?
MS. GILLAN: Again, I think we need to focus on the perception. The reality is that there are a number of very visible cases that have unfortunately wound their way through various enforcement actions and litigation, that have been having very significant problems with auditor independence.
Below that visible level, myself at CalPERS, as I mentioned, I visit poor performers regularly and there's always a weakness in audit function.
So I do think that there is, both of those incidents creates a perception of a problem, of apossibility, and that needs to be eliminated.
CHAIRMAN LEVITT: You know, I'd like to address this question to Ms. Gillan and Mr. Cleveland in particular.
My mother for 38 years was a school teacher in Brooklyn, New York, and from the time I was five years old, I can remember the constant questioning she would throw at my father about her pension and what they would look forward to and how much they would get from it.
They had kind of a depression mentality, and my guess is that these issues of auditor independence are really ones that the typical pensioneer simply cannot grasp, but if explained in the most basic terms it would seem to me that every such person in America would rise up and cheer the Commission for thinking about these issues and raising the debate and imposing a standard that would defy the erosion of the kinds of protections that I think they would regard to be important.
MR. CLEVELAND: Actually, Commissioner, I'm glad you talked about your mother's pension, because there has been a--this is something I think a lot of us don't think about, because we assume that pension funds today have always invested in publicly traded securities.
Well, not really, because in 1950, pension funds, all pension funds owned 0.9 percent of the publicly traded securities in this country. That's not 9 percent, that's less than 1 percent of the publicly traded securities in this country were held by pension funds.
Today that number is 55 percent.
Why? These managed funds have great reliance and presume to be the case that the external auditors are independent and the numbers are right, that's absolutely critical.
Because in order to manage the risk of a portfolio, the fiduciaries need to rely on a transparent and accountable system for publicly traded securities.
If those numbers are not reliable, the fiduciaries cannot do their jobs because they cannot manage the risk of the portfolio, it is impossible.
At that point, investment in publicly traded securities becomes mere speculation, which is why in your mother's day, and in my father's day, that pension funds not only did not, but often time legally were prohibited from investing in publicly tradedsecurities because they were deemed speculative.
What's happened in the last 50 years is we've gone from .9 percent to 55 bears in large part because there has been methodologies developed to manage portfolio risk and that is premised on a fact that those numbers are right.
It is axiomatic. You cannot manage what you cannot measure. If there's an issue of measurement here we cannot manage. If we cannot manage, pension funds cannot invest in publicly traded securities.
CHAIRMAN LEVITT: Ms. Gillian?
MS. GILLAN: I think a short answer is I would not be here, would not be permitted to use trust fund money to travel here if our Board wasn't absolutely convinced that our 1.2 million members were concerned about this issue.
I think as more and more of our members have grown to be individual investors on their own behalf in addition to the retirement that we provide for them, through the E-mails and letters I get, they are more and more concerned and active in our corporate governance program which the issue of auditor independence falls within, so I do think that if they were all fully aware, they would be there in busloads.
CHAIRMAN LEVITT: If nothing else, I am so proud of my fellow Commissioners who have really made this the investors commission whose principal concern has been for the well-being of investors.
COMMISSIONER HUNT: Thank you all for being here.
Mr. Cleveland, you mentioned that in your view if an auditing firm is allowed to make a lot of money from consultants rather from the audit function, you didn't think the audit committee could control them, is that right?
MR. CLEVELAND: That's right, Commissioner Hunt, that's right.
COMMISSIONER HUNT: What about the serpentine wall, by which the consultant was managed by management, and the quasi separate auditing function was managed by the audit committee, you don't think that would work?
MR. CLEVELAND: The reason I don't is this. This actually touches on a fair amount of discussion that we've had this morning, questions from yourselves and answers by panelists with respect to how this should work.
The way it should work, and this gets to thesynergies and the special information or knowledge, understanding that external auditor, that external auditors derive by being involved in these consultancies.
The way it was supposed to work was best corporate governance practices and principles is the audit committee is supposed to control the external auditor.
The external auditor should be looking to the audit committee as basically the client, not the management.
Right now, that is great, that's the theory.
In practice, it's difficult, and on the train down here, I didn't take the red eye like Ralph did, in this issue, Robert Felton, who was counsel to the President in 1975, not speaking to auditor independence but speaking to his reflection and experiences as a director on many boards, as a chairman of several companies as, having been around, very sage and experienced veteran, and what Robert Felton wrote in Directorship magazine, the most current issue is, "Why won't auditors be frank with the directors?"
Well, "Auditors are far more afraid of being fired by management than by the audit committee."
Now, to put an accounting firm even more under the control and direction of management by having their -- frankly, the revenues being more dependent upon management, this is completely frustrating the corporate governance rule of the audit committee. It is undermining the audit committee.
Talk about unintended consequences. This is why your rule is strengthening the hand of the audit committee in those governances.
COMMISSIONER HUNT: Thank you.
Mr. Whitworth, you said, cited the Brandeis quote or part of it, that sunlight is not appropriate here, that disclosure alone--
MR. WHITWORTH: This would not be appropriate, absolutely.
I think it's because of this appearance issue that seems to permeate this discussion.
Just to disclose, to put that asterisk on that statement in the annual report, for example, to say by the way, your independent auditor provided such and such services that amounted to millions of dollars, I think that alone would undermine the value that our system derives from having independent auditors, so that's why I subscribe to the approach that you're taking with the caveats that I have listedin my testimony.
I also agree with Mr. Cleveland that I think as part of this process we have to even further strengthen audit committee's hands here.
Audit committees should negotiate the relationship with the external auditor. They should be responsible for managing that relationship.
They should be responsible for making sure, for example, that the audit partner incentives, their bonus is not somehow linked to external audit services which can be the case.
They should also insure that the audit function is not being provided as a loss leader for other services, and the audit committee, the work that you've done in the past has completely changed the dynamic with an axe.
I can tell you that from experience. The audit partners are giving us different statements. We're having executive sessions. We're talking about these and other issues, and I think this process is an excellent overlay to that, and I think you should push on with it.
COMMISSIONER HUNT: You think that should be a complete division of functions within the firms or separation?
MR. WHITWORTH: I give a couple of examples where I think it's appropriate if the audit committee approves it for the external auditor to provide nonaudit services.
One example is, for example, Rod Hills and I last year found ourselves with hands full with Waste Management. I was chairman of the board, he was chairman of the audit committee.
We found our bookkeeping function, just the basic function in many of our profit centers were behind, so we asked our internal auditor and our external auditor which was outsourced to come in, ultimately we brought in 1,200 consultants that worked with us for a number of months to bring those books up to date.
COMMISSIONER HUNT: 1,200?
MR. WHITWORTH: Yes, that was the right thing for us to do, but the audit committee supervised that and I literally met with them every day at the end of the day, both audit partners.
That was an example I gave.
The other one was in the area of due diligence. I think it is appropriate that an external auditor provide some services in the area of due diligence in mergers and acquisitions.
I think that's a case where they are uniquely qualified to advise the Board on the quality of the acquisition targets, accounting systems and how they compare to their own.
COMMISSIONER HUNT: Thank you all for coming.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: I just want to thank Ms. Cleveland and Ms. Gillan for being here today, because we are really, really fortunate to have the perspective of those you represent adding to this debate.
It is a perspective that I don't believe we ever forget, but it's good to make sure.
Mr. Whitworth, from your testimony, you just alluded to the example where in an emergency, you got the approval of the audit committee to have the internal and external audit performed by the same firm, is that correct?
MR. WHITWORTH: No, it wasn't the internal--no, no, we had separate internal auditors and distinct external auditors. We brought resources from both of those firms to assist in an effort to bring our books up to date. Just basic reconciliation of accounts and balance sheets.
COMMISSIONER CAREY: So they were performed by separate firms?
MR. WHITWORTH: Yes, they were, and I believe that's appropriate and that should always be the case.
COMMISSIONER CAREY: The instance of finding an auditor who could perform nonaudit services when they are uniquely well suited to do so, how would you establish when that's the case?
Are there objective criteria?
MR. WHITWORTH: That's one of the difficulties with the rule-making, which is your job and ultimately, but, and it's why -- an approach that I thought was appropriate is if you required, for example, the audit committee ably to certify the independence of the auditor and you had a bright line test that said if a certain percent, if their external audit services rose to a certain level, let's say 20 percent, 50 percent of the cost of their audit services, then by definition, they would not qualify as independent, but below that, it would be up to the audit committee to make a certification.
If they didn't make that certification, then the independent auditor wouldn't be consideredindependent for purposes of the disclosure and the listing requirement.
That's just a simplified approach, because I think that if you're going to go the way that the rule is headed, that it's probably better to just say no nonaudit services, even though I think there's these cases, because otherwise you're going to end up having your staff spend an enormous amount of time, I'm afraid, ferreting out definitional issues with respect to independent auditors rather than some of the other very important enforcement areas that you already focus on.
And so it's a very difficult question, and I didn't realize, I have to say and I haven't focused enough on this issue, and so that's why this is all so important until I started reading the rule, and it really made me think as well as others and you, but the devil really is in the details here and it's going to be difficult.
But having said that, do it, in one form or another.
COMMISSIONER CAREY: It's important for something as complex as this, not to let the perfect be the enemy of the good. There are some issues where we will never be able to find the perfect solution.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: Well, I think we are looking the devil squarely in the eye on this one.
I just want to thank you all for coming, particularly for taking the red eye, I know how difficult that can be.
I appreciate your comments and I think it's important to consider, as Ms. Gillan and Mr. Cleveland said outright, which is the idea that an auditor could provide an independent audit and consulting services goes against intuition and common sense and that type of thing, and if you think that as professionals, imagine what investors must say as they hear this as people who may not be as knowledgeable about what actually occurs.
But one thing that seems to have come up today is the role of the audit committee and ways that we could perhaps strengthen their role in determining independence, and I'm just wondering if that is something that could be achieved and could that somehow augment or I guess, I guess augment our proposal.
MS. GILLAN: Could I respond to that?
I think it's a little early to tell exactly how your rules of a year or so ago are really going tobe implemented fully and how they're going to change the operation of the audit committees.
I have to say that over the last eleven-some years, I've met with probably 100 or more audit committees, all of bad-performing companies, and so I want to make the point that there are really, really high caliber audit committees out there, and there are very, very poor audit committees out there, today, tomorrow, next year, the year after that.
That's just going to be a fact, and I sort of subscribe to that you've done quite a bit on audit committee independence as of now and it needs to sort of work its way out a little bit, but that it's more important to put the pressure on the industry.
The corporations need your help, I think, to make the industry make the decisions that they need to make, that are hard and financially against their interest.
MR. CLEVELAND: And again, to respond to the question, I think it would be helpful to the audit committee to an extreme degree to have an extrinsic statement of independence that comes from this Commission.
COMMISSIONER UNGER: If we said you can't provide any nonaudit services, that would be a veryclear line.
MR. CLEVELAND: Nonaudit services to the company that you're performing --
COMMISSIONER UNGER: Right.
MR. CLEVELAND: I agree.
MR. WHITWORTH: I would like to echo that. I think you should put more responsibility on the audit committee here in addition to whatever else you do, and this certification that I described I think would be something that would be good for you to consider, that the audit committee annually certifies the independence and describes in the proxy, the process and procedures and criteria that they use for determining that.
That makes everybody think about it, and even, and that makes the audit committee, if you're going to allow them in some cases to use the external auditor for services, when they do that, think very hard about it, and think about that process.
COMMISSIONER CAREY: I think it should be pointed out that the role of the panel on audit committee effectiveness was really helpful because I think in board rooms around America audit committees and the rest of the boards are beginning to give voice to identify ideas that before they only thought, andthat's a really, really welcome dialogue.
MR. WHITWORTH: Well, for example, now we certify the independence of the audit committee members and that has been a very interesting discussion.
COMMISSIONER CAREY: And the competence.
MR. WHITWORTH: And the competence in many board meetings that I've been in that question, of people that you just assumed obviously they should be on the audit committee because of their experience or competence and then you start looking at the independence issue, and it raises another question.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Thank you very much.
Panel 5 (Morning)
Our next panel consists of Jo Ann Golden, vice president for the New York Society of Certified Public Accountants, Mr. Dennis Paul Spackman, chairman and Mr. David Costello, president and chief executive officer of the National Association of State Boards of Accountancy, Mr. William G. Bishop, president of the Institute of Internal Auditors, Ms. Jacqueline Wagner, general auditor, General Motors Corporation.
And we have somebody at the end of the table that does not have a name tag.
MS. LaMATA: Nancy Newman LaMata, presidentelect of the New York Society of CPAs.
COMMISSIONER HUNT: Thank you all.
Why don't we begin with you, Mr. Bishop?
MS. WAGNER: I'm Jacqueline Wagner here today representing the 70,000 members plus of the Institute of Internal Auditors, and we would really appreciate, we do appreciate the opportunity to be here speaking today on this very important topic.
Bill Bishop, who is with me today, is the president of the Institute of Internal Auditors.
The subject of auditor independence is vital to the publicly held organizations and the public accounting firms that employ many of our members.
The relationship of internal auditors with the independent public accountants is also very important in the overall system of controls within organizations today.
In addition to being certified internal auditors, many IIA members are also certified public accountants and have deep roots in the auditing profession.
You already have received the position paper from the IARIA and it is our hope that you find the paper both supportive and constructive.
IIA leaders have believed for some time thatthe issue of auditor independence is one that needs to be addressed, especially with the growing number of extended audit services that are now offered to clients by professional service firms.
However, we do not believe that a total exclusion of nonaudit services provided by an organization's public accounting firm is appropriate.
Our research and the experiences of our members have been that nonaudit services provided by public accountants can complement and enhance the capabilities of internal auditing functions.
At the same time, the IIA members that I represent believe that there are certain tasks that are incompatible with the organizational independence of the external auditor.
The IIA believes that, for the most part, these tasks are largely delineated in the AICPA's code of professional conduct, although we would like to ensure that the limitations are in fact observed by the members and firms of the profession.
Although we believe that the private sector should address independence issues through self regulation, we also acknowledge that failure to respond to this challenge will force the government to act either through regulation or legislation.
One nonaudit service that the IIA has consistently voiced opposition to is the total outsourcing of internal auditing to the external auditor. The IIA believes that the total outsourcing of the internal auditing function to the organization's external auditing firm impairs that firm's independence.
The primary reason for this stance is that modern internal auditing is so intertwined with the governance, risk management and control functions of the organization that the organizational independence of the auditor cannot be maintained.
Thus total outsourcing challenges two of the principles proposed by the SEC, namely, the assumption of managerial responsibilities and the possibility of auditing one's own work.
We believe that the Independence Standards Board has been constituted specifically to address independence challenges, and we would like to see that the Independence Standards Board takes on the task of clarifying and specifying those activities that would impair the independence of the external auditor.
We are basically in agreement with the four principles for evaluating independence that the SEC has put forth, but we believe there needs to begreater definition communicated to both firms and their clients.
We also agree with the report of the Public Oversight Board's panel on audit effectiveness that greater representation from clients and the investing public would strengthen the Independence Standards Board.
As I mentioned earlier, there are a number of nonaudit services provided by firms that are very helpful to publicly held companies.
In your proposed rule, consideration is given to disclosure regarding nonaudit services and related fees.
However, the most difficult questions are, one, at what level of service does interdependence cause an impairment of independence, and two, who will decide when that point is reached.
We simply do not believe that it is possible for a single central authority in either the public or private sector to answer these questions for all publicly held organizations in the United States.
There are too many permutations in sizes and relationships of both firms and their clients to make this feasible.
For the types of nonaudit services that maybe provided by the external auditor, the IIA believes we can find guidance in the Blue Ribbon Committee's report on improving the effectiveness of corporate audit committees.
In its report, the committee recommended that the audit committee of the board engage in dialogue with the independent auditor about independence.
The IIA suggests the audit committee should review and disclose information about nonaudit service fees.
This could include review of the nature and characteristics of individual nonaudit engagements, as well as a review of the aggregate fee for all nonaudit services.
In dialogue with the external auditor, the audit committee can best judge any potential impairment of independence based on the specific circumstances of the firm and its auditors.
In essence, this would place the central responsibility for consideration of auditor independence at each publicly held company's board.
We would also expect the judgment to be made in coordination with management and the internal auditors.
In summary, we believe there should not be a blanket prohibition against nonaudit services provided by the external auditor.
However, the Independence Standards Board should develop guidance to better define acceptable/unacceptable practices.
Audit committees should set specific guidelines for nonaudit services and evaluate nonaudit services on a regular basis, and disclosures related to nonaudit services should be reinstated.
We believe these steps should significantly enhance independence while allowing needed flexibility.
CHAIRMAN LEVITT: Mr. Bishop?
MR. BISHOP: Chairman Levitt, we decided to consolidate our comments in the interests of time, so I will respond to any questions when you get to that point, but I think Ms. Wagner has represented our position.
CHAIRMAN LEVITT: Thank you very much.
MR. COSTELLO: The National Association of State Boards of Accountancy have also decided to consolidate our comments and Mr. Spackman will give our report and I'll also be available for questions.
CHAIRMAN LEVITT: Mr. Spackman.
MR. SPACKMAN: Thank you.
CHAIRMAN LEVITT: Thank you very much.
MR. SPACKMAN: We do want to make sure we have time to respond to your questions. We understand those are very important.
I am Dennis Spackman, chairman of the National Association of State Boards of Accountancy, NASBA, and this of course is our president and CEO, David Costello.
NASBA is the membership organization of the 54 boards of accountancy responsible for the licensing and regulation of accountancy in the 50 United States, Puerto Rico, the Virgin Islands, Guam and Washington, D.C.
State Boards of Accountancy take seriously their responsibility of protecting the public interest, and they have a keen understanding of the importance of the public's trust and confidence in the services provided by the licensed accountant.
So I can assure you, we consider the Commission's efforts to revise auditor independence requirements to be of considerable importance.
We also want to express our appreciation forthe opportunity to participate in these hearings.
Today and on September 20th, you will hear from a number of different boards of accountancy. Each will be expressing their own views, but you are likely to hear a common theme, and that is the importance each board places on upholding auditor independence.
We would like to commend the Commission for being willing to take on such a monumental task.
Everyone testifying has recognized a lot of change has occurred in the profession since most of the existing independence requirements were adopted.
Their relevance has now been drawn into question, and so new guidance is needed.
You have heard many criticize the proposed changes, claiming they won't fit today's complex global markets.
They would deter new young professionals from entering the profession and prevent firms from being full service providers.
Many have also testified that these claims are overstated.
Well, David and I would like you to understand that we believe the public's continued trust and confidence in the audit function should begiven primary importance.
We suggest the Commission give precedence during its deliberations to the public's concerns and interests.
We also believe the four principles that underlie the proposed revisions provide a sound approach to addressing the needed changes to independence requirements. They represent a simply stated, usable baseline that is on the mark.
It was easy for us to come to this conclusion, because we found them to be consistent with and supportive of three of the five core values recently adopted by NASBA.
We've included copies of our core values in our written testimony for your information. Our position regarding independence should not be misunderstood.
The public's continued effect and confidence in the audit function is entirely dependent on the profession's continued adherence to the principles of integrity, objectivity and independence.
It is equally important to recognize that the public's perception of auditor independence is as important as its reality.
The importance of the public's concernregarding the potential conflicts that might arise when the auditor provides nonaudit services to an audit client should not be ignored.
The significance of these concerns have been noted by the panel on audit effectiveness and in studies conducted by Earnscliffe for the ISB and Wertlin Worldwide for NASBA. One can only conclude then the public's trust and confidence in the audit function is dependent on independence in both fact and appearance.
You have our written testimony and so I won't comment at this time on each of your individual proposed changes.
We will, however, be glad to respond to any question you might have regarding them.
To conclude, I would like to make one final point, and that has to do with the Independence Standards Board.
We applaud the wisdom that brought about the Independence Standards Board, and in particular the selection of its chairman and executive director.
We encourage the Commission to take the opportunity as it works through the process of determining changes that might be made to independence requirements to reinforce the important role andmission of the ISB.
While there may be a need on occasion to provide broad guidance, actions that would appear to preempt the work of the ISB will only undermine its stature.
As you consider actions that might be taken to revise auditor independence requirements, we urge you to focus on the remedy that is most likely to preserve the public's confidence in the audit function.
We believe that solution would necessarily include retention of independence in both fact and appearance.
We all understand the importance of the audit function to preserving the public's confidence in our capital markets, and it is that long-standing confidence that has been the means of making them the strongest in the world.
Let's not give that up for the short-term benefit of a few.
Thank you again for the opportunity of representing our views.
CHAIRMAN LEVITT: thank you.
Jo Ann Golden.
MS. GOLDEN: Today I have with me Nancy Newman LaMata, president elect of New York State Society of Certified Public Accountants.
We will present our testimony together but within the time frame.
MS. LaMATA: We also have with us William Stocker, who is chair of the Society's Auditing Standards and Procedures Committee.
In the audience over there, Robert Waxman, who is chair of the Society's SEC Practice Committee, and Alan Fedderman, who is chair of the Society's ethics, Professional Ethics Committee.
These gentlemen and their committees have collaborated in the Society's discussions of the proposed rules.
Jo Ann and I will be presenting the Society's comments concerning the proposed rule-making, underscoring certain overriding concerns that recurred during committee deliberations.
The Society's comments reflect the various viewpoints of the individuals participating in those discussions, rather than the firms we represent.
These comments reflect the richness that is the Society's 33,000 members, and its diversity.
The first overriding concern is the use of the four governing principles.
When we've applied these principles, we found that the guidance derived from them is too abstract for any practical usefulness and therefore may prove counterproductive.
It has proven difficult for the committees to reach a consensus on how to assess compliance with the provisions, because these principles are open to broad interpretation.
Let's explore advocacy. I would contend that it is appropriate to be an advocate in certain situations that where the interest is quality financial reporting.
Isn't the requirement to provide a preferability letter an example of an SEC mandated advocacy role? We must be careful in providing rules that they are not too broad-brushed and therefore open to different interpretations.
These governing principles would better serve accountants and registrants as factors, tools to be used in assessing an accountant's independence in a given situation, and as a topic discussed with the audit committee.
Many of our members, including Jo Ann, don't even service registrants, yet our members are wary that these rules will have a de facto standard for theprofession and have a harsh and chilling effect on the role of the accountant outside of the SEC registrant arena.
MS. GOLDEN: Our second concern regards the application of the proposed rules on nonaudit services to smaller SEC registrants.
Committee members have indicated that the financial accountant sophistication of some SEC clients is insufficient to completely satisfy the details of certain accounting standards and that these clients expect their accountants to advise them in situations and provide some assistance.
We recommend an exclusion for smaller SEC registrants that do not have the trained resources to navigate the complex SEC reporting and accounting standards without the assistance of their accountant.
We are often the most knowledgeable participants in a very complicated accounting transaction and must first educate and then guide our clients in this way.
The accountant's navigational assistance keeps the small SEC registrant on course and actually improves financial reporting.
In a related concern, committee membersdiscussed the potential unintended consequence.
These rules may have another second tort, especially a proposed prohibition of certain services to auditing clients.
Will other regulators including State Boards of Accountancy adopt similar rules to prohibit consulting services for audit clients?
A "no" answer to this question could cause turmoil, confusion and conflict.
A "yes" answer will cause other problems.
What should be a win/win scenario is coming down to a lose/lose setup for the audit profession of clients including SEC registrants.
Limiting the provision of expert services that otherwise enhance financial statement quality could have a very damaging impact on the general performance of business and the economy, especially in communities where small practitioners often serve as business advisers to their clients and are often the sole resources for IT and other consulting services.
A third recurring concern raised by committee members gives a clear preference for the Independence Standards Board to be given implementation support and time to work effectively.
We believe standard setting is best done notby the private sector and just when the ISB is making progress, SEC steps in and proposes some dramatic changes.
We believe the ISB's efforts should be continued to be supported.
Also, we wholeheartedly support an effort between the board and the audit committee which is a first line of defense regarding auditor independence.
Another one is the proposed fee disclosure requirement.
There was a consensus with the committee that the level of detail required by the proposed rules will cause confusing information.
Nonaudit services in the fee information now go to the audit committee under ISB No. 1.
Perhaps it would be more meaningful to investors to know the audit committee reviewed the information, was satisfied and then disclosed the amount in an aggregate amount similar to the British approach.
MS. LaMATA: Lastly, what we have focused on in our concerns today, Jo Ann and I would like to personally thank you for your proposal to reduce the number of circumstances in which client employment of family members is considered to impair independence.
We both come from two career households and know the pressures that can be created by raising a family and meeting the demanding requirements of the accounting profession.
Our experience is shared by a number of accounting professionals, both male and female. The current rules are restrictive, arbitrary and inequitable and cause problems for families.
They inhibit the attraction and retention of high quality people for the profession without providing a corresponding benefit in the public interest.
CHAIRMAN LEVITT: Thank you very much.
Ms. Golden and Ms. LaMata, you've indicated that the four principles are too broad.
Would it be better to try and narrow the language of the principles or to use them not as rules themselves, but as guiding principles to the rules?
MS. LaMATA: I think they should be put in the context of a larger framework of independence, such as the ISB is working on.
CHAIRMAN LEVITT: You suggested an exclusion for smaller SEC registrants.
I'm sympathetic to the unique burdens on small business, having run a number of small businesses in my lifetime.
I guess our problem is that we also find that it's often the small registrants that are the most vulnerable to fraud and therefore in the most need of independent checks.
I assume that auditors don't provide their audit clients with business advisory services for free.
Why can't smaller registrants spend these fees with a firm that is not their auditor?
MS. GOLDEN: I think one of the things that truly happens with small companies who are sort of emerging, obviously in the technology area, you can really see that, is that they don't have sometimes the resources to go out and hire a huge number of firms.
We all specifically as auditors, as independent auditors, know our role, and we also must be very careful, and what this is sort of saying is we don't trust you to really sort of establish a base for these clients.
For instance, with myself, I don't handle SEC clients, but if that situation occurred where a client was sort of emerging as a possibility, I still have to have certain quality of work that has beendone on that client, audit standards that I still have to comply with if an SEC auditor was taking over for that client.
So you still are working within that framework and the same guidelines.
CHAIRMAN LEVITT: Well, again, the Commission has constantly got to balance various interests; the interests of industry versus investors, interests of the profession versus the client.
In the absence of truly effective self-regulatory mechanism that would relieve us of the burden of oversight to some extent, the imperative of protecting investors from whatever area may be creating a problem, and some of the smaller SEC registrants appear to be those that also have problems, and I think we simply can't turn away from that.
Now, you mentioned confusion would result in the disclosure of the audit fees, and how that information may be confusing, I really am not certain about that.
Why is it any more confusing than the financial information that companies must currently disclose in other areas?
MS. GOLDEN: I think that just, if you presented just sort of a traditional investor with a myriad list of the kinds of services that are provided with a whole detail --
CHAIRMAN LEVITT: Let's say it's not a myriad list. Let us say the fact that company A charges, is charged by their auditor a million dollars for an audit, and $10 million for consulting services, would you find that confusing?
MS. LaMATA: No, that's not confusing, and essentially that's the same answer you would get under the UK disclosure system.
CHAIRMAN LEVITT: So you would be comfortable with that kind of disclosure?
MS. GOLDEN: Yes.
MS. LaMATA: Honestly more meaningful to an investor, because they're looking to see where independence is impaired and they're going to look at multiple.
CHAIRMAN LEVITT: I share the feeling that this Commission certainly has done a Herculean job in simplifying the kinds of disclosure that companies give to investors in the interest of seeing to it that investors read and understand what they're getting.
And if we just give them too much they'renot going to read it, and I think that's the spirit of your response, and I share that feeling and I think the Commission in terms of addressing this issue will be very mindful of the importance of seeing to it that disclosure is not necessarily the most detailed disclosure, but first and foremost will be the most comprehensible disclosure.
I think your point is extremely well taken.
I'd like to ask the state regulators, and perhaps Mr. Spackman, you can speak for them, you face similar difficulties with enforcement of the independence rules as we the Commission do.
I'd like to know how you have found the adequacy of the AICPA trade group, their disciplinary process and do you believe it needs improvement?
MR. SPACKMAN: I've spent quite a bit of time on this matter with the AICPA, and there is some real frustration in working in relationship with them on these kinds of cases.
They are a membership organization and they are concerned with liabilities that may be incurred in sharing during the course of their review information that would be helpful to State Boards of Accountancy, and so frequently state boards are frustrated with the situation that something is going on within theInstitute.
They're reluctant to proceed simultaneously with that, and so they sit back and wait for the Institute to complete its work before they proceed, and so that's something that we have talked with them long and hard about in trying to remedy.
CHAIRMAN LEVITT: So you're saying that you think they have not done an adequate job up to now?
MR. SPACKMAN: They're hamstrung with those legal exposures.
Now, there are some other situations where we looked at a particular case and we wonder why something isn't happening to it, and we then will proceed on our own.
CHAIRMAN LEVITT: Evidently, you share the feeling that perceptions are important.
Don't you believe that whatever mechanism, whether it be the AICPA, POB or some other self-regulatory mechanism should take on the responsibility for disciplinary proceedings?
MR. SPACKMAN: Commissioner Levitt, you know I am a strong advocate and have worked hard to advance coordination and cooperation and disciplinary processes, and we've come together with the Commission and are working out those processes.
There is a need to strengthen discipline within the profession, and since there are really three legs to the stool right now in the profession to do that, the POB does not have as of yet an internal disciplinary process.
There needs to be that sharing and cooperation. It is unfair for a member of the profession -- maybe not unfair, it's difficult and costly for a member of the profession to have to undergo examinations and adjudicative processes on three fronts. It would be much better if that could be coordinated and cooperation could take place so that there isn't that redundancy and years of extension of time and exorbitant legal costs in that process.
CHAIRMAN LEVITT: And I completely agree with you.
I think that the profession, the accounting profession is one of the most noble and diligent professions in the history of American business, and a vast majority of accountants are responsible, hard-working and underpaid individuals.
MR. SPACKMAN: I hear applause in the background.
CHAIRMAN LEVITT: I feel that they are innocent victims of a system that has developed around them.
Other industries facing similar problems have embraced the notion that an assault upon their integrity, inadvertent or otherwise, hurts all of them, and because of that, they've embraced various notions of self regulation that really have served to protect them and protect them well.
I think the mutual fund industry is one such group.
I think this spirit, this approach, this structure is lacking in this industry.
Now, we're hearing that we should wait on these rules until we have evidence that the lack of independence has caused an audit failure, a so-called smoking gun.
How would you react to that statement?
MR. SPACKMAN: Well, that's an issue that as a member of a state board, a chair of a state board for three years, I had to wrestle with on a day-to-day basis.
My involvement over the last decade with NASBA working across the states with various state boards draws me to the position that you will not find a smoking gun very easily that you can point at.
There are lots of signs and symptoms out there and we can cite cases all day long where there might have been some problem with nonaudit services jeopardizing the independence and objectivity of the audit.
But the fact is, when these things come down the complaint line and go into adjudication, that smoking gun gets, it disappears because things get settled before the case is concluded or in the course of the case, the attorneys choose to find in egregious situations more strong arguments that close the case.
Commissioner Levitt, it's a public policy decision that you're going to have to make on that situation.
There is not going to be clear evidence, but what I pointed out today and in our written testimony is the clear evidence that the public has serious concern with appearance, and you and I know the importance that appearance plays.
It is the public's reality. So I urge you to make a public policy decision on this matter.
It is not something you are going to find and prove in a laboratory.
CHAIRMAN LEVITT: Have you talked to the AICPA's leadership about your views that theirextensive attack on an independent agency may be counterproductive?
MR. SPACKMAN: We held a Summit meeting just two or three weeks ago, and in that Summit meeting I expressed my unhappiness at that action.
I think it's inappropriate, I think it is an end run.
I don't think it raises the stature of professionalism of this profession, and I feel badly that it's going on.
You have written testimony, I've seen it coming to you with a lot of other members of the institute that are really not happy with this kind of gamesmanship.
I would hate to see these kinds of decisions made in the halls of Congress. I'd rather have them done in an open forum such as this, with a Commission that we can work with on a unilateral basis.
CHAIRMAN LEVITT: So would I.
I'm deeply grateful for the sophistication of your testimony and the comprehensive coverage and the sensitivity to the very real dilemma that policy makers are faced with in trying to bring about a public interest solution to not just a group of business people versus a group of bureaucrats.
It's an industry which has received a Federal charter, in effect, which has a mission, thankfully, that goes far beyond the bottom line, and hopefully the future will see a resolution of the kind of relationships that have developed in the past.
COMMISSIONER HUNT: I don't have any questions.
I think that one of the people have mentioned that, I think Ms. Wagner, that the Independence Standards Board, you think they should work first?
MS. WAGNER: We believe that a lot of work has been done to date to the best of our knowledge, and there is an opportunity for that group to provide the guidelines, the basis and the framework, and so we are encouraging that work to continue.
Our testimony was specifically directed to the areas that affect our organization, namely the nonaudit services and outsourcing of internal auditing.
We don't mean to imply that there's not a need for rules, that we do certainly agree and state it in the paper that we provided that we support muchof what the SEC has put forward and the proposals, but we do feel that there's a place for the ISB.
Bill, do you want to--
MR. BISHOP: I would also add to that, we also put in our written testimony that if the ISB is charged by the SEC with developing these guidelines, that what are acceptable nonaudit services and what are not acceptable, we also suggest that the ISB be weighted a little more heavily toward the private sector and away from the public accounting industry.
CHAIRMAN LEVITT: That's a good suggestion, because right now the balance is such that the perception in the public may well be that we face a constantly stalemated board on a number of issues.
A number of commentators and I believe the O'Malley Committee has also urged the balance be weighted more in terms for the public protection.
COMMISSIONER HUNT: I don't have any more questions.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: I'm reminded of the story, it is a real challenge to find a Commission in the public interest because there are so many competing constituencies.
There was an ongoing negotiation going onbetween the fishing rights between Great Britain, Sweden and the United States and a stranger walked into the negotiations one day and when asked who he was, he said, "Well, of course I'm the lawyer for the fish."
I do have some questions for this very illustrious panel.
I address it to Ms. Golden or your colleagues, how would you determine which companies qualify as smaller SEC registrants for the purpose of defining independence?
MS. GOLDEN: That's where the bar is set. A bar has to be set.
I mean, obviously, it would have to be based on either capital assets, capital to be raised, some sort of parameters need to be set.
I would be really a little, it would be a little presumptuous of me to set that bar right now, but something should be set.
COMMISSIONER CAREY: It is a hard thing to achieve, just even in theory.
MS. GOLDEN: I agree.
MS. LaMATA: Well, essentially, you do it now in certain registrations, because you're saying if it's a Reg D offering it's limited to these parameters, I think you could set similar parameters.
COMMISSIONER CAREY: What steps would you suggest we take to effect a stronger relationship between the accountant and the audit committee?
MS. LaMATA: A stronger relationship between the two, I think we're working on that now with ISB 1 and essentially making sure now that we have qualified members on audit committees, that regular meetings is the key.
COMMISSIONER CAREY: Strengthening the audit committee beyond what's already been done to a point where they can, as Bevis Longstreth suggested, go to the audit committee and actually say tell us why you're independent.
How do you get them to the point where they can ask a question that runs the risk of challenging the integrity?
Do you think we could ever get there?
MS. LaMATA: Oh, absolutely. I think the audit committee has no stake with the auditor the way management might, and that's the benefit to the audit committee, and essentially they can challenge every service that's being provided, and open and frank discussions of those services is the way to do that.
COMMISSIONER CAREY: Thank you.
My next question is for Mr. Spackman or Mr. Costello.
Could you explain more fully why you reject the argument that the profession will not be able to attract qualified staff?
MR. SPACKMAN: That is a very emotional and complex issue.
I serve on the advisory board of two universities and I observed the Big Five firms and other major firms come on to these campuses and make offerings to bright students, and there is a disparity in what they're willing to pay somebody to come on to their consulting staff with what they're willing to pay for somebody to come on the audit staff.
There is a big salary differential, an incentive and as was testified a little earlier today, individuals look at career paths to be more promising as they sit in front of those recruiters in nonattest areas.
The profession to a great extent is doing it to itself and it's doing it when it gives up audits in very competitive low ball kinds of bidding processes.
I see that because my employer engagesfirms all around the world, Big Five and other, and so we see that kind of competitiveness.
We had a special meeting a couple of weeks ago with leadership of the American Accounting Association and we talked about some of these problems.
Why aren't more students going into accounting?
Part of the problem is a lack of attractiveness in the academic arena.
There are a lot of issues that contribute to that. The profession does it to itself, the academic community doesn't have an attractive curriculum.
I don't believe you can argue that it is just because nonattest services will attract students into the profession.
As was said before, 75, 80 percent of the clients of these firms do not go to their auditor for nonattest technical consulting services. They go to other than the auditor.
That leaves a big market for firms to bring in and attract not only business, but qualified students that can serve nonattest clients in technical areas and then be loaned across to support audit clients in those same technical areas.
It is not an argument, I believe, that holds real water.
COMMISSIONER CAREY: Thank you very much.
CHAIRMAN LEVITT: Ms. Unger?
COMMISSIONER UNGER: I wasn't going to ask a question, but since you raised this issue, I just wanted to ask one question and that is what accounts for the firms offering more money for the nonattest services?
MR. SPACKMAN: Are you asking me again?
COMMISSIONER UNGER: Yes. What are the reasons?
MR. SPACKMAN: It's the larger margins in those areas and the fact that the market arena is growing so rapidly.
The growth in this area has been 26 percent over the last few years and continues to grow and accelerate. So a demand for a limited number of high caliber students is very high.
COMMISSIONER UNGER: So 80 percent of the audit clients are not getting consulting services from the firms, yet their revenue from nonauditing services is 50 to 70 percent of their overall revenue, where is that coming from? Other companies?
MR. SPACKMAN: Yes.
COMMISSIONER UNGER: Or does that 20 percent make up that much?
MR. SPACKMAN: It's growth in nonaudit client companies, predominantly.
COMMISSIONER UNGER: I just wanted to pick up really on the eloquent dialogue that you and the chairman had about really the basis and the fundamental reason for undertaking this proposal and to echo his words, if I may, that this is not something personal, this is a change in the industry and a change in the dynamics of the business and competition, and our goal is to preserve the independence, and so we're looking at how to accomplish that.
In some cases I hope that would encourage the growth of which is and protect the integrity of the financial reporting system, and so I hope that we can work together to accomplish that, and I know the devil is in the detail and the devil is getting bigger and bigger, but I appreciate your time here and your input into the process.
CHAIRMAN LEVITT: Thank you all very much. We're going to take a lunch break and we will begin promptly at 1:00.
(Whereupon, at 12:30 p.m. a luncheon recesswas taken.)
* * *
(Time Noted: 1:10 p.m.)
CHAIRMAN LEVITT: Good afternoon.
Panel 1 (Afternoon)
The next panel will feature Tom Gardner, the co-founder of The Motley Fool, and Bernard Blum of Blum Shapiro Financial Services, Inc.
MR. GARDNER: Good afternoon. My name is Tom Gardner, and I am co-founder of The Motley Fool, Inc. of Alexandria, Virginia and I'd like to thank the Commission for affording me the opportunity to testify about auditors independence.
In 1994, my brother and I started The Motley Fool with the mission to educate, amuse and enrich the individual investor.
Today we employ more than 350 Fools and have offices in the U.S., the UK and Germany.
On average, each month across the globe The Motley Fool is reaching more than 25 million individual investors through on-line broadcasting and publishing platforms.
Our work is driven by our belief that average people, you and I, ought to take a vastly moreactive 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 on-line and off-line information resources for investors, and we manage a 24-hour open network of communication on money between people in more than 100 countries across 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 compounded growth, information about how their financial advisor is paid, information about real after tax and after fee rates of return with managed future funds information about any public companies' quarterly earnings result.
I know that it's vital for every stock market participant to have access to the same information at the same time.
This idea of the need for complete public market transparency is the source of the integrity and stability that make our markets the envy of the world.
In that vein, the SEC'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 today.
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.
Therefore, there must be a mechanism or process whereby investors can take comfort in the veracity of the financial statements.
Over 60 years ago, Congress recognized this need when they confirmed federal securities laws which required that all companies regularly file financial statements audited by an independent auditor.
Nowhere else did federal security 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 world independence.
Somewhere along the way we lost the prefix. The array of relationships that exist between public companies and their auditors today are moisturizers down a slippery slope to dependent audits, and when the objectivity of independent audits is compromised, we lose ground in achieving transparency that is fundamental to a robust public market.
Again, without transparency, individual investors far and away our largest market's 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 audit firms inking substantial business and consulting service contracts with companies whose financial performance they're 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, I do not, however, have the cure-all solution for corporate auditing.
The best I can offer today is that independent auditing is critical to the security and opportunity and effort by our equities markets.
No one on any side of this issue can disagree with that.
But there's no simple remedy to the problem.
I have two possible solutions today that I'd like to share, but they're the thoughts of an individual investor with no formal accounting training and a guy who calls himself a Fool, so weight my ideas 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 investmentdecisions.
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 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 and it should be.
A complete detailed disclosure would give investors the opportunity to decide for themselves whether or not a company's commercial relations were impacting the purity of an 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 consultingrelationship 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 personally would see no reason to be any more nor less distrustful of the validity of those 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 the company and the auditor.
The risks are immense.
Therefore, to both parties, 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 enter risks substantial enough to deter unhealthy conflicted relationships between public corporations and independent auditor disclosure is also consistent with free market thinking.
Confidence in or skepticism of the company's financial statements will be factored into the market's evaluation of that business.
When companies and their auditors want topursue ancillary business relationships, required disclosure would help insure the integrity of the audited financial statements and it would also become a factor in company evaluation.
The most important point of 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 U.S. Supreme Court's outside position that auditors be watchdogs for investors with a duty of independently certifying financial statements of a public company.
The high court has made it exceedingly clear to the auditing community that its responsibilities are to accompany shareholders, not to its executive team.
However, the problem with untying the meaningful and existing commercial ties between auditing businesses and public corporations today is that doing so will 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 the loss of value for the firm, and that loss in value extends not just to the executives at auditing companies but throughout the entire industry.
This sort of decline in the value of auditing 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 if it can be shown to raise the retention rates of the best and brightest accountants in the auditing field.
I close where I began. The issue is extremely complex, particularly for a Fool.
Both sides present viable arguments insupport of their position.
Unfortunately, none of the solutions I have proposed are a cure-all for the problem.
Nonetheless, there is no reasonable 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 the commercial relations between auditing opens investors up to additional risk.
Nevertheless, without any empirical evidence at present that such relationships actually harm investors, I'm reticent to support immediate restrictions today.
However, if evidence can show a correlation between these relationships and the undermining of the integrity of the market, and I am certainly open to the possibility that such evidence exists, I believe we should consider subsidizing tighter restrictions against auditor partnerships.
CHAIRMAN LEVITT: Mr. Blum.
MR. BLUM: Chairman Levitt and Commissioners, good afternoon. My name is BernieBlum.
As a certified financial planner practitioner and a member of the National Government Relations Committee of the FPA the Financial Planning Association, I am pleased to testify in support of the Commission's proposed revision of the rules relating to auditor independence.
Like many financial planners, I started my career in a different area of the financial services industry. I began as an accountant more than 40 years ago, and continue to be actively involved as a CPA in my firm.
I currently serve as chair of the Connecticut State Board of Accountancy.
I care deeply about both professions. It isn't unusual for accountants to move into financial planning. 16 percent of the CFP licensees are CPAs, so I fully understand and sympathize with the trend of the accounting profession to offer more comprehensive service to our clients.
Some of you may have heard the story in the national media recently that financial planners were rated as having the best job in the country.
According to one article in USA Today, low stress, high income and plenty of time off were majorreasons why my colleagues and I are at the top of the list this year.
I'm not sure I would agree with the rationale, but I would concur from the perspective that the job satisfaction that we get from helping people with their financial goals is tremendous.
Mr. Chairman, as for the low stress aspects of a planner's job, I think we would all like to keep unnecessary stress out of our lives.
One way to help financial planners accomplish this is to do what you have proposed in this room, and that is to maintain true independence in the attest function of publicly traded companies.
There have been others who appeared before you far better qualified to discuss the technical aspects of the rule.
They have provided to you, in my opinion, with evidence that the existing rule may be getting frayed around the edges, as it were, because of a growing conflict with other consulting services offered by the auditing firms to their clients.
It is the FPA's position that whether the problem of independence is significant or not, there is a growing perception that these conflicts of interest can interfere with external audits.
That is our chief concern.
My testimony will focus on why financial planners support a strengthened SEC rule to anticipate and prevent the erosion of public confidence in financial statements certified by the accounting profession.
As a CPA, I can tell you that I have been following this issue for some time.
However, as a financial planner, I suspect that many of my CFP colleagues have not paid as close attention.
It is a little like taking certain things in life for granted. I think many of us have always taken audited financial statements for granted. In a way, without the certified audit, financial planners simply would not be able to do their jobs. It is truly the basic core data around which our capital markets operate.
Financial planners who provide advice on the stock market, of course, rely implicitly on the accuracy of financial statements reviewed by CPA firms.
While comprehensive financial planning involves many aspects outside of giving securities advice, those services may include advice on long-termelder care, divorce, tax and estate planning.
Investment advice remains a core part of the planning process.
FPA has identified specialty areas that involve advice on publicly traded securities and that we believe would negatively be affected by the erosion of independence rule.
Perhaps the most commonly recognized specialty area is that of investment planning and related advisory services.
Approximately 90 percent of the CFP practitioners offer investment planning to their clients separately as part of developing a comprehensive financial plan.
Another specialty area is the management of the securities business in which financial planners act as portfolio managers and in some cases provide investment management consulting services.
Retirement and pension planning is another area which the auditors' independence role is a direct impact.
It is obvious that the most widely offered financial planning service, given the obvious demographic changes result in a higher demand for our services by baby boomers.
Approximately 87 percent of the financial planners provide retirement planning.
Retirement and pension planning, of course, generally requires investor recommendations to help clients prepare for retirement or to maintain a certain lifestyle after reaching retirement age.
In summary, outside of a limited client engagement, that does not involve comprehensive planning, we are directly affected by what happens in the auditing process.
By we, I mean not only the 29,000 members of the FPA, but also the 110,000-plus investment advisers who rely on this same financial data.
As I mentioned earlier, financial planners tend not to question the reliability of a company's financial statement when they make specific recommendations to buy or sell securities.
That's not their job.
Planners are primarily concerned with other complex factors involved in securities investments, tax consequences, income or rate of return, liquidity and volatility, the client's investment time horizon, risk tolerance and so on.
It is simply beyond the planner's capacity and the investment public as well to assess theaccuracy or to be directly concerned with the attest function.
Having an independent and unbiased auditing report is a critical part of financial planning.
Millions of Americans are entering the stock market. Just last week the Investment Company Institute reported that 88 million individuals now own mutual funds up 6 percent from last year.
At the same time, the typical fund investor has an annual household income of less than 75,000.
Let me make one other observation.
CHAIRMAN LEVITT: Mr. Blum, we're running over. We really have a very tight schedule.
MR. BLUM: Just one paragraph for my conclusion.
Mr. Chairman, in conclusion, we cannot go back to yesterday and simply put on green visors again. Those days are gone forever.
The accounting graduate today is turning to other lucrative career paths. Change is coming fast.
In the near future, you will not be able to tell the difference between a bank and an insurance company and a brokerage firm.
Where flexibility is the final rule with the broadening of such services by accountants into areas,where they are not in conflict we truly support such changes.
On the other hand, we remain firmly ground in the belief that financial reports must be prepared by independent and objective accountants in order to maintain the public's thrust.
Information must be current, and someone who is truly independent must be able to verify this data for the investor.
In order for the SEC and the State Boards of Accountancy to monitor the auditing function, there must be a clear delineation of the revised rule on when the auditor is or is not objective.
Questions raised in the SEC rule-making are valid and important and must be answered.
These issues must be addressed jointly with the accounting profession in a constructive dialogue that to date regrettably has seen both sides talk past each other, not to each other.
In our opinion, a group of key SEC staff and AICPA leadership should discuss these issues to determine proper solutions and interpretations.
CHAIRMAN LEVITT: Thank you.
COMMISSIONER HUNT: No questions.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: No questions.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: I have one question.
Mr. Gardner, if we had disclosure about the potential conflicts that could exist between an auditor, or an auditor that provides auditing services and consulting services, do you think that would be enough to cure the conflict itself and perhaps the harm it would have on the integrity of financial information?
MR. GARDNER: It does not cure the perception issue, and the perception issue may be determined to be the biggest factor facing you all as you consider this.
I think as a long-run solution, though, disclosure would ultimately place the responsibility on the auditor and the company and the individual examples of companies and auditors who violated the trust that the investment community afforded them would be punished for violating that trust.
I believe it could be a long-run solution. It's not something that would immediately erase any violations.
COMMISSIONER UNGER: But if the crux of theissue is the independence of financial statements generally, then if an investor has to go to the financial statements and read about potential conflicts, what does that do overall in terms of your faith or the credibility, I guess, of the financial reporting system?
MR. GARDNER: I think it still places the responsibility on the individual investor and the investing community to do their research.
You all may determine that that's too much of a responsibility for an individual to bear. I don't personally think it is, but I can see both sides of it.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Thank you very much.
Panel 2 (Afternoon)
Our next panel is Domenick Esposito, chief executive officer of Grant Thornton, LLP, and Thomas S. Goodkind, formerly with Arthur Andersen.
I might say to Mr. Esposito that all too often this dialogue the interests of firms other than the Big Five have been largely neglected, and I think in a vibrant industry, whether it be accounting, brokerage or anything else, the growing, innovative entrepreneurial firms that may be just a notch below in terms of size and perhaps heritage of the verylargest representatives of the industry, often spawn the most creative ideas and often represent the kinds of mid-range companies that would be tomorrow's leaders, and we're particularly anxious to have your views.
MR. ESPOSITO: Thank you, Mr. Chairman. Good afternoon.
My name is Domenick Esposito and I'm the chief executive officer of Grant Thornton, LLP. I am a CPA and I have been in public accounting for over 31 years.
Grant Thornton is the largest tax and management services accounting firm whose principal strategic focus is serving middle market entrepreneurial companies.
Our audit clients include more than 400 SEC registrants.
In the global rankings, we are the sixth largest accounting firm.
We appreciate the opportunity today because the market that we serve has very different needs from the principal market companies like DuPont and Merck served by the Big Five firms.
We applaud the SEC for its efforts to bringthese issues to the forefront for public discussion and resolution.
We do have concerns, however.
Our concerns are not about us. We receive only 1 percent of our revenues from consulting to SEC registrants.
Our concern is about our clients and our stakeholders, and their ability to receive efficient and effective advisory services. We believe that some of the rules could affect their competitiveness.
The owners and executives who run middle market companies exemplify the American entrepreneurial spirit.
Many have founded the companies they lead and continue to maintain significant ownership interest.
What these entrepreneurs have in common is their drive to grow businesses that are in reality extensions of themselves.
They want their companies to prosper so that stakeholders can benefit from the results of their hard labor.
However, most middle market companies do not have internal resources to keep up with complex financial and tax requirements and strategic businessissues to either growing their business or moving into new areas, such as e-commerce.
Consequently, little market companies turn to their independent accountants for help.
They view us as valued business advisers, in large part because of the broad institutional knowledge that we developed by performing the annual audit.
As auditors, we have no learning curve to climb and thus can render objective, impartial advice, more economically and more efficiently than third parties.
Moreover, by providing advice in these areas, we enhance our knowledge and understanding of our client's businesses, which in turn enables us to conduct more effective audits.
In our formal letter to the Commission, we offer comments on all of the major areas addressed in the proposed independence rules, but today I will limit my comments to two areas, one where we agree with the SEC's position and one where we urge the Commission to reconsider.
We agree there is an urgent need for the Commission to deal with the antiquated rules concerning financial and employment relationships.
The current rules on these relationships do not serve to protect the public. They only hinder the auditor's effectiveness and create undue anxiety about the integrity of the profession. However, we do not agree that there is the same urgency to deal with the scope of services issue. We strongly urge the Commission to maintain public commitment to the Independent Standards Board by allowing the ISB to consider the scope of services issue.
The ISB should address this issue after it completes its proposed principles based independence framework in which it identifies the threats and mitigating safeguards that go into determining which services should be provided by an independent auditor.
The proposed limitation of nonaudit services is not a modernization of the independence rules.
It is merely a codification of views on auditor independence that are either outdated or unsubstantiated.
At first glance the four governing principles for determining when an auditor is not independent appear to be irrefutable.
However, the proposed rule applies these principles without considering safeguards that are or could be designed to prevent nonaudit services fromimpairing auditor independence.
Consequently, there are two reasons we urge the Commission to reconsider.
First such application allows the arbitrary proscription of nonaudit services.
Second such application will eventually lead to an expansion of the proscribed services.
Indeed, the independent auditor could ultimately be precluded from providing many of the services that middle market companies need and demand, putting those companies at a severe competitive disadvantage.
We use an integrated service approach in servicing our clients, both audit advice, tax advice and consulting advice.
Examples include evaluation and adoption of accounting policies.
Our clients often rely on us for objective advice on appropriate accounting policy involving transactions and relationships.
For example, they turn to us for help in interpreting the rules for revenue recognition.
Earnings per share on stock compensation.
Our clients frequently require assistance when the computation and disclosure associated withEPS are at stake.
Business combinations, when negotiating and restructuring business combinations, our clients often call upon us to interpret the rules.
Implementation of financial and management software.
Because we understand our client's accounting policies and transactions and management information requirements, they often call upon us to recommend specific software and related hardware.
And finally, strategic consulting services.
Throughout their life cycle, our clients ask us for a variety of strategic advice.
Such assistance includes helping to sharpen their business strategy, identifying areas for product and process improvement, integrating acquisitions, et cetera.
In conclusion, Grant Thornton has served middle market companies for more than 75 years.
We believe that our reputation for independence, integrity and objectivity is the foundation for delivering value for our clients.
They are our principal focus and the single most important reasons my partners and I go to work every morning.
In our experience, these companies require many more advisory services than their larger competitors and they want to receive their services from their independent accountants who know them well because of the knowledge they gain through the annual audit.
Finally, I'd like to express my concern over the appearance of a widening rift between the SEC and the accounting profession.
Auditor independence has been the subject of a public debate in the national press over the past several months.
Unfortunately, many of these reports have been filled with self-serving rhetoric.
This public debate has served only to obscure our shared interest and responsibility of protecting the investment public.
Moreover, we are concerned that issuance of new rules governing auditing independence will create a public perception that the SEC has supplanted the ISB as a source for such change.
CHAIRMAN LEVITT: Mr. Goodkind?
MR. GOODKIND: First of all, thank you to Chairman Levitt and the Commissioners for this opportunity to participate in today's hearings on the Securities and Exchange Commission's proposal to revise the rules of auditor independence, and let me say I supported your efforts to strengthen our profession.
I speak to you today as a CPA who has spent nearly six busy seasons auditing while employed by a Big Five audit firm here in New York.
In my statement today, I feel that I represent the auditor in the field.
I have a family background in auditing as well. My grandfather passed the first CPA exam given in the United States in 1916 and later started his own auditing firm here in New York, and my father joined my grandfather's firm and then eventually started a brokerage firm, owning seats on the New York Exchanges and the American.
Both of them taught me never to invest in an entity stock without a careful reading of its audited financial statements, and as a CPA, I believe like my dad and grandfather in the independent and impartial audit and as an investor, I rely on auditor independence.
Now the AICPA codification of statements on auditing standards in its section on independencecements the cornerstone of our profession when it states, "It is of utmost importance to the profession that the general public maintain confidence in the independence of independent auditors.
Public confidence would be impaired by evidence that independence was actually lacking, and it might also be impaired by the existence of circumstances which reasonable people might believe likely to influence independence.
Independent auditors should not only be independent. In fact, they should avoid situations that may lead outsiders to doubt their independence."
Now, the question is why would someone think that an auditor isn't independent in appearance?
Well, the problem with auditor independence appeared when auditors in great number began taking extra work at loan staff consultants to the clients they were auditing.
This greatly increased profits but hurt the appearance of independence of the audit.
When an audit partner allowed staff to prepare and then audit financials, it may lead outsiders to doubt independence.
That conflict in appearance is all that is necessary to hurt the integrity of the profession.
In loan staff work, the auditor participates in putting together financial statements or helps with the computer systems that puts the financials together.
If the auditor then gives herself or himself a perfect grade on doing the loan staff work, would you trust the grade?
Investors trust the grade because investors don't fully understand that this is happening, but the Commission understands it and would like it stopped and I applaud their integrity.
Having audit firms also be consultants for the same client is a problem.
If I'm hired to make profits go up, will I then report that profits went down? Should I be trusted to?
Whether I'm honest or not, there is the appearance problem again.
Do investors really want their financial statements audited by their company's consultants?
I think this work hurts the appearance of the audit profession. It hurts auditor independence.
According to the SEC, since 1983, audit firms have greatly increased the amount of revenues derived through consulting practices.
Consulting fees have gone up from 10 to over 50 percent of revenue. Opponents of this proposal that requires independence say there's no empirical evidence pointing to a conflict.
In fact, from inside the audit I have never seen empirical evidence pointing to a conflict, but here as far as empirical evidence is concerned, none is needed.
The problem is the potential of the conflict.
The primary motivation of an auditor should be to insure that the financial statements that the client prepared are materially correct.
Their motivation should not be to offer extra services to the client, no matter how lucrative.
Consulting business should occur away from the audit client. The SEC proposal to revise the rules of auditor independence will bring a renewed focus on our audit work, helping remind auditors of their role in the financial community.
There is a trust between investor and auditor that requires auditor independence in fact and appearance.
If the auditor acts on behalf of the investor and then takes a loan staff or consulting jobacting in behalf of the company, the auditor is hurting its relationship with the investing public.
If an auditor takes a loan staff or consulting job with an audit client, the auditor is sacrificing independence.
I've always told this to auditor friends of mine in the field who are currently auditing as well.
I now tell it to the public for whom I've worked so many years.
Fundamentally, as the AICPA states, we must prove ourselves independent from our clients.
This more than anything else will preserve the integrity of the profession.
There is no better way to do this and there is no better way to strengthen the audit profession than to support this proposal.
I urge all my fellow CPAs to fight for its passing. It is honorable to stand up for what is right, however unpopular it seems.
CHAIRMAN LEVITT: Thank you very much.
Mr. Esposito, this issue is not a new issue for the profession or for the Commission. It goes back many, many years.
To suggest a time delay to give more opportunity for debate and discussion is an argumentthat was raised in 1975 when the Metcalf Waxman hearings took place, out of which grew the Public Oversight Board.
I think that there is clearly a failure in this industry to develop the kind of self-regulating mechanism that could reassure the public.
I would assume that you would agree with that.
As to the role of the Independence Standards Board, as you know, that Board is evenly divided between the industry and the public members.
It's probably not a good way to assure the public that this group on controversial issues can do anything except come up with an insufficient compromise.
I would suggest to you that at a meeting in December the public members of the ISB, including its renewed focus on our audit work, helping remind auditors of their role in the financial community.
There is a trust between investor and auditor that requires auditor independence in fact and appearance.
If the auditor acts on behalf of the investor and then takes a loan staff or consulting job acting in behalf of the company, the auditor ishurting its relationship with the investing public.
If an auditor takes a loan staff or consulting job with an audit client, the auditor is sacrificing independence.
I've always told this to auditor friends of mine in the field who are currently auditing as well.
I now tell it to the public for whom I've worked so many years.
Fundamentally, as the AICPA states, we must prove ourselves independent from our clients.
This more than anything else will preserve the integrity of the profession.
There is no better way to do this and there is no better way to strengthen the audit profession than to support this proposal.
I urge all my fellow CPAs to fight for its passing. It is honorable to stand up for what is right, however unpopular it seems.
CHAIRMAN LEVITT: Thank you very much.
Mr. Esposito, this issue is not a new issue to the profession or the Commission. It goes back many, many years.
To suggest a time delay to give more opportunity for debate and discussion is an argument that was made in 1975 when the Metcalf Waxman hearingstook place, out of which grew the Public Oversight Board.
I think that there is clearly a failure in this industry to develop the kind of self-regulating mechanism to really show the public.
I would assume that you would agree with that.
As to the role of the Independence Standards Board, as you know, that Board is evenly divided between the industry and the public members.
It's probably not a good way to assure the public that this group on controversial issues can do anything except come up with an insufficient compromise.
I would suggest to you that at a meeting in December the members of the ISB, including its chairman, they urged the Commission to move forward on this issue, and they were supportive of the notion of separation of services.
But I guess the real issue breaks down to whether perception is or is not important. The auditing standard number one of the AICPA talks about appearance.
To me, appearance is every bit of perception.
Wouldn't you agree that perception is darned important, or maybe we wouldn't be here today?
MR. ESPOSITO: Yes, I would.
CHAIRMAN LEVITT: Mr. Goodkind, many in the profession state that they're having a hard time recruiting auditors.
Why do you think that's so?
MR. GOODKIND: They're not offering enough money. I know that speaking for most of my friends working at CPA firms, namely Big Five, that you've been with an audit firm five, six years, you bill out maybe between 250 to $300 an hour here in New York, and you're taking home about 30, 35.
I mean, I never question where all of the rest of the money goes to, but it's not to the auditor in the field and it certainly isn't being offered to the first year graduate from a top school with top grades. It's simply money.
We find auditors more and more going to investment banking.
CHAIRMAN LEVITT: In your experience, what nonaudit services resulted in a higher quality audit?
MR. GOODKIND: I really can't think of any. That's a very hard question to answer.
I could see any of the -- you mean performedby the same firm that's conducting the audit?
CHAIRMAN LEVITT: Yes.
MR. GOODKIND: I can't think of any that couldn't have been done by an outside firm.
It's just a matter of convenience, of them choosing us, and it actually made things a little different when critiquing that work of a fellow auditor, who would sometimes have to be on the same engagement as me, maybe the next audit.
Again, we did do that criticism and I never found that criticism lacking, it just made things very difficult.
CHAIRMAN LEVITT: Mr. Esposito, you identify a number of services that you performed for your audit clients. You didn't mention internal audit outsourcing.
Is this a service you do a lot for your audit clients and if you do, do you feel that it adds value to the audit?
MR. ESPOSITO: We do not, Mr. Chairman, we do not perform internal audit outsourcing for our clients.
CHAIRMAN LEVITT: Why?
MR. ESPOSITO: It's just a service we do not perform.
CHAIRMAN LEVITT: Do you think it does represent potential conflict?
MR. ESPOSITO: I think if there is the entire internal audit department outsourced, it can present a conflict.
CHAIRMAN LEVITT: The witness from the Federal Reserve Board and the controller's office suggested that for banking institutions this may represent a significant perceptual problem.
Would you agree with that?
MR. ESPOSITO: Yes.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: No questions.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: I guess I'm curious to know whether you think there actually is a problem.
Everyone talks about an appearance problem, so where do we get that appearance from, if it doesn't actually exist?
Is it because everyone thinks in their own mind they couldn't be independent if they were performing consulting services?
Could you shed some light on that?
MR. ESPOSITO: Are you addressing that to me?
COMMISSIONER UNGER: Mr. Goodkind.
MR. GOODKIND: From pretty much the day I started publicly auditing as a CPA, I'd been involved in discussions with friends as to why we would prepare the financials and then audit them, or even perform consulting services.
It just seemed like an out-and-out conflict in the very beginning.
Tremendous measures were taken in order to avoid the conflict from occurring, and I never saw the conflict arise, but there was such potential, and because of that, I could see a need for an outside organization such as the SEC imposing stronger rules.
COMMISSIONER UNGER: Do you think that conflict could ever be a rebuttable presumption that a firm could overcome somehow through disclosure?
That's for both of you.
MR. ESPOSITO: I'm sorry, could you repeat the question?
COMMISSIONER UNGER: Do you think that that conflict could be a rebuttable presumption that could be overcome with a disclosure?
MR. ESPOSITO: Perhaps, Commissioner. I strongly would encourage the work that is occurring being undertaken by the ISB to reach a conclusion tosee if they could provide us the safeguards to that end.
CHAIRMAN LEVITT: Even though the ISB is presently divided in terms of industry and nonindustry, and even though the public members of the ISB has urged the Commission to move forward.
MR. GOODKIND: I understand.
COMMISSIONER UNGER: This is one of those situations where everybody seems to want everybody else to do it.
I think the bank regulators want us to do it, they're happy with doing it, the ISB want us to do it, because--I guess you have to look the devil in the eyes.
I think it is a hard task and of course everybody is happy to have somebody else undertake that task, and so I guess it's us.
CHAIRMAN LEVITT: Thank you very much.
MR. TURNER: Mr. Chairman, I'd like to ask one question to Mr. Goodkind.
At our public hearing on July 26th, Commissioner Unger asked a question about how often do you transfer knowledge between the consultants on a particular client and the auditors who actually work on that particular client.
In your experience as an audit partner, how often did the consultants participate in the audit and how often was there a transfer, an active transfer of knowledge going back and forth as related to the audit?
MR. GOODKIND: I am sorry I have to correct you that I wasn't a partner at Andersen.
In my experience, a transference of knowledge, I have rarely seen that occur in my experience.
It's, the only time I have seen outside consultants come in was possibly to value some sort of commodity which was difficult to value.
We were very heavily scrutinized that we would go through it.
It was, we had to bring them in to understand what they were doing as well.
I still can't understand why that couldn't be done by an outside firm. I mean, and again, these are people that we will continue, we continue working with for years, to overly criticize their work might be a bit difficult.
MR. TURNER: Thank you.
CHAIRMAN LEVITT: Thank you very much.
Panel 3 (Afternoon)
Our next witness is the Honorable Robert Morgenthau, the District Attorney for the County of New York.
I would say there's probably few people in our society today who more symbolize the virtues of independence, integrity, and a willingness to stand alone than Mr. Morgenthau.
Certainly, the people of the City of New York have installed Mr. Morgenthau as kind of the Mt. Rushmore of district attorney's attest to that circumstance.
We are honored by your presence today and look forward to your testimony.
MR. MORGENTHAU: Thank you very much, Mr. Chairman, for those generous comments. I appreciate the opportunity to be here. Commissioner Carey, Commissioner Unger and members of the staff.
I think the subject of auditor independence and the Commission's proposed rules to ensure independence is crucial to the viability of the financial markets.
The importance of the independently audited financial statements to the investing public cannot be overstated.
In the past four years, my office has prosecuted more than 200 defendants in securities cases for bilking innocent investors of millions of dollars, in many instances defrauding unsophisticated victims of their life savings.
In the great bulk of these cases, investors lost money because they were fed inaccurate financial information and projections.
Although these cases by and large involve dishonest securities brokers and not faulty audits, they illustrate the importance of investors being able to base their decisions on reliable sources of information.
Chief among the repositories of reliable information in our system of securities regulation are the independently audited financial statements filed by public companies.
These statements play a vital role in the country's and the world's economy.
They not only serve to protect individual investors, but engender confidence in the securities markets, and promote capital formation.
If misused, however, audited financial statements can do great damage.
As the distinguished Federal Appellate CourtJudge Henry Friendly said writing for the Court of Appeals in the Second Circuit in United States v. Benjamin, "in our complex society, the accountant's certificate and the lawyer's opinion can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar."
If anybody thinks I'm picking on the accounting profession, I point out that the lead defendant, Martin Benjamin, was a lawyer.
Also in the interests of complete disclosure, the United States Attorney for the Southern District of New York who prosecuted that case was Robert M. Morgenthau. Of counsel in that case was John S. Martin, Jr., now a federal Judge.
Like judges and public prosecutors, accounting firms when they exercise the function of independent auditors occupy positions of public trust.
As United States Supreme Court has said, "by certifying the public reports, that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with a client.
The public watchdog function demands that the accountant maintain total independence from aclient at all times and requires complete fidelity to the public trust." And writing for the Court was Chief Justice Warren Berger.
Like judges and prosecutors, auditors exercising their public responsibility must not only be independent, they must also be seen as independent.
That is to say, they must avoid even the appearance of a conflict of interest.
It is not only the fact but also the appearance of independence that insures when a judge or prosecutor makes a decision in a controversial case, that the public will accept the results.
That same appearance of independence is vital to the public acceptance of the integrity of the securities markets.
The Commission's proposed rules by limiting business interests that might compromise or appear to compromise an auditor's independent judgment would serve an important public position.
My experience in law enforcement, eight and a half years, United States Attorney for the Southern District of New York and 25 years as Manhattan District Attorney, has shown that accountants like other professionals are susceptible to the temptation to engage in questionable activities or exercisequestionable judgment on behalf of a paying client.
This happens on occasion, even at the best of firms.
For example, in 1996, the District Attorney's Office obtained convictions in a case involving the bribery of bank officers in connection with the sale of Brazilian debt, transactions which earned about $6 million for the defendants and the co-conspirators, most of it tax free, thanks to the use of offshore corporations and bank accounts.
In that case, the bribes were paid by a private debt trader, former vice president of a major American bank, through shell companies set up and managed in Antigua by one of the Big Five accounting firms.
The illegal payments which included bribes paid to a U.S. banker, to two bankers in the Florida agency of a Colombian bank and to a banker in the second largest bank in the Netherlands were all arranged by employees of the Big Five accounting firm.
When my office approached the major accounting firm's office in New York for assistance, we got no help, only the explanation that the offshore firm was not part of the same legal entity as the identical namesake in New York and elsewhere in theworld.
In another case that my office investigated, a bank, the client of a major accounting firm, had destroyed the original records of an improper $500 million transaction, and created new backdated records representing, misrepresenting the nature of the deal.
Our investigators were surprised to learn that the accounting firm, despite being aware of the falsification, had issued a clean audit opinion, reporting no material weakness in the client's internal controls.
It was therefore on that case that bank went bankrupt and many of the investors, depositors and creditors were severely damaged.
Pressed for an explanation, the audit partner said that the destruction and falsification of records was not material, because the client had made money on the transaction.
In that case, as in most cases, it was impossible to tell whether financial considerations played a role in the auditor's issuing the opinion he did.
But this only underscores the need for a clear rule limiting the occasions when financial opportunities or relationships might play an improperrole in influencing an auditor.
As the Commission has reported, the range of nonaudited, nonaudit services provided by accounting firms and the revenues generated by these services, more than $15 billion for the Big Five firms alone in 1999, are considerable and growing.
Also, relationships of accounting firms with investors and other businesses are becoming more common and more complex.
The Commission is on the right track in seeking to prevent lucrative business activities and relationships from corrupting the critical audit function.
It is also correct to require disclosure of any such matters that might materially bear on the auditor's independence.
To be sure, there are those who will see any proposed restrictions and disclosure requirements as unduly harmful to the economic interests of the accounting firms deterring the most qualified and able people in the firms from engaging in independent audit functions.
This is an argument that I've heard before.
In 1966 when I was United States Attorney at a time when accountants and lawyers were virtuallyexempt from criminal prosecution for professional misdeeds, it was my office who indicted two national partners and a senior associate in a national accounting firm for conspiracy and mail fraud in connection with a false financial statement.
The defendants were charged with, among other things, concealing the fact that the president of the client corporation had siphoned off $4 million from the corporation through an affiliated company.
The prosecution generated much criticism in the accounting profession.
Among the complaints was that the prosecution would deter the best and brightest from entering the profession.
Even the chief accountant of the SEC at that time declined to testify as an expert witness for the prosecution in that case.
Nonetheless, the defendants were convicted and sentenced to prison.
I did not think it harmed the fortunes of the accounting firms in any way, if anything it likely encouraged good people to join the profession, knowing that shady dealings would not be tolerated.
The fact that the convicted accounting partners were pardoned by President Nixon before theyspent a day in prison does not alter my judgment in that matter the least bit.
In any event, the appropriateness of the proposed independence rules cannot be measured solely against the bottom line on the balance sheets of the accounting firms.
Ensuring the independence of auditors as they carry out their public responsibilities must be given paramount consideration.
In the investigation of fraud and other economic crimes, the trail of ill gotten gains often leads prosecutors to offshore jurisdictions that foster extreme secrecy in financial matters and which have virtually no laws or regulations restricting the pursuit of wealth.
What distinguishes the United States from these jurisdictions is the requirement of transparency in financial dealings and the public confidence in our financial markets and institutions fostered by responsible regulation and oversight.
The rules proposed by the Commission by safeguarding the independence of auditors will help preserve this vital distinction.
I realize that the stakes in this matter are very high.
The newspapers in recent days reported ongoing discussions of the sale by one of the Big Five accounting firms of its management and information technology consulting practice of between 17 billion and $18 billion.
I am certain the lobbying in Congress and elsewhere against the proposed rules has been intense.
I'm confident, however, that the Commission under the leadership of Chairman Arthur Levitt has the wisdom and courage to adopt these rules.
CHAIRMAN LEVITT: Thank you very much, Mr. Morgenthau.
I gather from your statement that one of the prevalent arguments being cited against this proposal is that there is no smoking gun and perception is absolutely no basis upon which to formulate a rule, that you would not agree with that.
MR. MORGENTHAU: That is correct, Mr. Chairman.
CHAIRMAN LEVITT: Do you have trouble showing that auditors were compromised by financial incentives by having some difficulty getting into an accountant's mind?
MR. MORGENTHAU: Well, I think what we haveseen in the cases that I have referred to and many others, a flagrant disregard by accounting firms for improper and often criminal conduct by the clients that they audited.
And it's just crucial that not only auditors be independent, but that they are perceived to be independent, and I don't think that they can be independent on any long-term basis or are perceived to be if they're performing other services.
I mean, I want to say I was flabbergasted to read in the paper that the consulting business of one firm is worth between 17 and $18 billion.
I had no idea of the value of those services, when obviously, and I don't criticize the accounting firms for that. That has to be a major factor in their operation. It probably produces more income than the auditing function, which makes it all the more important those two functions be kept separate.
CHAIRMAN LEVITT: As a prosecutor, will our proposed rule help or hinder you from doing your job?
MR. MORGENTHAU: I think it will help.
I think it means that we may not have to do our job in many cases, because I think when those functions are independent, then you can rely on theaudit function and we'll have less to do rather than more.
I always say the best day of my life would be when I had nothing to do.
CHAIRMAN LEVITT: Commissioner Hunt?
COMMISSIONER HUNT: Thank you for your testimony, Mr. Morgenthau.
I take it you are proposing a complete separation of the audit function and the consulting function?
MR. MORGENTHAU: Yes, sir.
COMMISSIONER HUNT: The two not being able to live under one corporate roof.
MR. MORGENTHAU: I don't think they can. That is my view.
They have to be entirely separate, and if for any reason there's some minor performance of duties for an audit client, I think that has to be fully disclosed in the corporate financial statement.
COMMISSIONER HUNT: So you would advocate both separation and disclosure?
MR. MORGENTHAU: And disclosure when appropriate, yes, absolutely.
COMMISSIONER HUNT: Well, thank you very much for your appearance.
CHAIRMAN LEVITT: Commissioner Carey?
COMMISSIONER CAREY: Mr. Morgenthau, thank you very much for appearing here today.
I just want to understand, is it the thing you find most attractive about the proposed rule, is it that the clarity this would give to what are appropriate and inappropriate relationships between accounting firms and the companies they audit, would that be able to, would that help you to build better cases against people who perpetrate financial fraud?
MR. MORGENTHAU: Yes. I mean, I think it would be clear to us that the auditor had no economic interest in sustaining their findings, so that would be helpful.
I think it would also avoid coming in that many cases, because I think if you had totally independent auditor looking out solely for the public's interest, I think there would be less cases of fraud.
COMMISSIONER CAREY: Thank you very much.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: I have no questions. Thank you very much for your testimony, though.
MR. MORGENTHAU: Thank you for the opportunity of being with you.
Panel 4 (Afternoon)
CHAIRMAN LEVITT: Our next panel is Mr. Jay Eisenhofer of Grant & Eisenhofer, PA and Mr. Charles R. Drott.
COMMISSIONER HUNT: Good afternoon, gentlemen. Thank you for taking the time to appear before us.
I guess we'll start with Mr. Eisenhofer and then follow that with Mr. Drott.
MR. EISENHOFER: Good afternoon. I want to thank the Commissioners for this opportunity to comment on this very important subject.
I am Jay Eisenhofer of the law firm of Grant & Eisenhofer in Wilmington, Delaware.
My practice primarily involves the representation of institutional investors such as state pension funds including the pension funds of the states of Colorado, Florida, Wisconsin and Louisiana among others, as well as private investment managers in class action securities and corporate litigation.
I am here to tell you that your proposed rule will not make my job any easier.
Your rule, I believe, will cut down on fraud, cut down on auditor self interest, and increase the reliability of financial statements.
You are going to make it much more difficultfor attorneys such as myself who represent institutional investors that frequently are plaintiffs in these corporate and securities cases.
As you know, the hardest thing to prove in a securities fraud case is what is called scienter, or state of mind.
In a securities fraud case you must prove that the defendants acted intentionally or recklessly in misrepresenting the facts about the company.
To prove intent, a plaintiff obviously cannot go into the head of a defendant, so the plaintiff must usually prove intent through circumstantial evidence including motive.
One of the best motives is obviously financial interest.
One of the best ways to prove financial interest is showing that an audit firm, in particular, received substantial nonaudit consulting fees from the client, fees that would be at risk if the audit firm challenged company management.
If you take this away, this element of case away, then you're going to be taking away one of the best tools that we as lawyers representing plaintiffs in these litigations have to try and prove scienter, but you will also be increasing the reliability offinancial statements.
So I am actually here to endorse the proposed rules for auditor independence that the Commission has proposed.
I've been involved in many cases where it has been apparent that theoretically independent auditors are anything but.
The auditors have approved the financial reporting of the companies they audit, and sometimes within a few months the company reports new financial results that are completely at variance with those the auditor had approved.
The question is how could this have happened?
This is particularly a problem in the current environment where company stock prices are increasingly dependent on showing growth and on meeting or exceeding the expectations of Wall Street investment analysts. Even one missed profit number can have a significant negative effect on stock price.
This places great pressure on company executives to insure that each quarter the profits are in the expected range, regardless of whether the quarter has been as good as the analyst expected.
In order to meet these expectations, we often find that corporations will sometimes make questionable assumptions.
Of course, this is in a minority of cases, but this is something that does occur on an all too frequent basis.
It will make questionable assumptions and other changes in order to support earnings in the short run.
Again, the question is how could this happen with the auditor supposedly looking over management's shoulders.
So as we all know, the annual audit does not always uncover questionable practices or insure that the company's financial condition is fully and accurately reported.
The question that arises in our case is is it because auditing is at least at times a low margin business that the audit firms use as a way to establish client relationships?
Is it because the audit firms want to stay on good terms with management so they can get the more lucrative consulting jobs?
People being people, at least in some situations, I think we know the answers.
It's difficult for me to talk about specific cases that I've been involved in, because almost always the information that we receive in a particular case is subject to confidentiality orders that are imposed before the defendants will produce documents to the plaintiffs, so it's difficult to talk about anything other than the allegations of the case, but I would like to use one example of a case which is currently pending, which has received a great deal of publicity in which we represent one of the co-lead plaintiffs and we are co-lead counsel, and that is a case which is pending here in New York in the Southern District of New York against Oxford Health Plans, a leading HMO here in the New York area.
Oxford was a very successful company in terms of its stock price, met or exceeded analysts earnings expectations for quarter after quarter and had obtained a very good reputation for being a very profitable company, being able to provide its services at a reasonable price to its customers.
In early 1997, its former auditors who have been named as defendants in the pending lawsuit, issued an unqualified opinion on Oxford's financial statements for 1996.
Those financial statements portrayed afast-growing very profitable company. Barely eight months after the auditor's clean opinion was submitted in October 1997, Oxford admitted in public statements that its actual financial picture was much different than that which was in the audited financials.
The price of Oxford stock fell 60 percent in a single day. The stock eventually declined by nearly 90 percent from its high point of approximately $80 a share and only recently after several years has climbed back into the upper 20s.
The admission about Oxford's true condition came about only because of an audit by the New York State Insurance Department.
The New York State regulators eventually required that Oxford's auditor be replaced.
In our complaint, we alleged that the auditor fell down on the job and failed to adequately police management, who was determined to meet analyst's expectations to keep the stock price up at any price.
Was the reason for the decline or the reasons for the auditor's failure because the relationship with management became too close?
Oxford was a large client generating substantial fees.
Because of its rapid growth, Oxford certainly promised significantly greater fees in the future through auditing and other relationships.
Although the audit relationship itself will always present the potential for some cloud as to the impartiality of the auditor's judgment, since the auditor will always have some self interest in retaining the future auditing fees, the rule that the Commission has promulgated will go a long way towards insuring that at least a great portion of the conflict of interest from lucrative consulting fees has been eliminated.
In particular, I'd like to point out in relation to Oxford one aspect of the Commission's proposed rule, and that is that the rule restricts certain areas of consulting on computer systems of audit clients.
Although in the Oxford case, the audit firm was not providing computing consulting services one of the most significant problems Oxford faced was as a result of problems with its computer system.
Despite the substantial computer problems Oxford experienced in the last quarter of 1996, there was nothing in the auditor's report for 1996 that demonstrated the effect this problem was having on thecompany.
Certainly had the audit firm itself been providing those computer consulting services to Oxford, it is very difficult to see how the auditor would have been in a position to publicly expose those computer problems and put its own consulting work at tremendous risk and expose itself to significant potential financial liability.
I believe it is extremely important to maintain the separation or to increase the separation between auditors whose job in part is to uncover these computer-related problems and the consultants themselves.
Thank you for the opportunity to speak with you today.
CHAIRMAN LEVITT: Mr. Drott, your testimony seems to--I'm sorry.
MR. DROTT: Good afternoon.
COMMISSIONER UNGER: We're really speeding things up now.
MR. DROTT: I promise you, I will try to be brief.
My name is Charles Drott, and I want to thank Chairman Levitt and all the Commissioners forthe opportunity to express my views before this important hearing today.
By way of background, I have been an audit partner and a technical review partner in two major accounting firms in my career, which has spanned 36 years as a professional accountant, and more to the point to today's hearing, I have been involved for the past sixteen years in significant litigation involving audit failures of significant proportions, involving all of the Big Five accounting firms, as well as a number of other national but smaller firms of the Big Five firms.
My overall conclusion, based on this experience, has been that in most of the cases that I have been involved in, meaning at least 50 cases that I have been involved in regarding audit failures, that the underlying cause of most of these situations was compromised auditor independence.
This involved auditors auditing their own work, acting as advocates for their clients, entering into improper business relationships with their clients, and acting as management for their clients.
Therefore, I, too, applaud the SEC's initiative in its current proposal to strengthen auditor independence and in turn financial reportingcredibility in our nation.
I would also tell you that in these cases that I have been involved, that in the majority of them, there have been significant nonaudit services performed, by the audit firm for their audit clients, and nonaudit services will be the issue that I will address primarily with you today.
I would further tell you that in many of these cases, there were also something called a loss leader audit engagement involved, whereby the audit firm accepted audit engagement which resulted in fees such that they would either lose money or make a very marginal profit in order to secure other profitable consulting business.
I think perhaps one of the best things I can do at this point is to share with you one example that I encountered a few years ago, and it's not unusual, in that this same scenario has appeared in a number of the cases that I've been involved.
A few years ago I was retained as an expert witness in a massive fraud case in which top client management perpetrated a financial fraud, financial reporting fraud, and the company was audited by a Big Five accounting firm.
The fraud was never detected by the Big Fivefirm and the same firm took many, many shortcuts in its audit, which I so testified to at the time.
I also concluded that the firm compromised its independence in a number of ways, not the least of which is the number of nonaudit services that were in fact performed by this firm.
And these nonaudit services were such that I had trouble at times distinguishing whether or not the firm, the accounting firm was functioning as client management or in fact as independent auditors and these services involved everything to performing bookkeeping services for its client to advocating its client's position to the press, performing a number of systems type engagements, things of that nature.
As a result of the shortcuts that the audit firm took and the compromise of its independence, this company, I should say the fraud was never reported and the company later filed bankruptcy, and there was a loss of many, many millions to investors.
Therefore, unlike, contrary to the position of some that I have heard in the accounting industry, I believe that there is a definite link between the provision of nonaudit services by an auditor for its audit client and compromised independence.
Therefore, I recommend to the Securities andExchange Commission that it institute a complete ban on the provision of any and all nonaudit services to its audit clients.
I do not believe there will be any significant harm that comes either to the client or to the auditor as a result of this.
I also would ask the Commission to consider that if a complete ban is not initiated by the Commission, that I would recommend that the practice of engaging in loss leader audit engagements be halted.
I thank you very much for your time.
CHAIRMAN LEVITT: Thank you very much.
Getting back to Mr. Drott.
Your testimony seems to suggest that there are examples of audit failures linked to consulting services.
What do you think the public hasn't seen them. You're a certified share examiner, you've seen the cases, why hasn't the public seen them?
MR. DROTT: Well, the only time these issues come to light, Chairman Levitt, to my knowledge, is when there is significant litigation.
Obviously, the accounting firm is not sharing this information, and I don't know of anyvehicle at the present time that requires them to do so.
CHAIRMAN LEVITT: The example you've cited seems to indicate that clear signs or problems were ignored by the auditor.
I suspect that many accounting issues are a great deal more subtle.
Some of them, for instance, dealing with the question of so-called managed earnings are judgment calls which could be made one way or another.
They're not illegal, but certainly they impact on what the investor sees.
Would you agree that in many respects that kind of judgment call may be just as dangerous to investors as the more blatant kinds you've testified to?
MR. DROTT: Yes, indeed, I would agree with that.
CHAIRMAN LEVITT: What role have audit committees played in the cases you've been involved with?
MR. DROTT: The cases that I've been involved in are typically very large, publicly held companies, so obviously there are audit committees in place.
What we have found in these cases is a really wide variety of involvement by the audit committees.
In some instances the audit committees are very involved and very knowledgeable of really what is going on with respect to such things as you just mentioned; managed earnings, and really, a number of times just don't take the unpopular position that we feel they should take.
In other instances, the audit committees really aren't that deeply involved with their company. So it's a mixed bag.
CHAIRMAN LEVITT: Mr. Eisenhofer, is it difficult to prove clearly that the auditor was influenced by large consulting fees?
MR. EISENHOFER: It's always difficult to prove something like that as a certainty, but what you're attempting to do is to use that information to demonstrate that the auditor had a motive that in combination with other facts that you're able to elicit demonstrates that the auditor at least recklessly disregarded its obligations, if not intentionally did so.
Yes, in many cases it is very difficult, but in many cases it's surprising just how dramatic theproof that's out there really is.
CHAIRMAN LEVITT: Are there other services besides for computer work that you think might pose problems in the performance of public independent audit?
MR. EISENHOFER: First of all, I think any time you've got the internal audit function being outsourced to the audit firm, I don't see how the audit function could possibly be independent.
It's basically a review of the audit firm's own work.
I mean, that's one thing, and I think it absolutely makes no sense for audit firms to be able to do.
But I think that it's more a question of the amount of fees that provides a financial incentive as opposed to the types of work.
Yes, there are some types of work which are so interrelated with preparation of financial statements, like outsourcing internal audit function, that it seems like that they should not be allowed.
However, any type of consulting work where there is the potential for lucrative fees presents the possibility of what Mr. Drott referred to in his testimony, which is that the audit work itself willsimply be used as a loss leader to establish the client relationship so that the audit firm can then obtain these very lucrative consulting fees, which have allowed the audit firms to build these tremendously profitable consulting businesses.
CHAIRMAN LEVITT: Commissioner Hunt?
COMMISSIONER HUNT: Thank you, gentlemen, both for appearing.
Mr. Eisenhofer, do you think it's possible to solve this problem, for example, outsourcing the internal audit to another auditing firm and maintaining the traditional relationship between the outside auditing firm and the client?
MR. EISENHOFER: I think that that would be a better situation.
I think that considering the relationships between Big Five audit firms, I think that that will not completely eliminate the problem, but I think it would go quite a ways towards helping address it.
COMMISSIONER HUNT: What does that mean, the relationship between the Big Five auditing firms?
MR. EISENHOFER: I think they are somewhat protective of each other.
COMMISSIONER HUNT: You mean they are reluctant, for example, to testify against one another in litigation.
MR. EISENHOFER: I believe it's more than reluctant.
COMMISSIONER HUNT: Do they ever?
MR. EISENHOFER: Not that I'm aware of.
COMMISSIONER HUNT: Oh, I see. Have you seen cases where you think a limit on the percentage of money earned in auditing fees would set a cap so that if you earn 40 or 50 percent in consulting fees, you get up to that level, we or other regulators ought to have a real concern as to whether or not that's prima facie evidence of perhaps a lack of independence?
MR. EISENHOFER: I would have a hard time quantifying it without more empirical evidence.
I think that it's very possible that with the right empirical evidence, that a rule that establishes criteria like that might make a lot of sense, but what that level would be I couldn't really say as I sit here.
COMMISSIONER HUNT: I understand.
If this Commission had the power, and it probably does not unfortunately, to see the fees to know whether they were loss lender fees on the auditing side, do you think that would be a useful remedy, you know, the auditing fees coming in at an annual fee that for that size audit looks to be on its face not what a firm making a rational business decision to do, do you think that would be an early warning sign?
MR. EISENHOFER: I think it would be a very interesting exercise to look through some of the more significant financial frauds that have occurred in the past few years and examine the level of auditing fees in those cases, the amount of consulting, the amount of consulting fees in relationship to those auditors with the companies, and I think if you did so, you'll find empirical evidence which everyone says, or which the critics of the proposal say is lacking.
COMMISSIONER HUNT: And finally, in your experience, do you think you have seen cases where you could draw the conclusions. I'm sure you couldn't prove it in court, that for the consulting fees, this kind of accounting error wouldn't have been made.
MR. EISENHOFER: I've certainly seen cases where there doesn't seem to be any other explanation.
COMMISSIONER HUNT: Like accounting basic 101 has been violated and why would they do that except for the lucrative consulting fees on the other side?
MR. EISENHOFER: We see all the time where questions which occur naturally to us as people who are not well versed in auditing, have never been asked, and we said, you look at it and you say why at least weren't the questions asked?
The only reason for not asking the questions appears to be that you don't want to know the answers.
COMMISSIONER HUNT: Thank you, Mr. Eisenhofer.
CHAIRMAN LEVITT: Mr. Carey?
COMMISSIONER CAREY: Mr. Eisenhofer, in the Oxford case, could you describe what nonaudit services were being performed by the auditors?
MR. EISENHOFER: I think that I only have that information pursuant to a confidentiality agreement, so I don't believe that I can say it.
COMMISSIONER CAREY: Well, that's a great response -- I'm kidding.
MR. EISENHOFER: It's not a confidentiality agreement that we asked for.
COMMISSIONER CAREY: Not at all.
What factors led to the auditor and management becoming too close or would that be the same?
MR. EISENHOFER: I think that's the same.
COMMISSIONER CAREY: Okay. More broadly, do you think that any nonaudit services should be permitted by the rule?
MR. EISENHOFER: I think maybe there should be a materiality standard.
COMMISSIONER CAREY: Similar to the one described by Commissioner Hunt?
MR. EISENHOFER: Yes. Maybe a de minimus level would be appropriate for convenience sake, but when you start talking about significant multimillion dollar engagements, you begin to get into the problem area that the Commission is trying to address.
COMMISSIONER CAREY: Thank you.
Mr. Drott, you described the presence, the possibility of rules prohibiting loss leader engagements.
How would you suggest the rule define a loss leader engagement without forcing the firms to give up proprietary information?
MR. DROTT: Commissioner Carey, I have seen auditing firms receive compensation, and what we call realization rates, which is the amount they received versus the amount of time they invest in the audit.
I've seen them range anywhere from in the low 20 percent all the way up to 45 and 50 percent,and at those rates, the firm is either losing money or certainly making a very marginal profit.
I would think the way to approach the issue would be to define loss leader engagements as those engagements that would literally result in either a loss or a very marginal profit to the auditing firm based on their standard billable rates.
COMMISSIONER CAREY: Okay, thank you.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: How exactly does this loss leader relationship come about?
Can you explain that? Or engagement, I guess is what you call it.
MR. DROTT: Yes, Ms. Unger.
The way it comes about, basically, Commissioner, is that the auditing firm typically has a lot of pressures, of competitive pressures, obviously.
There's a lot of competition for auditing and the firm obviously is trying to price its services, its audit services at a low enough price to get the client as opposed to another firm.
The thought process I've seen numerous times is that if we take a loss, or we take a marginal profit by discounting our audit fees, we'll more thanlikely make it up by selling nonaudit services or consulting services, or perhaps even additional attest services, but the idea is that the audit is only one of a series of services that the firm intends to sell to the client.
COMMISSIONER UNGER: But is that a quid pro quo for having the discount on the audit itself?
Is that there will be other services to be performed by the firm in the future?
MR. DROTT: I think that's the idea.
That's certainly the intention of the thought process that goes into it.
COMMISSIONER UNGER: But is it explicit in the engagement itself?
MR. DROTT: Not necessarily.
Sometimes an audit engagement is entered into in the beginning and there are already some consulting services that are going to be performed and other cases not.
COMMISSIONER UNGER: The numbers that have been talked about today is that about 80 percent of the firm's clients don't use the firm for consulting services, so do any of that 80 percent of the client base get a discount on their audit?
MR. DROTT: Oh, I suspect they do, yes. Ican't speak for every firm, obviously, and how they do every audit, but based on my experiences and with my own accounting firms in which I've been a partner, and based on all of the cases that I've been involved in, I would say that that 80 percent I'm sure gets discounted audit fees, and not necessarily all of them.
COMMISSIONER UNGER: Do companies usually shop around for their auditor based on the cost of the audit?
MR. DROTT: Oh, I think that's a very prevalent practice, yes.
I think lowering the cost of an audit is seen as lowering overhead for the company and I think that's very common.
COMMISSIONER UNGER: And the loss leader phenomenon has come up recently? The last five years?
MR. DROTT: Oh, I think it's been around for many decades, yes.
COMMISSIONER UNGER: So it's not necessarily something that's developed as a result of the increase in consulting services?
MR. DROTT: I don't think it's new, but I would, in answer to that question, I would say that certainly the increase in consulting services hascaused the loss leader phenomenon to be more prevalent and to increase, yes, I would say that.
Because the idea is to sell consulting services to make up for the loss in the audit fees.
COMMISSIONER UNGER: Right, but it's not an explicit arrangement that precedes the audit itself?
MR. DROTT: Not necessarily, no.
COMMISSIONER UNGER: Thank you.
Mr. Eisenhofer, I'm sorry we're going to make your job easier, or we might, but the good news is the rules are so complex that the lawyers will be doing something else.
How many cases have you brought for lack of independence, if any?
Not brought, represented.
MR. EISENHOFER: We don't actually bring cases specifically for lack of independence.
What we bring cases for is misstating the financial statements, and to the extent that the auditors are defendants in those cases, then the accusation or allegation is that they are complicit in the misstatement of the financial statements and the lack of independence is a way in which you attempt to prove motive, and motive is helpful in terms of proving the state of mind which is necessary toestablish securities fraud.
So it's not that the case is actually brought for lack of independence, it's just that lack of independence is an element in the proof that you're putting forward.
COMMISSIONER UNGER: Thank you for clarifying that.
In that case, how many cases was that an element, the lack of independence by the auditors?
MR. EISENHOFER: You're talking about in cases I've personally been involved in?
Half a dozen cases in the last couple of years.
COMMISSIONER UNGER: Out of how many cases have you been involved in?
MR. EISENHOFER: Maybe a dozen, twelve to fifteen.
COMMISSIONER UNGER: So about half the cases?
MR. EISENHOFER: Yes.
COMMISSIONER UNGER: Thank you.
COMMISSIONER HUNT: I have one follow-up question, gentlemen.
Would a client who had never had a previous relationship with a particular audit firm, starting anew relationship, be able to look at the fees charged for the audit services the first couple of years and know that they were getting a bargain and that maybe other relationships were expected?
MR. DROTT: Commissioner Hunt, I would say in answer to that, yes, that is a possibility and it's also the possibility that, and I've seen this done many times, is that the audit fee may be lower in the beginning, with the expectation that irrespective of consulting services it will be raised in the future, but yes, I think the answer to your question is yes.
COMMISSIONER HUNT: Do you think, I know you don't know this, Mr. Drott, do you think there are ever any discussion, look, this is a ridiculously low figure given what we've been paying the last few years for our previous auditor, what's going on here?
MR. DROTT: I think the company would be all too delighted to take the lowest fee it could get.
COMMISSIONER HUNT: It's probably part of their fiduciary responsibility as a matter of fact, one could argue.
I think it really depends on each, like you said, it's hard to answer because it depends on each set of circumstances and facts.
COMMISSIONER HUNT: Thank you.
CHAIRMAN LEVITT: Thank you very much.
Panel 5 (Afternoon)
Next panel consists of John Guinan, partner of KPMG; Robert Elliott, chairman of the AICPA, Barry Melancon, president and chief executive officer, Harold Monk, chairman of the PCPS Executive Committee; Gordon A. Viere, chairman of the Practice Group Advisory Committee, and Gary Shamis, chairman of the PCPS Management of an Accounting Practice Committee, representing the American Institute of Certified Public Accountants.
Gentlemen, I would ask that you define the initials wherever possible. I'm always confused by the smorgasbord of initials that stand for the variety of committees that you represent.
Mr. Guinan, our hope was that Steve Butler, the chairman of your firm could be with us today.
Unfortunately, his schedule did not allow that, and the Commission has scheduled an extra hearing, I guess it's next Thursday on the 21st, to give Mr. Butler and the AICPA additional time to present their testimony.
Could you fill in for him in the meantime?
MR. GUINAN: Thank you, Mr. Chairman.
Good afternoon, my name is John Guinan. I'm an audit partner with KPMG, LLP.
I think I should point out while you have placed me at this panel with the AICPA members who I represent, I'm not here to represent the AICPA, but as you already indicated I'm here on behalf of our chairman and CEO, Mr. Stephen Butler.
I will pass along to Mr. Butler the new scheduled date for the hearing because he very much wanted to be here today, and was disappointed that he cannot testify and respond to your questions in person.
I think as you are aware, when Mr. Butler communicated to the staff that he had an interest in testifying before the Commission, he also indicated to you that he had a schedule limitation today and he preferred to have gone on in the morning since he had a long-standing commitment to chair several meetings in Europe starting tomorrow so he had to leave this afternoon to go to Europe so that's why he's not here in person.
I thought that what would be important is to summarize Mr. Butler's testimony for the Commission.
I would also ask that his full testimony be read into the record if he's not able to rearrange his calendar and participate in the July 21st session.
COMMISSIONER HUNT: Do I understand, sir,that revised testimony was submitted today or presented today?
MR. GUINAN: Yes, Commissioner.
What I'd like to do is present Mr. Butler's testimony in summary form for the Commission right now.
Mr. Butler is greatly concerned by the Commission's recent proposal to restrict services provided by firms that conduct independent audits.
It would sever our connection to the vital oxygen supply of people, products and technologies that we need to serve clients in our new global economy.
To understand this is to understand the forces shaping business in general and our profession in particular.
In the future, we need to have a latitude to develop new services because the business world will be dramatically different.
Most business observers acknowledge that even in the future business processes and systems to support these processes will become even more critical to the functioning of business enterprise, particularly when it comes to conveying information about the enterprise of third-party users.
From our experiences today, we know what the evolution of the audit and the information age will likely result in attestation around systems and processes, such things as security, privacy, accuracy and so forth.
Clearly, if business is to move forward in that direction, our professionals must have skills that extend beyond accounting measurement, as well as products and solutions that go beyond the traditional audit function.
Specifically, we need broader skills and solutions around risk, technology, performance measurements and other areas.
It is a logical and natural evolution of our business.
Steve would ask you if he were here today, if the audit profession is to cede these services to others, then whom would it be?
It is the audit profession that has proven time and again its capacity to adapt to changing times while preserving the public trust, and it is the audit profession that does so much to protect that trust.
Steve's experience as chairman of KPMG and also chairman of KPMG International drawn from hundreds of meetings with corporate leaders, numerousdiscussions with our audit committee clients and countless conversations with our partners and professionals advise him that investor confidence and market expectations of auditor independence are very positive and strong.
There's no fundamental unease within the marketplace on this subject.
With this insight, Steve must conclude there's no compelling reason for the Commission's proposal.
In addition, there's no empirical evidence that the expanded scope of services has ever caused an audit failure, diminished audit effectiveness or weakened investor confidence.
I think Steve would summarize his concerns with the Commission's proposal in three broad areas.
First, it would constitute a huge setback in our ability to attract and retain the best and brightest professionals.
It would severely inhibit our ability to create the next generation of products and solutions that our clients will need and our profession will require to stay on top of dramatic changes in business.
Third, it will gradually degrade theprofession's ability to produce high quality independent audits for the 21st Century by choking off the profession's access to the best people, ideas, products, processing and technologies.
Steve has never been prouder, he tells me, of what his profession has done and KPMG has done.
Together we have responded to the call of the new economy and helped to certify its viability by ensuring the integrity and the freeflow of meaningful information for investors and all publics that rely on information.
At KPMG, we have always viewed auditing as a growth business.
Rather than stifling or prohibiting innovation, we should bring more to encourage it, Steve will urge the Commission to take a thoughtful pause.
Let's assess together the fundamental market shifts that we're dealing with.
Together, let's reach a common understanding of the dynamism of these trends and the impact on financial markets and ascertain what works best for the public, the marketplace, business and the profession.
Steve offers our firm's brightest minds tothis endeavor, the same bright minds that will ensure that audit quality in the 21st Century keeps pace with dramatic changes in the new economy.
CHAIRMAN LEVITT: Thank you very much.
Mr. Robert K. Elliott, chairman of the AICPA and partner in KPMG.
MR. ELLIOTT: Good afternoon. My name is Robert Elliott. I am the chairman of the American Institute of Certified Public Accountants, the 340,000 member voice of the American accounting profession.
With me today are four other leaders of the profession: Barry Melancon, president and CEO of the AICPA; Gordon Viere, chairman of the AICPA's Practice Group B Advisory Committee representing 67 firms with over 9,000 AICPA members; Gary Shamis, chairman of the AICPA's Management of an Accounting Practice Committee representing approximately 44,000 practice units, and Harold Monk, chairman of the PCPS of the AICPA with more than 6,800 local regional CPA firm members.
CHAIRMAN LEVITT: What does PCPS stand for?
MR. MONK: Mr. Chairman, it used to stand for Private Companies Practice Section.
We have changed that to Partnering for CPA Success to help with the envisioning our membersmoving into a greater variety of services to enhance the success of their firms.
CHAIRMAN LEVITT: Thank you very much.
MR. MELANCON: Mr. Chairman, before we continue, just because we were not here this morning when you announced the hearing that apparently the Commission is now holding on next Thursday, is it our understanding that you will have a public hearing on that day and that the profession will be given significant time to present its case at that time?
CHAIRMAN LEVITT: Yes, it is.
MR. MELANCON: Given this, does it make sense from your or our perspective that we sort of piecemeal this presentation, because we obviously have a story to tell.
We did have some concerns about the amount of time which we've expressed to you.
CHAIRMAN LEVITT: Why don't, you know, why don't you go ahead almost as if this was the only opportunity, and then you can supplement that next week, but feel perfectly free to just give us either a summary or give us the most important parts of it, and of course you will be able to supplement that and amend it if you like next week.
So feel perfectly comfortable with the timetoday and the time you'll have next week.
MR. ELLIOTT: Thank you very much, Mr. Chairman. We appreciate the extra opportunity next week. But I will go ahead with some of the remarks I intended to make.
CHAIRMAN LEVITT: Great.
We in the AICPA are disappointed in the rush to judgment manifest in the SEC's premature issuance of a hastily and poorly drafted rule proposal followed by an inadequate comment period.
We believe it deprives interested parties of due process.
The release misuses evidence and omits relevant findings.
There should have been an orderly process of issuing a concept release especially when you propose to radically restructure the accounting profession without due process of law.
The American capital markets as everyone in this room knows are the best in the world.
There are many reasons for this, but one of the most important is the reliability and availability of financial information about American investment opportunities.
This situation reflects well on the efforts of our profession for over a century, the efforts of both our members in practice who audit and assure the reliability of financial statements and our members in business and industry who prepare high quality financial statements.
We are intensely proud of the crucial role we have played in this achievement.
Despite the fact that the accounting profession and the SEC are natural allies in that we both desire that investors be supplied with high quality information with which to make their investment decisions and we both devote our efforts to that end, nevertheless our relationship has deteriorated in recent years, because certain officials have treated the accounting profession almost as if it were the enemy.
This campaign has eroded the trust that is indispensable to the success of our common efforts and ill serves the public interest.
We are committed to auditor independence and have taken increasingly rigorous steps for over a century to ensure auditor independence.
There is no evidence that lack of auditor independence is even an infrequent problem, let alonea current crisis.
Yet the proposed rule points to a problem where none exists, so it can propose a solution where none is needed.
I have testified before the United States Senate that our capital markets require a new accounting model for the new economy; that the SEC's current proposal would strip the accounting profession of the talents necessary to help design and to audit the new model; and that the SEC ought to scrap its auditor independence proposal and instead issue promptly a concept release on a business reporting model for the new economy.
I implore the SEC to change the focus of this debate.
Let us move forward to address the real needs of a 21st Century business reporting system.
MR. MELANCON: Mr. Chairman, and members of the Commission, given the time frame that we have as well, I will limit my remarks to a couple of process points.
I'm concerned that there has been a rush to regulate, if you will, a trampling on the traditions of the SEC, the public interest and even the profession's interest.
I am troubled and really saddened by this process. This is not the SEC that we have known, respected and worked with as a profession and in fact supported for many, many decades.
75 days is not sufficient for the public to consider your lengthy and complex proposal.
It includes more than 400 questions, many of which raise fundamental issues about the wisdom of the proposed regulatory approach.
Public hearings such as today with over 40 witnesses, turn the process into more of a ritual than a real dialogue.
The proposal at hand collapses a concept release and a specific rule-making proposal into the same process, asserting that it is considering fundamentally different regulatory alternatives.
Frankly, it is hard to reconcile the purported open mind of these alternatives with many of the statements in its proposals, the specificity of the rules it has proposed and the allowance of only 75 days for comments.
We have fundamental issues with the rules ranging from the lack of any objective basis to the overly broad four principles, to the lack of cost benefit analysis.
Taking just one principle, what is meant by mutuality of interest?
How are our members to know they are in compliance with this principle, or more significantly how will you know and how will practitioners guess, how a member of the staff will guess, how a reasonable investor will guess a particular practice in fact is independent?
Your guidance does not guide our members or your staff. So we are left with an eye of the beholder discretion of the SEC staff to determine after the fact that any practice of which it disapproves impairs independence.
Eye of the beholder, after the fact discretion is a rule of regulators, not the rule of law.
The absence of a meaningful cost benefit analysis of the impact of the proposed rule reflects the haste with which the Commission is proceeding.
How else can we explain the failure to examine the cost that the proposed rule would impose upon the economy? The cost of restricting services to clients. The cost of denying accounting firms and their clients economies of scope and scale. The costs of depriving clients the right to select the preferredservice provider. The cost of handicapping firms from participating in the new economy. The cost of adding substantially new administrative and compliance procedures. The cost of increasing pressure for further industry consolidation. And the cost of otherwise impairing competition.
It is the Commission's responsibility, not the public's, to conduct this kind of cost benefit analysis, so that interested parties participating in the rule-making process, have the opportunity to study and comment on the staff's analysis, and the Commission, therefore, can be fully informed.
The overall lack of empirical support for this rule-making runs counter to the modern consensus on how regulation should work.
The EPA, for example, would never propose, let alone implement, environmental regulations concerning sources of pollution based upon common sense or its perceptions that certain industries cause pollution.
One could not ban or restrict an emission without detailed and reliable studies to determine the source. No reviewing court would allow it.
The SEC rulemaking on this issue affecting the way accounting firms practice, should be held tono less a standard. Yet there is no empirical basis, no studies, no data, supporting the proposed rule.
The truncated process the Commission has adopted cannot be justified in terms of urgency.
The Earnscliffe report on which the proposed release places much emphasis, did not find any evidence of crisis.
To the contrary, the phase 2 study specifically found that the more survey respondents "became informed about current safeguards, the more confident they became in the independence of the auditor."
The director of that study project was quoted as saying, "There's a consensus that the system is functioning reasonably well," and went on to say, "There's no groundswell of demand by either individual investors or executives for the prohibition type approach favored by the SEC." And the just released Penn Schoen Berland poll of 600 investors found that nine out of ten investors trusted the annual audit of the companies they invest in, as well as the audit committees and board of directors.
Moreover, 91 percent say the annual audit of financial statements of these companies is credible.
These findings are in line with the findingsof the POB's Panel on Audit Effectiveness, " both the profession and the quality of audits are fundamentally sound."
The nonaudit services that have been reviewed in the POB report did not determine a detrimental effect, and in fact in 25 percent of the audits they reviewed actually enriched the audit.
There is no crisis of confidence in audit independence or the quality of audited financial statements.
We need to restore the Commission's tradition of deliberative decision-making in the public's interest.
We believe this can be accomplished by the Commission taking the lead, by withdrawing the proposed rule and issuing the concept release and developing a new GAAP for the new economy and allowing the ISB to do the work for which it was created just three years ago, the development of a principles based framework for auditor independence and the issuance of modernized standards.
I'll now turn it over to some of my colleagues.
MR. VIERE: Mr. Chairman, Commissioners Hunt, Carey and Unger, thank you for the opportunityto testify today.
I am the chairman of the AICPA's Practice Group B advisory committee. Practice Group B includes firms with 50 AICPA members or more, excluding the largest five firms. Our current membership includes 67 firms and more than 9,000 AICPA members.
We serve principally small, middle market, closely held and family businesses.
I'm also the managing partner of a Minnesota based firm of Larson, Allen, Weishar & Company. With over 700 employees, we do a full spectrum of audit, tax and financial consulting work for the closely held and family business marketplace.
In both of those capacities, I oppose the rule proposal in its current form.
I'd like to add that the world of firms such as mine as the clients that we serve is quite substantially different than the world you heard about so far today.
I would urge that the Commission take the time and energy to understand the ramifications of a decision you might make on firms such as ours, and more importantly, the type of client that we serve.
MR. SHAMIS: My name is Gary Shamis. I speak on behalf of myself as a practicing CPA for 22 years. My firm, Saltz, Shamis & Goldfarb, the 50th largest firm in the country; as chairman of the Leading Edge Alliance, an association of 30 of the 125 largest firms in the country, and as chairman of the AICPA management of an Accounting Practice Committee representing approximately 44,000 practice units.
I have to tell you that sitting here this morning, I feel like I'm crashing a party. The discussion seems to be the debate between the Big Five and the SEC. My constituents are being significantly impacted but not really considered by the SEC. And I'm hoping that if I can do anything, it will be to make you think about the impact on non-SEC type firms.
Up until 60 days ago I was an interested bystander in the process of updating the auditors independence rules. Today I find myself as a potential casualty in the path of a speeding train, namely the new SEC rule proposal. I find myself so concerned with the proposed changes that I can't sleep at night, worrying about what may happen to mypractice, my career, my clients and my profession. I believe the implementation of these rules will profoundly change the accounting profession. The process and actions by the SEC completely confuse me and many other CPAs across the country. Most of us CPA's, who are not in the largest five firms have little or no involvement with the SEC, and are confused as to why the SEC is proceeding on this course to profoundly change our lives and our profession.
We don't understand why the SEC will not permit the Independence Standards Board to complete their work and to propose new standards for independence. It is our understanding that the ISB was created at the encouragement of the SEC to address the very issues the SEC now seeks to change through this rule making.
We don't understand the timing the SEC imposed upon the process. We have been given 75 days to respond to changes that profoundly impact our practices, our profession and our clients. We have found that because of the chosen time period many of our members have not yet been informed. Our Congressional representatives are not able to listen to us, given such a short comment period and in this,an election year.
We don't understand why the SEC has limited our due process by attempting to limit our professional association, the AICPA, to a mere 15 minutes in a single hearing, which has changed now, we do appreciate it, relating to a change that will have such a profound impact. We can't believe the SEC will not permit our concerns to be thoroughly heard.
We don't understand the necessity of these proposed rule changes. There is no empirical evidence of audit failures and the POB Panel on Audit Effectiveness concluded that the audit process was fundamentally sound.
With respect to ancillary services, there is no evidence that these services negatively impact the audit process. In fact, we would argue that ancillary services enhance the audit practice and have provided tremendous benefit to American businesses.
My intention not to debate the SEC's reasons and logic in determining their position. At first blush these rules and debate have little or no relevance to most CPA firms, other than the five largest, because of their lack of SEC audit engagements. The concern has developed, though, that these rules will become the benchmark for the entireCPA profession.
In anticipation of this hearing, I talked to three of the members of the Ohio Board of Accountancy -- I practice in Ohio -- to inquire how these rule changes at the federal level will influence their requirements on independence. I was sufficiently convinced from my discussion with the Ohio board members that a change at the SEC level has a very good chance of affecting the rules that govern my firm's independence.
Having concluded that this change could impact my firm, we closely studied the proposed rules and determined that the rules would have disastrous impact on my firm and firms like mine.
Before I comment on the impact of these rules, I would like to state that my firm has never had an audit failure due to providing ancillary consulting and business services, and I am not aware of any comparable firms have had an audit failure relating to their consulting efforts.
We take the existing independence rules quite seriously, and consequently abide by all the existing rules. We are professionals that follow our code of ethics and practice by the highest moral standards. We would never be influenced by our ownpersonal financial well-being versus our professional ethics.
The impacts of the proposed SEC rule changes will significantly impact my firm and firms like mine, clients, associations of accounting firms and recruiting. My firm and firms like mine have evolved over the past decade to provide higher level value added services to our clients. These services have helped to increase profitability and performance of our clients in addition to the traditional assurance services we provide.
The magnitude of consulting fees my firm and firms like mine generate in relation to assurance services fees varies. If these new SEC rules become applicable to my firm, we will have to dismantle our firm. We will reduce our work force by approximately 50 percent by selling off business lines and/or terminating employees.
The financial results of imploding our firm will be devastating to me and my partners. Long term commitments for rental space will be in place, but not needed. Client relationships will be terminated and significant investments made into developing and acquiring additional consulting services will be lost.
My firm and firms like mine are members ofloosely organized national associations of accounting firms. These associations are necessary to compete against the five largest firms and to have available broader expertise to service our client base. These associations are necessary to service clients in different geographic areas around the country and the world.
The new SEC rules relating to the definitions of affiliates and business relationships would most likely end the associations of accounting firms and provide the five largest firms a competitive advantage by limiting the scope of service available to clients of the smaller firms.
If the proposed rules are adopted, clients would be denied access to services previously provided by their CPA firm. The clients would be severely limited. In many instances the CPA firm would be the most effective and qualified provider of services due to their intimate knowledge of the client.
We have approached many of our clients to discuss the impact of these new rules and our clients are very upset at the prospect of our firm disengaging from previously provided services. The clients cannot understand why the SEC is concerned in limiting their choice of service provided. In our specific case thechanges will impact over 50 percent of our clients, 1750 businesses all across Ohio. We are just one firm. The magnitude of the collective impact nationwide is huge.
The accounting profession is facing perhaps its biggest challenge, the challenge of attracting students into the profession. Enrollments are decreasing. Competition for quality graduates has become difficult with new opportunities in the business world. We are concerned that a narrowing of the scope of the profession to assurance and tax services will make the profession less attractive to future graduates. The resulting graduate we can attract may not be the best and brightest and the numbers may not be sufficient for the related work. These circumstances may result in less qualified auditors charging out at a much higher rate.
I love my job and I love the entrepreneurial opportunities available in the accounting profession. If my occupation and my firm were reduced to simply part of a federally regulated industry, I would look for another business opportunity, as I believe many CPAs would. My firm and the firms I speak for have a 100 year history of protecting the public and providing business resources to small and medium sizedbusinesses. The firms have complied with a code of professional ethics and have taken on self regulation of the audit process. We have done all of this and retained the coveted position of most trusted adviser to American business.
We believe that the current independence rules can be improved, enhanced and updated, but not at the expense of damaging the individual firm units, the clients of the firms, and the future of the accounting profession.
CHAIRMAN LEVITT: Thank you very much.
Mr. Shamis, can I ask you how many publicly owned companies do you perform audits for?
MR. SHAMIS: None.
CHAIRMAN LEVITT: How many?
MR. SHAMIS: Zero.
CHAIRMAN LEVITT: So that these rules wouldn't impact your firm, would they?
MR. SHAMIS: These rules would not impact our firm, unless the state of Ohio would use these rules as a benchmark for their independence standards, which they have indicated that they would.
CHAIRMAN LEVITT: Let me say something that I want to clarify.
As strongly as I may feel about certainissues, I feel just as passionately about the importance of small business in the United States.
I built four or five very small companies, and the rights of those companies as part of our economy are fundamental to everything I believe in.
I also believe that the vast, overwhelming majority of accountants in the United States are good, honorable, decent, underpaid people, and I would feel inadequate to the job I have been honored to be appointed to if I did anything in any way that would cast aspersions upon this important and honorable group of people.
And what I have said goes even more strongly to those like yourself.
I would suggest to you that your answer that these rules would not affect you in any possible way is very significant.
MR. SHAMIS: Excuse me, that's not what I said.
What I said was--
CHAIRMAN LEVITT: You said that if your state board applied these rules to you in ways that neither you nor I can anticipate--
MR. SHAMIS: But I have talked to my stateboard.
CHAIRMAN LEVITT: But I'm talking about these rules right now. As to what your State Board or some other body may or may not do I think that's so hypothetical that it's irrelevant to our decision at this point.
COMMISSIONER HUNT: Good afternoon, gentlemen, thank you for being here.
I guess I want to start off by saying I am struck by the difference in the perspective of this panel in terms of these rules and the perception of the panel that preceded you, Messrs. Eisenhofer and Drott, who said they had seen many instances in which it seemed to them, to use my phrase -- the "but for" phrase -- but for these conflicts of interest that these kinds of accounting failures would not have occurred.
How do you explain the wide disparity in views about our proposed rules between you and other members of both the accounting profession and the legal profession?
MR. MELANCON: Commissioner Hunt, I'll take a shot at that question.
You pointed out something that goes to thefundamental difficulty that we have in even responding to this and in understanding the proposed rule.
It's very easy for people to give supposition. It's very easy to say, you know, I have some facts but I can't disclose them.
We believe, of course, that there is a significant lack of evidence on the substantive side that relates to the points that people are alleging. And of course we believe that that is a very difficult basis to move forward on a rule-making.
Likewise we have submitted to you that through the work of the POB panel, through the work of the Earnscliffe report, which is a public opinion review at a very high level, through the work of the study that I referenced in my remark, that there's ample indication to the other side. So if there are substantive facts, this profession has a tremendous history.
In fact, the POB report in 1994 was extraordinary, excuse me, the General Accounting Office's report, that the profession's response to virtually every call for change and to address any notion that might need to be addressed, we have a tremendous record from that standpoint as a profession, and we are not afraid to address anyfuture, today or in the future issues that can be substantiated is in fact a problem.
We are on the same side as you from the standpoint of wanting independent audits. We want quality financial reporting and we want a financial reporting system that reflects the next century.
So I would say to you that it is very difficult for us to respond without evidence being presented.
COMMISSIONER HUNT: Anybody else want to respond?
Do any of you agree with the comments that were made earlier today by several commenters that in this area perception is reality, and if there is a perception out there of conflict, then that is in fact a problem?
MR. MELANCON: We do not believe that the basis for rule-making simply be on the basis of perception. That there is a higher, as I referenced in my remarks, the perception that something might pollute is not a basis for the EPA to go to rule-making on that basis. It has to be able to be substantiated.
COMMISSIONER HUNT: Well, would that we were the EPA, but we're not.
MR. ELLIOTT: Commissioner, can I respond to that?
COMMISSIONER HUNT: Yes.
MR. ELLIOTT: We believe that appearances are very important and capital markets require confidence in financial statements and audit reports, and the member firms of the AICPA are basing their business of auditing on their reputations, and that is heavily affected by appearance. There is no question about that. We are not disputing that appearance is important.
What we are saying is that the evidence, the broad evidence taken from survey results and so forth do not indicate that investors are concerned, that they see an appearance problem. And that, I might add is despite the fact that the SEC has been telling them that they should be concerned about that for the last couple of years. So we believe that appearance is important, but that we need to look at the broad evidence.
MR. GUINAN: If I could add one other point, Commissioner, to that, we believe that the audit committees, which have been most recently empowered by the Commission, the Exchanges, and others really are appropriate to delve into whether or not there is aproblem with independence. It really ought to be that body that should make a decision whether in a particular case, based on facts and circumstances, there's a concern about independence.
COMMISSIONER HUNT: So you believe this is an issue that should be essentially left to the audit committee?
MR. GUINAN: I believe the audit committee is the appropriate party to look at whether or not there's an independence problem.
COMMISSIONER HUNT: Do any of you -- I know you agree with the change in the rules about family relationships and investment -- that's not what we're talking about here.
We're talking about scope of services.
Do any of you think there's any need for a change in the rule vis-a-vis on scope of services?
MR. MELANCON: Commissioner Hunt, we do not believe that there's a need for change in those rule.
And I might add that even on the other side, the investment issues, we have certainly supported the modernization of those rules. There are nuances in the proposal as written that are substantially different, the impact is different than what has occurred through the ISB deliberative process. Andthere are some points of concern -- not nearly, as you point out, and I would agree with you, not nearly on the substantive side or significant side as the scope of services.
MR. GUINAN: Commissioner, also, our response letter which will be filed in connection with the proposal process, also, will address the modernization section of the proposal, but I will tell you that areas of concern to us deal with the definition of an affiliate of a client and also an affiliate of an audit firm.
They are areas that we have tremendous concern with that go beyond even areas where the ISB has produced some original exposures.
MR. ELLIOTT: Commissioner, relative to the scope of service issue, to answer your question as to whether we think rule changes are needed, the answer is no, if what it means is making lists of services.
But what we believe should be the case is that there should be a principles-based conceptual foundation by which these issues could be addressed.
The Independence Standards Board is well along in its formation and articulation of a conceptual framework. And we believe that project should be completed. Then the question of the typethat you ask should be referred not to a list of services that's been hammered out, let's say, by negotiation, but by respect to a set of principles so that the determination could be based on some logical foundations.
CHAIRMAN LEVITT: Would you favor the restructuring of the Independence Standards Board as has been recommended by the O'Malley Commission and by the Board independent members themselves, giving greater weight to public membership on that Board, and thereby increasing public confidence in the ability of that board to act in an independent fashion?
MR. MELANCON: As a member of that board, I would just comment that just for the record, there has never been a split on any issue that the board--
CHAIRMAN LEVITT: That's not the question I've asked you. I asked you would you recommend increasing the number of public representatives on the board.
MR. MELANCON: I would not recommend that.
CHAIRMAN LEVITT: You would oppose that, is that correct?
MR. MELANCON: I would not recommend that proposal. I think it has worked from the standpoint of dialogue and education.
I think there are tremendously honorable and talented individuals from the public who serve on that panel, and I think that that board's--
CHAIRMAN LEVITT: How many public members does the AICPA have?
MR. MELANCON: How many public members--
CHAIRMAN LEVITT: Of their board.
MR. MELANCON: We have three.
CHAIRMAN LEVITT: How many members do you have on your board?
MR. MELANCON: 21.
CHAIRMAN LEVITT: Excuse me --
COMMISSIONER HUNT: That's all right. As I understand it, the AICPA's own rules presently prohibit appraisal and broker-dealer/investment services as perhaps impairing or impairing independence, and that the SEC Practice Section rules currently prohibit certain evaluation, actuarial and human resource services.
Do you recall why the AICPA determined that these services impair auditor independence and has so stated in their rulings?
MR. MELANCON: We have a whole plethora of rules that address independence, Commissioner Hunt.
I cannot address specifically what occurredduring each of those exposure processes nor would time allow me to do so if I could recall it.
The fact of the matter is that we have addressed issues such as the one that you've addressed.
We believe that from the perspective of a self-regulatory organization that there are opportunities to address, and that we have in fact, through due process, reached those conclusions and we hold our members accountable from that perspective, and in fact they're accountable even in the work that they do is related to the SEC work on the basis of those rules.
COMMISSIONER HUNT: I take it, then, that you agree with the prohibitions in the rules promulgated by the professional organizations?
MR. MELANCON: I would tell you that our rules as well as probably any other standard setting body rules must undergo constant re-evaluation, and there are certainly rules that I do not agree with that are on the books of our own organization. And I think they need to, just as other bodies' rules need to be modernized to reflect the new economy.
I would say that rules have to do that, and we're taking a lead in many of those instances today.
CHAIRMAN LEVITT: Are you saying that some of the prohibitions already on your books are prohibitions that you might eliminate?
MR. MELANCON: I think that those are subject to due process consideration.
I am not going to speak to any specific one in this time frame because they have not gone through that process, but clearly I think it's important that all regulatory structures, yours, ours, state boards, other agencies, are reflective of a modern economy and I think in reading some of the speeches that several members of this Commission have given, I would think that you would agree with that, as well.
CHAIRMAN LEVITT: I gather, then, from what you say that the likelihood is that the organization would move towards relaxing some of the prohibitions rather than towards strengthening them?
MR. MELANCON: I did not say that, Mr. Chairman.
CHAIRMAN LEVITT: May I ask you that question?
MR. MELANCON: I cannot predict through our due process that we would or wouldn't.
I think these rules have to be looked at.
I will tell you that they will be done inthe sunshine, if they are undertaken. And I will also tell you that we are adding public members to our ethics committee prior to making any move in that particular process.
MR. GUINAN: If I could also clarify, I think there may have been some confusion at least in my understanding of your question. The SEC Practice Section does not address bookkeeping services or evaluation services.
The SEC Practice Section does address a component of the human resources consulting, but not to the extent it's in the Commission's proposal.
COMMISSIONER HUNT: Okay, thank you.
If we were to revise certain of our proposals to parallel the AICPA or the SEC Practice Section rules, would that go a long way to allaying your concerns?
MR. ELLIOTT: The problem with that, Commissioner Hunt, is that any such codification would be without respect to the conceptual framework which has yet to be completed. But that in any case it's our belief, we were working on the supposition the Financial Reporting Release 50 of the Commission, delegating these matters to the ISB, was still in effect, and so our recommendation is that the ISB begiven the responsibility to examine these issues under its conceptual framework and then to make its decision.
So our concern is with the SEC in effect taking back independence rule-making, which seems contrary to Financial Reporting Release 50.
COMMISSIONER HUNT: Along those lines, would those of you at the table find more satisfactory a conceptual framework involving the four basic principles enunciated in the Commission's release, rather than a rather detailed set of rules, as has been articulated?
MR. ELLIOTT: We have advocated a principles-based approach, we the accounting profession, for a number of years. And we do favor that, and we believe that's the direction that the Independence Standards Board is moving with the conceptual framework project.
The four items that are indicated in your proposed rule as principles in our view do not rise to the level of principles. They are not a complete and concise description of a set of principles. They are mutually in conflict with each other and worst of all, they don't permit a predictable conclusion on the basis of an accountant or accounting firm as to whatwill or won't be permitted. So, although we favor a principle based approach, we do not believe those four identified as principles in the release are the right principles.
COMMISSIONER HUNT: You would add more or change the ones that exist or both?
MR. ELLIOTT: Change.
COMMISSIONER HUNT: Change those four?
MR. ELLIOTT: I have no preconception as to what the right number of principles is, and the ISB is I think is making good progress on exactly that issue.
COMMISSIONER HUNT: I only have a couple of more questions. Do you believe that outsourcing the internal audit to the auditor can improve the quality of the audit, the overall internal and external audit?
MR. MELANCON: Our rules prohibit the complete outsourcing. There still has to be management responsibility for the overall internal audit function, just for the record and by your response I realize that you know that. We believe that from the standpoint of extended audit services that there can be benefits that get reached from that standpoint. Access to information. But we certainly agree that the ultimate responsibility for internal auditing, the management decision making, must relywith management, not with the auditor.
COMMISSIONER HUNT: To the extent that there is outsourcing, do you think it makes a difference whether the outsourcing goes to the already existing external auditor or to another firm?
MR. MELANCON: Well, certainly, if internal audit is outsourced to another firm, that's simply a decision that management is making and it doesn't rise to the issue of the scope of services point that we're having. So that is, I would think that management has the right to make that decision and it makes no difference to us if they make that decision.
CHAIRMAN LEVITT: You think there's no conflict in the internal audit being given, the internal audit outsourcing is given to the auditor who performed the audit?
MR. MELANCON: Provided the proper management controls are in place.
COMMISSIONER HUNT: So you think that it's at least theoretically possible that that could happen? I take it then, I don't want to put words in your mouth, you also probably think it's possible to improve the quality of the overall audit?
MR. ELLIOTT: It is possible. Commissioner Hunt, the question of internal audit outsourcing is aset of words, we might all believe they mean the same thing, but they probably do mean different things. There are things that are done under the rubric of internal auditing that would be perfectly consistent to have the external auditor do them. There are other things that might get into an area of making management recommendations and carrying through on them that might clearly violate one of our other rules against taking part in management, so I think it's very difficult to just say internal audit outsourcing and drop an axe on that, without really knowing the nature and nuance of what's covered by that terminology.
COMMISSIONER HUNT: Okay, in terms of existing prohibitions, not those in our proposed rule, do you think all or any of them enhance the quality and the provision of the independent audit?
MR. MELANCON: Could you clarify the question?
COMMISSIONER HUNT: The current prohibitions on the kind of work the firms can do for the audit clients. Is it your view that they enhance the quality of the audit?
MR. MELANCON: I really apologize, I'm not sure I catch the--
COMMISSIONER HUNT: Well, I mentioned the prohibitions a little earlier for people in appraisal, brokerage and investment services, your rules I think says that this impairs independence, and I assumed therefore that you also believe it improves the quality of the audit.
MR. GUINAN: The AICPA rules do not prohibit bookkeeping and do permit appraisal services in certain circumstances. So it's not a prohibition.
COMMISSIONER HUNT: Okay, limitation on. Well, I hope we can continue to get at this problem. I also want to say that several panel members, not yours, have mentioned that they see a growing deterioration between the relationship between this agency and your profession. And to the extent that that has occurred, I certainly sincerely hope all of us can work to stop that deterioration and improve the relationship for the future.
MR. ELLIOTT: Commissioner, we completely agree with that.
COMMISSIONER HUNT: Thank you very much.
CHAIRMAN LEVITT: Commissioner Carey.
COMMISSIONER CAREY: Thank you, Mr. Chairman. You gentlemen are all firmly against the proposed rule. I think there's no mistake about that. And your organization is described as representing the profession's interests, but I do not find it to be quite so monolithic, when particularly in light of the hearings that we've had where we've had prominent members of the AICPA endorse this proposal and say that there actually is an appearance problem that warrants, that there is at the very least an appearance problem that warrants a regulatory approach. And also not all of the Big Five have adopted an approach of fierce opposition. And certainly some of the smaller CPA firms have played a very constructive role in the Commission's deliberations. Would it be correct to say that there is dissent at some level in the AICPA about this proposal?
MR. MELANCON: Commissioner Carey, certainly any organization that represents hundreds of thousands of people are not going to have hundreds of thousands of people to agree precisely on any one point, just as no representative body or the constituencies that you represent from the standpoint of your public service would all agree on every issue. So I think that that's just a fact of differences of opinion on different issues.
But the fact of the matter is is that youhave before you the representatives of our board of directors, which have debated this issue at length and are clearly supportive of the positions that we have articulated to you, the representatives of our 45,000 or so practice units, which have commented to you, Mr. Monk, who represents the PCPS group, which is additional 7,000 firms, and the group B firms and Mr. Viere has indicated to you, have all deliberated and debated on this issue and have reached the same conclusion.
In addition to that, even our members in business and industry committee have debated this issue and expressed the board's position from the standpoint of expressing our concerns and opposition. So we have a very elaborate member participation and due process standpoint, and clearly, the overwhelming response of our profession is of grave concern for the proposed rule. And just for the record, because of the way you announced the hearing on next Thursday, our full record we would submit, our full testimony we would submit for the record which goes into further detail and obviously we'll submit other information along those lines to support the concerns that we have, which you're referencing.
MR. MONK: Could I just--
COMMISSIONER CAREY: Could I just elaborate on my question before you do answer, Mr. Monk? At the outset of this effort, shortly after Chairman Levitt's speech, the AICPA did announce that they were no longer going to fund the independence projects until there was in the SEC Practice Section. Is that correct?
MR. MELANCON: I do not think it's correct we were not going to fund independence projects, that's not correct.
COMMISSIONER CAREY: Forgive me, my mistake, withdraw the question.
MR. MONK: If I could address your previous question, especially relating to the smaller firms that are members of the AICPA, our organization is primarily small firms and mostly very small firms as a matter of fact and most of our member firms do not audit SEC clients. That does not mean that this is not an issue for them.
Unfortunately, they're very much like I am, when I first saw this proposal come out and said this is a Big Five problem. This is not my problem. But as it progressed, and as I learned more about it, it became clear to me that this was a problem for our firm and for our member firms. And I think as theylearn more about it, if they have time, you'll find that you will receive a greater response from many small firms indicating the impact this would have potentially on their practice. Because despite what Chairman Levitt said, if the other government agencies pick up and follow the lead of the SEC, which I don't believe there's much doubt that some of them will, that will have an impact on the small firms' audit clientele without question, because many of those are tied to federal regulatory clients.
COMMISSIONER CAREY: Mr. Elliott, you referenced the Penn Schoen poll during your testimony, during your question of Mr. Hunt. Having seen a number of polls during my life often what you get is very much a product of what you asked.
I would like to ask you just to indulge me in saying I think the question that was put to the respondents in the poll was not by my view balanced. It was: "Should regulators play a bigger role, smaller role or about the same role as they do now, prohibiting accounting firms from offering a range of services, for example, information technology, consulting to any clients they audit?" That was the way the question was asked.
I would have asked the question in adifferent way, which is: "Should regulators play a bigger role, smaller role or about the same role as they do now, maintaining the independence of public accountants such that conflicts of interest are reduced and investors continue to believe in the integrity of the numbers."
Would you take issue with the way that I would ask the question?
MR. ELLIOTT: The question of the construction of polls, I agree with you Commissioner Carey, can induce results and opinions where none previously existed and there is an academic literature on that, and it is very difficult as you and I and everybody probably else in this room knows to construct a truly neutral poll. And I would not doubt if we all sat down together we would craft slightly different questions. But let me--
COMMISSIONER CAREY: Well, depending on our objectives --
MR. ELLIOTT: Let me refer to the work that was done by the Earnscliffe Group and the reason I want to refer to that is that group was working for the Independence Standards Board and that board has four public members and those four public members are not particularly interested in biased--
COMMISSIONER CAREY: Excuse me, I missed part of what you said. What group was working for the Independence Board?
MR. ELLIOTT: The Earnscliffe, we also referred to the Earnscliffe research and, in fact, your own proposed rule refers to the Earnscliffe research. My point is that that research was designed under the oversight of the ISB including its four public members, and I would be astonished if they would have done anything in terms of the design of the survey that tried to reach one answer in preference to another, but rather to find the true results. So yes, we could take a look at any one question, I agree, and we could reworded it, but the way in which you reword it, might also induce an answer that was perhaps more in concert with the direction that you would like the answer to come out. But I can assure you that the Earnscliffe research was done by an independent group for the Independence Standards Board.
COMMISSIONER CAREY: That is Penn Schoen. I know that you referred to that, we're referring to other. We're not basing our entire statement on one particular poll. What we are saying is this--
COMMISSIONER CAREY: But that is the poll that coincides with your appearance today, so it hasconsiderable weight.
MR. ELLIOTT: It happens to have out relatively recently, but we can refer to these others such as these Earnscliffe polls which are really; the findings are consistent. Our point is this: That whatever approach you take to this question of independence, it's much more important to know what investors are thinking, rather than to rely on anecdotes. And if you want to find out what they're thinking, the only way to do it is by some method that gives them an opportunity to respond. And as we read the rule proposal, we don't see that it's based on broadly gathered evidence that there is a problem.
COMMISSIONER CAREY: Would any of you like to respond, do you think there's any merit to the assertion that the appearance of independence is compromised when certain nonaudit services are provided.
MR. ELLIOTT: Certainly there are nonaudit services which would not be provided because they would be completely inconsistent with an audit and if investors became aware of those types of services in conjunction with an audit they would be concerned and rightly so. That's why we do have rules, and that's why we do prohibit lots of relationships. In additionto the rules that are on the books, between the AICPA's rules and the ISB's rules and the SEC's rules, individual firms have rules that in many respects are even more restrictive. And despite any set of rules, you have firms that look at potential services and decide that they just don't want to associate them with an audit. So the individual auditors are extremely concerned that they do anything in terms of linking other services with an audit that would impair either the fact or the appearance of their independence.
CHAIRMAN LEVITT: Would you support the codification of your own rules precisely, your own rules word by word, would you support the codification of that, since these are rules that--
MR. ELLIOTT: By the SEC? No. We would support the ISB going through a process --
CHAIRMAN LEVITT: Why would you oppose the codification by the SEC?
MR. ELLIOTT: Because once the SEC has codified these things and put them, and poured concrete around them, they tie the hands of the Independence Standards Board, which theoretically you delegated to deal with these issues.
CHAIRMAN LEVITT: The SEC does not have thelegislative right to abdicate our responsibility in terms of independence rules. We can call upon an ISB to counsel with us. We can call upon them to undertake tasks. We cannot give up our mandated obligation to do so, sir.
MR. ELLIOTT: I agree with that completely, Chairman, but that's already covered in Financial Reporting Release 50. But once you begin to take over the functions of the ISB, you leave them in a position where there's not much for them to do, except to interpret around the edges of the rule that the Commission has set.
CHAIRMAN LEVITT: We have never given up that function. We have never abdicated, nor will we ever.
MR. ELLIOTT: I understand that.
COMMISSIONER CAREY: Mr. Melancon, I just want to clarify what I said when I misspoke. In a letter in May the AICPA withdrew funding for a POB review for four of the Big Five firms excluding PWC's compliance with the independence rules and after there was some considerable objection they reinstated it. Is that correct?
MR. MELANCON: We did not withdraw funding. We simply asked for a clarification of what theproject was, and we said that good due process was to understand what the process was and as soon as it was clarified--
CHAIRMAN LEVITT: Did the letter indicate that the funding was withdrawn?
MR. MELANCON: Mr. Chairman, there was a letter that was written, yes, and as you know the letter was requested by--
CHAIRMAN LEVITT: But did the letter indicate that the funding was withdrawn? Do I have to read the letter?
MR. MELANCON: Mr. Chairman, the letter indicated the funding was withdrawn.
CHAIRMAN LEVITT: Thank you.
MR. MELANCON: The fact of the matter is that the letter addressed and was a follow-up of oral discussions, numerous discussions in which we asked for the details of the engagement to be performed.
COMMISSIONER CAREY: Thank you.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: Now that my colleagues have warmed you up, it's my turn.
COMMISSIONER CAREY: Here comes the heavy.
COMMISSIONER UNGER: I am concerned about what I heard you express in terms of the commentperiod and the ability of the AICPA to respond in full to the proposal. So I was wondering, from a process perspective first, who actually prepares the comment letter for the AICPA?
MR. MELANCON: We will seek input from a variety of sources and we will have either staff or contracted, in effect contracted staff or services, professional services to do writing, and assimilate the data.
COMMISSIONER UNGER: And do you have outside firms and consultants help you with this?
MR. MELANCON: We for a variety of different projects and different services we use either internal staff or outside staff, depending on what's appropriate at the time.
MR. GUINAN: If I could elaborate on that, Commissioner, the typical process is a former member of the professional ethics executive committee of the AICPA would be for that particular group at least to review what the staff has put together. And there may be other groups within the AICPA that would also review a response to a proposal by the Commission.
MR. MELANCON: But in this case, Commissioner, to clarify, in addition to the input from the members' perspective, ultimately our Boardhas taken a position on this, because this particular issue crosses multiple committee disciplines from the standpoint of the profession.
COMMISSIONER UNGER: So then does the letter have to be signed off on before you can submit it?
MR. MELANCON: The letter will be supported by our leadership, yes, ma'am.
COMMISSIONER UNGER: Which is the entire Board, all 21?
MR. MELANCON: Well, they will certainly support the conceptual directions, the major points. It may not be the precise, final, exact words. The process obviously has to be a little bit fluid.
COMMISSIONER UNGER: How many individuals do you have working on this particular project?
MR. MELANCON: I don't have an answer to that question off the top of my head, but it obviously is a major project for us, a major issue and one that we are devoting considerable resources to.
COMMISSIONER UNGER: We had a witness earlier this morning, Ralph Whitworth, who said that in the Waste Management crisis they put 1200 auditors on the books, so you have something to aspire to, if this truly is a crisis.
But everywhere I go, I hear that theaccountants are spending tons of money on this particular proposal and fighting this proposal and that you've been spending a lot of time up on the Hill. I still have a lot of friends up there. Yet I haven't been visited by you all and you haven't met with me. I don't know about my colleagues so I can't speak for them, yet we are also talking about the deterioration of a relationship, but what kind of relationship is this?
We put out a proposal and you go up and fight on Capitol Hill and have a pretty intensive letter writing campaign about the proposal, yet you don't come in and talk to the individual Commissioners. Is there a reason that you haven't contacted us?
MR. MELANCON: We will certainly contact you, Commissioner Unger. You, I'm sure, will be looking forward to it.
COMMISSIONER CAREY: As would I.
CHAIRMAN LEVITT: As would I.
MR. MELANCON: Thank you. Commissioner Levitt, we have had many conversations.
The issue of, you know, the process and the timing of what and when we present information obviously is part of dealing with any particularproposal, and we certainly consider all alternatives and the best way to approach it given the particular situation. But I will agree with you that the importance of dialogue is always there. We have tried to be forthright in this issue, but there are some fundamental differences of opinion.
COMMISSIONER UNGER: Among your membership or among the Commission?
MR. MELANCON: No, ma'am, I think between members of the Commission that have spoken out against the profession very directly on this particular point. And it is unfortunate, and I think that your indication of a desire to try to improve that and our indication of a desire to improve that I think is a very positive thing.
COMMISSIONER UNGER: Well I'll tell you in the same vein of this conversation that perhaps part of the problem is going up to Capitol Hill before you have a dialogue with the people who put out the proposal, because if it's the substance of the proposal that you have a problem with, we would certainly be amenable to hearing that. And that's where your first line of defense, offense, whatever the case may be, should be, I'm not telling you how torun your business, obviously. Or how to deal with a particular issue. But by the same token, I worked up on Capitol Hill and I know extending the comment period is the first area that people tend to focus on without going to the merits of the proposal.
And I would think that given the vast sums of money that you allegedly have been spending -- and I won't ask you how much you've spent on this particular proposal -- and the fact that at least some of your membership is not happy with the tactics that you've undertaken, that in fact it would be helpful to have a constructive dialogue instead of a battle and that might be time better spent.
And just so you know, Mr. Shamis, and I forget who else raised the question of whether we have been considering, I'm sorry, Mr. Monk, I think you're it, whether we have been in contact with smaller firms, I got a letter, actually, Jack Katz got the letter but we all got it as a result, from a small firm, Ziaman Touchet, I think is the firm. He attached the talking points and the letter that the AICPA had sent around August 10th, which was not too long after the proposal. And it's three pages of single spaced talking points, so you obviously had something to say, to start a letter writing campaignagainst the proposal. And what he says in the cover letter is that the AICPA is simply an advocate of the Big Five and other firms at that level, and that most people in the smaller firms do not have the huge consulting practices and do not have what could be to be construed to be impairments to our independence feel that your proposed rule is necessary and appropriate. So rest assured the small firms are in fact part of our consideration of the proposal.
MR. MELANCON: But you heard from three representatives of firms that are not Big Five that expressed that concern to you today.
COMMISSIONER UNGER: And we heard from about 22 witnesses today, not including the first day of the testimony, that said we should completely eliminate anything other than audit services performed by the firms.
MR. MELANCON: If this is a matter of how many people we generate for testimony, which I don't think it would with respect to your time that that's the desire of this process--
COMMISSIONER UNGER: Please don't.
MR. MELANCON: But if that were the judgment, we certainly would be willing to have as many people as you would like to schedule time toexpress that other opinion.
COMMISSIONER UNGER: NO, I appreciate that. We could certainly get into a battle of the witnesses as it were, but my point is that we did hear from a cross section of very credible witnesses. We heard from investor groups, we heard from lawyers, from different people who are not in your industry per se, not all of them, some of them, but who are impacted by what we've been calling the perception that the financial statements in fact are not independently audited and that's really why we're here today --is to question how in this new age or new era of technology that we can preserve that independence and the integrity of the financial reporting system.
COMMISSIONER CAREY: I want to echo what Commissioner Unger has said because I like the rest of my colleagues have an open door policy and I've had many people come in to discuss this proposal and most of them have been representative of what I would describe as smaller interests, and very few have represented, -- well, there's actually been no request from the AICPA.
MR. ELLIOTT: Commissioner Unger, could I get back to the point you were making and reinforce Barry's point? Obviously this is not a plebescite. It's not how many people we can get lined up on one side or the other. But rather it has to do with the quality of the arguments.
I'm sure that the SEC will be taking a look and seeing how much depth underlies the various arguments.
The point I want to respond to is you say witnesses come and say we should have audit only firms, firms that are essentially statutory auditors. We want to make as clear as possible to you that we believe that if audit firms were solely audit firms, solely statutory audit firms, that the quality of accounting in auditing in the United States would go down, and it would go down increasingly quickly in the future for two reasons.
The first reason is that the process of describing increasingly complex and high technology businesses, which are the backbone of our economy, will not be done by a bunch of narrowly focused auditors. And secondly, the appeal of the profession of statutory auditing for new talent coming to the profession would be approximately zero. There would be many opportunities for people to have more payoff somewhere else. So between the fact that the statutory auditing profession would not be able toaudit businesses in the new economy and could not attract talent, we believe that the Commission really needs to dig down into those arguments and really wrestle them to the ground. And to have witnesses come and say I find we could have statutory audit firms, no skin off my nose, it's not my business, it's free for me to make those suggestions, is one that you have to regard in terms of the motivations of the various witnesses and what they stand to gain and lose.
We are not here simply because we believe that auditors, and we take Chairman Levitt's point, that auditors are underpaid. We'd all like to be paid more. This is not about how much accountants are paid. This is about our ability to provide the profession the same level of high quality information for investors that has enabled the American economy to zoom ahead of the rest of the world because of its transparency.
The question is will we be able to keep that up in the next generation as business and industry and the financial markets change. The SEC is enforcing rules written or statutes written before the invention of the computer, Internet, on-line trading, on-line exchanges, on-line offering of securities and soforth, and this is a different world. And we need as a profession to have the skills, the capabilities, the talents to move into that space and serve those investors in that future world.
That's what this is about. And we want to do that and we believe you want to do it. That's why I said in my remarks at the outset that we are fundamentally on the same side, the side providing transparency for American investors so that the American markets could continue to be the best in the world.
COMMISSIONER UNGER: Now you're talking.
CHAIRMAN LEVITT: I wish to note that during the course of this one hour and fifteen minute dialogue following the introduction of your formal testimony there was not one mention made of the words "public interest."
COMMISSIONER UNGER: Could I, I'm sorry --the last thing I want to say is, that sounded like the beginning of a dialogue and if you could come next week to talk about the substance--
MR. ELLIOTT: I will be pleased to spend as much time next week as you want talking about that. And, although Chairman Levitt, I did not say "public interest," those particular words, I don't see how youcould have listened to what I just said, without hearing the "pubic interest" writ large.
COMMISSIONER UNGER: If we could talk about the practicalities of the rule instead of the short time frame, I think that would be much more productive.
COMMISSIONER CAREY: I want to reaffirm my desire to have a dialogue with your organization and hope that you will take my colleagues and I up on the invitation to come to speak with us privately as well as publicly.
MR. ELLIOTT: We will do that.
COMMISSIONER UNGER: Quasi-private, actually.
CHAIRMAN LEVITT: I think it was you, Barry, who said it's important to know what investors are thinking? Don't you think that the judgment of CalPERS, representing one of the largest funds in the world and TIAA-CREF, don't you think those views represent what investors are thinking?
MR. MELANCON: I think they are one factor of a variety of investors and a variety of interests, and they are certainly an input mechanism. And I respect the fact that they have opinions, and they can express those opinions and that is part of the inputthat you must consider, but it is not the only input as it relates to investors.
CHAIRMAN LEVITT: Thank you very much for your testimony. We look forward to meeting you again next week.
I'm going to call for a fifteen-minute break. We will begin promptly at 16 minutes after four.
Panel 6 (Afternoon)
CHAIRMAN LEVITT: Okay. Sorry to have delayed all of you. I'm delighted that you are here.
Robert Fox, New York State Board for Public Accountancy; Larry Gelfond, Colorado Accountancy Board; Baxter Rice, California State Board of Accountancy; Ann Ross, Robert Wilkes, South Carolina Accountancy Board.
Who wants to lead off?
MR. FOX: I guess we want to go from left to right.
My name is Robert Fox. I'm the chairman of the New York State Board for Public Accountancy, a member of the American Institute of CPAs and a practicing CPA in upstate New York with a firm of 80 people, not 80,000, 80 people.
I'm also a member of the UniformedAccountancy Act, which is a subcommittee, a joint committee of the National Association of State Boards of Accountancy and the AICPA.
My comments are based on my written testimony and a review of Dan Dustin's testimony, who because of scheduling conflicts is unable to attend today.
As I listened to the testimony earlier today, I thought it was interesting in some of the comments about the historical perspective. In my written testimony, I included a document that I received from Douglas Carmichael who testified before you previously.
I thought that his testimony was excellent, but even beyond that, the document that I submitted to you shows that there is a continuing struggle between the regulators and the practitioners, and I think a reading of that will really highlight the point.
It's further evidence of the continuing struggle with the Metcalf Commission report in the '70s and the GAO report in the 1990's, so I think what we heard from the panel before us, and today is nothing new, and we're here to support the SEC's four principles enumerated by the Commission.
I think, however, that a littleclarification might be helpful in reviewing Dan Goldwasser's testimony.
I found that he and the previous panel can take issue with some items.
I think that the positions and the principles that you stated are laudable and supportable. I think they just need to be explained a little further.
We support the disclosure of potential conflicts of interest, both for public and private companies.
I think anything that sees the light of day is important, and any disclosures that are required I think would be in the public interest.
In regard to independence in appearance, it is important and it represents an attitude, and I fear the attitude of the profession's leaders is to make more money and not to be concerned with the public interest, and I notice that Chairman Levitt mentioned that, and I wanted to stand up and say hooray for him when he made that comment earlier.
Public interest, even though I wear two hats, is very, very important to me.
By the way, I need to have a disclaimer that I didn't make originally because we didn't have timeto review my comments with my board.
These are my personal comments not necessarily a representation of the State Board of Accountancy of New York.
We did review the rule proposal earlier today, but it was too voluminous for them to really digest it as time went on.
As evidenced in prior comments, I am concerned about the pace of the process, and I am concerned about the Independence Standards Board becoming a victim of the process.
I think I heard in Chairman Levitt's comments that their points are being taken into consideration, I take comfort in that.
My main comments are going to be regarding the alternative practice structures in non-CPA ownership and that's the keynote of what I wanted to put in my comments.
I wanted to be a little different than everyone else in regard to the comments.
New York has taken a position against non-CPA ownership, which is a strong position, and there has been a movement towards non-CPA ownership, and I'd like to refer to a couple of paragraphs in my written testimony, and I'd like to take the time toread them. But before I read them, there's one other point I'd like to make.
At our meeting of the State Board this morning, there was a fairly lengthy discussion about assurance services and how assurance services fit in with attest services and the fact that the AICPA is defining assurance services slightly differently when it comes to independence.
I am not clear how assurance services will be taken into consideration by the SEC, but I hope that you will take those into consideration as we go through this.
In the third paragraph on page 5 of my written testimony, I wrote as follows: When one looks closely at the structures of most major firms and the structure of an APS, it is hard to discern any difference except for the origin of the firm.
If someone wants to claim that there is a difference, how will they explain the difference when proposed alliances with vendors occur and/or the nature of services continues to expand.
With a narrowed definition of independence, it should be expected that legal structures would be created so that regulation can be avoided and that only the audit team will meet the independencerequirements.
The single entity concept question in the APS structures should be considered closely.
In the last paragraph on that same page, I state: We as regulators need to evaluate the definition of independence with continuing evolution in mind.
We along with Congress need to determine whether we are willing to accept the firewall approach, which will provide sufficient protection of the public interest, or whether public accounting should be structured in a niche that assures independence as it has been perceived by the public in the past.
In my final statement on the last page, I think I come to what probably most people don't think about.
I am convinced that when you look at the structure of a CPA firm in an alternative practice structure from the structure of the committee that developed the practice memorandum, you'll see that the monopoly privilege given to CPAs in 1933 should be reexamined.
I do not favor allowing 100 percent non-CPA ownership of CPA firms, but it might be the onlyalternative if the profession keeps pushing for one-stop shopping.
MR. GELFOND: Chairman Levitt and Commissioners, good afternoon, and thank you for the opportunity to address you today on this very important matter.
My name is Larry Gelfond. I am a senior director with the local accounting firm of Gelfond, Hochstadt, Pangburn & Company in Denver, Colorado.
Our entire organization has approximately 80 professionals and we represent upwards of 20 SEC clients.
I hold a number of professional designations in addition to my CPA.
Today I come before you as a practicing CPA for over 35 years.
The past 12 years I have served as a member of the Colorado State Board of Accountants appointed by the Governor of Colorado.
During this period, I have served as president of the board three times.
Although I have served as a state regulator, my comments today are personal to me and are not to be interpreted as an official position of the Colorado State Board or NASBA. Both organizations may filetheir own official responses.
As a regulator, I have had the good fortune of voting on the granting of CPA licenses and the responsibility of upholding the rules and regulation of the state of Colorado.
At times, I was called upon to punish or suspend CPAs for their actions.
I have dealt with the SEC, the OCG, various other U.S. departments in connection with audit failures and discipline actions against individual CPAs and CPA firms.
Needless to say, there are numerous state agencies and local municipalities using the services of CPAs.
In addition, I have dealt with the self-regulated organizations such as the AICPA and the Colorado Society of CPAs.
I am a member in good standing of both organizations, and I also hold both of these organizations in high regard, although today candidly I thought I was present at Family Feud, but be that as it is, I believe that the AICPA in its official position on independence is attempting to hold on to an old bastion of service provided by its members.
I firmly believe the SEC is taking a correctposition in this long debated area of concern to the profession.
Many of my comments and thoughts are set forth in my official paper previously provided to the Commission.
I would like to emphasize a few points covered in my official statement and then answer any questions the Commission may have.
The rules that might come from the SEC will have significant influence on regulatory bodies.
I caution the Commission to move with understanding and clarity. This issue must be dealt without confusion.
The public expects no less.
The Big Five in anticipation of broad sweeping changes are looking at or having accomplished divestiture of their consulting practices.
I firmly believe that the auditing profession can prosper without the question of independence influencing the work of the CPAs.
In closing, I want to comment on the panel on audit effectiveness, which I had the pleasure of recently addressing.
In a very comprehensive and technical exposure draft, the panel considered in somewhatdetail the question of independence in Chapter 5.
Unfortunately, the panel did not come to a conclusion.
I believe the SEC's proposal will clearly accomplish what the panel and public oversight board have not been able to do.
Auditors should be independent, irrespective of other assignments and the rules of independence should apply across the board to all audit assignments.
Large or small, SEC or private.
As I indicated in my written statement, I currently spend a substantial amount of my time in the forensic arena.
In that capacity, I'm often called upon by our clients to testify as an expert witness for them.
I always reject these engagements, due to the appearance of lack of independence to either the judge or jury.
I learned early in my career that juries and judges have difficulty in looking at my independence, when in fact my firm represents the client, even though I may have had no involvement with that client. I will, sir, serve as a fact witness, though.
In attempting to modernize SEC rules, Iquestion the need to change existing rules, especially financial interests in the audit client.
In this modern day of on-line computer capability, there is no reason for CPAs not to learn and be aware of potential conflicts of interest with audit clients.
Finally, I listened this morning to a former SEC Commissioner who honestly admits that the repeal of the disclosure rule during his tenure was unfortunate and today feels that its reinstatement would not go far enough and supports total separation of audit and consulting firms.
Again, thank you and may I applaud you in this very difficult task before you.
CHAIRMAN LEVITT: Thank you very much, Mr. Gelfond.
MR. RICE: Mr. Chairman, members of the Commission and staff. My name is Baxter Rice. I'm the president of the California Board of Accountancy. I should also note that I am not a CPA, I am your ever elusive public member.
My comments reflect my own personal views and I know that my board is going to be supplying you with comments from the Board itself.
First of all, I'd like to commend the Commission for elevating this topic of auditor independence which is universally recognized as the core value of the accounting profession.
However, it's important to recognize that the majority of CPAs in California, we have well over 60,000 CPAs in California, are not serving SEC registrants.
For example, we have government CPAs and we have nonprofit LPAs and persons who do audit some closely held corporations.
So the great majority of our members are not Big Five members, and while they perform scores of audits and other attests works, their clients may not be publicly traded companies, so most licensees may not appear to be directly impacted by the Commission's rules.
However, what the Commission does, and this is something to emphasize what has been I've heard stated here already today, this Commission exercises great moral suasion in the marketplace, and so I also would caution that what you do will have an impact on non-SEC registrant CPAs.
I believe that there will be a number of states that look to the kinds of standards that areset by this Commission and will reflect those in their own regulatory process.
Further speaking as one involved in adopting enforcing regulations in California, I'm especially interested in and will follow closely the discussions of cost and benefits of the proposals, the impact on small businesses and other required analysis.
These critical steps are similar to the exercise we go to in California whenever we adopt or amend a regulation, and I am not aware of the full extent of the fiscal impacts of these regulations.
I also commend the Commission for taking a look at this area, because in this ever-revolving economy and business environment, it's important that we go back and take a look at these regulations and see whether they are really applicable, and whether or not what we do is going to in any way interfere with or is going to enhance auditor independence, including the public perception of auditor independence.
It's important to recognize in our changing world some prohibitions may be rendered obsolete.
The proposed restrictions on nonaudit services are the most controversial segment in my mind.
I would echo the previous comments that it'simportant to consider the impact of providing these services and what impact they may have upon the appearance in fact of independence as well as upon the ability of firms to provide quality audits.
However, I remain concerned regarding the availability and affordability of nonaudit services to the public.
The Commission's proposal suggests that there are services that may be permitted as a natural outgrowth of audit process and that providing these services would not impair an auditor's independence.
Examples include business risk assessments, tax services, actuarial evaluations and so forth.
I agree that providing these services could be very important for quality audits.
I also endorse the concept that these services could impair independence if they involve the auditor making management decisions or operating the client's internal controls or information systems.
On the topic of disclosure, the California Board would traditionally support disclosure requirements where such disclosure would assist the public in making informed choices.
There are limitations to the value of disclosure on proxy statements because proxystatements have less relevance to investment decisions than to shareholder voting decisions.
Therefore, if disclosure is adopted as a part of the solution, the placement enforcement of disclosure statements needs to be evaluated to be sure it provides the type of information that is meaningful to investors.
Thank you again for your willingness to listen to your regulatory partners, the State Boards of Accountancy and we are joined in our mission of public protection.
CHAIRMAN LEVITT: Ms. Ross.
MS. ROSS: Chairman Levitt, members of the Commission, my name is Ann Ross and I appreciate the opportunity to offer testimony relative to the Commission's proposed rules regarding auditor independence.
I speak to you today as a regulator as a partner in a local accounting firm that has practiced before the Commission for over 40 years, and as a member of the Independence Standard Board task force that assisted the ISB in drafting their third standard on employment with audit clients.
As a member of this task force, I was impressed with the ISB and the process the task forceused to deliberate, analyze public comment and draft standard number three. The committee was composed of members of industry, academia, the five largest firms, regulatory bodies, smaller firms and investors.
Each discipline brought a unique perspective to the table which prevented the Commission from having tunnel vision in addressing the issues.
At each and every turn along the way in crafting this standard we were exposed to views and questions even this diverse group of experts had not considered, but were forced to consider because of the deliberative process that is required to address such issues at the ISB. Our issue was only one of many that confronts the profession and the public today.
The SEC and the AICPA agreed jointly to create the Independence Standard Board to address issues of independence. I urge you not to regulate them out of existence and therefore stifle the evolution of considered standards that has been put in place to address all of these issues.
When I started my career in public accounting, advertising and direct solicitation were absolutely prohibited as a threat to auditor integrity and independence.
But times have changed and so have the rules regarding advertising and direct solicitation.
Lifting of this ban improved competition and effectiveness of the audit process.
The times are changing even faster now. The accounting profession which you acknowledge is part of the backbone of the American capital markets can't be relegated to providing only audit and tax services to its clients.
There are many who believe that if this proposed rule is implemented, it will filter down through other regulatory agencies such as the banking regulatory agencies and the State Boards of Accountancy and significantly limit the practice in all firms.
In order to keep the accounting profession as a viable part of the new economy, and insure the strength of audit resources and staff, one must realize to a very great extent what is good for the accounting profession in these changing times is also good for our investing public.
As a partner in an accounting firm, I can tell you that providing certain nonaudit services are part of what we offer to our clients add tremendous value to the audit services we provide.
I would like to address one of these types of nonaudit services specifically. The smaller public companies such as the ones we deal with look to us as a resource for highly technical professional services and advice.
These companies are not able to attract the talented people for their internal audit departments that the General Motors of this world are able to attract and retain.
Internal outsourcing if conducted by the outside accountant under the current AICPA standards offers these smaller public companies a viable alternative.
From the audit perspective, the more you know about the company you audit, the higher the quality of your audit.
The questions that must be asked are would these clients be better off without internal audit services, or would they be better off having to procure these services from other accountants not familiar with their business.
ISB rules are in place for disclosure of and communication about these services with audit committees.
I support disclosure arrangements and thecompany's filing with the Commission to allow an informed and knowledgeable investing public to make these judgments for themselves.
I compliment the Commission on the depth and intensity of the proposed rules and I fully support the modernization of the financial interest and family relationship rules.
The Commission's definition of the engagement team in crafting part of this rule may offer an alternative to addressing some of the other issues.
If safeguards in internal firm structure could be designed so that the independence of the audit engagement team could be preserved, perhaps the Commission would not see the need for an outright ban on nonaudit services.
Clear professional standards have been established and tested over time requiring CPAs to be independent.
Although generally developed by the profession itself through the AICPA, these standards have been adopted into law in all states and are enforced by all boards of accountancy.
The role of these state boards cannot be overemphasized and should not be ignored.
If and when an independence violation occurs, the South Carolina Board of Accountancy is prepared to enforce the law by taking action against the individual CPA.
The ISB has thus far embraced the concept of independence in fact and appearance and is working diligently to promulgate appropriately updated standards addressing various areas relating to independence.
As it relates to the Commission's proposed rule, I respectfully urge the Commission to let the ISB continue with and complete its work using the deliberative model that has been employed.
Let the new rules regarding communications with audit committees and new proxy disclosure requirements if deemed necessary for full disclosure have a chance to work.
To quote Chairman Allen of the ISB, there is no reason to believe that information about nonaudit services, if in fact it is information that relates to the integrity of the financial disclosure and thus to financial risk, will not be priced by the market analyst evaluating risk.
The principle of full and adequate disclosure has been a sound basis for regulation ofour capital markets and a test for what knowledgeable investors value.
Please give these alternatives a chance to work and guide us towards future regulation.
CHAIRMAN LEVITT: Mr. Wilkes, do you associate yourself with Ms. Ross' comments?
MR. WILKES: Yes, I do.
CHAIRMAN LEVITT: You know, Ms. Ross, that the independent members, all four of them, of the ISB, testified and unanimously asked the Commission to address this issue.
MS. ROSS: Yes, sir.
CHAIRMAN LEVITT: And would you favor increasing the public representation on the board of the ISB so that the public would be reassured that the public interest is being more adequately represented?
Because you have a situation where four members represent the profession, four represent independent members.
Would you support increasing the public representation?
MS. ROSS: The only way I can answer that question is to deal with the task force that I served on.
CHAIRMAN LEVITT: I can't hear you.
MS. ROSS: I'm sorry, the only way I can answer that question is to relate it to the task force that I served on since I don't serve on the Independent Standard Board itself.
There were probably four members from the profession, including myself, and probably six or seven members from, as I said, academia, investors and various disciplines and there really didn't seem to be a whole lot of discord.
If you all feel that the public is not adequately represented, I would encourage you to go forward with additional independent members on the Independence Standards Board.
CHAIRMAN LEVITT: How much weight would you give to the fact that these very distinguished people decided and they are an extraordinary group, have asked the Commission to do this?
MS. ROSS: If they feel it's that important, then that would be the impetus to do it.
CHAIRMAN LEVITT: They did so testify.
MS. ROSS: Yes, sir.
CHAIRMAN LEVITT: You raise an interesting point about the obligations of public agencies to be on the job.
Do you think that the preservation of thestatus quo in this area would detract from that sense that the SEC and State Boards are on the job?
MS. ROSS: I would have to just address the State Boards.
Our board is very active in going after bad accounting in the State of California. We have several review processes in place that lead us to cases we want to deal with.
In the six years I've been on the board, I can't honestly say we've dealt with an independence case at the board level, but we do try to move forward with as much speed as we can to deal with those issues brought before us.
CHAIRMAN LEVITT: Do you share our concern that the major groups representing the accounting profession, the AICPA, has not done a very comprehensive job with respect to the discipline procedures?
How do you think we can improve self regulation that should be the responsibility of whatever groups that may be out there?
MS. ROSS: One of my board members serves on the Joint Ethics and Enforcement Commission of the AICPA, and his sense is that, it has been proactive. He's one of the staunchest right wing supporters ofindependence rules of the Commission that we have on our board.
That's the only perspective I can judge the AICPA on.
CHAIRMAN LEVITT: Would you agree that the vast majority of independent accountants, the smaller ones in particular, this ruling would have no effect on them whatsoever?
MS. ROSS: If it comes down through the banking regulators--
CHAIRMAN LEVITT: It won't, it comes from us, and the banking regulators this morning testified that they would much prefer the SEC to handle this.
MS. ROSS: And I got the impression that they would follow suit as well, and that would affect a lot of the local accounting practitioners.
Now, I may be wrong--
COMMISSIONER UNGER: I think they were thinking they wouldn't have to if we do. In fact that would be duplicative and it would be better to have a uniform standard for all, rather than just banks as institutions.
MS. ROSS: You're dealing with the publicly registered banks.
I'm dealing with the closely held banks,community banks.
COMMISSIONER CAREY: State bank regulators would follow suit, is that what you're referring to?
MS. ROSS: That's exactly what I'm saying, and it would affect a lot of local accounting practitioners that don't practice before the Commission.
CHAIRMAN LEVITT: Mr. Gelfond, could you talk a little more about compensation?
Is compensation totally based on auditing or does consulting figure in the mix, and if so, how much?
MR. GELFOND: I've had the experience of both being with a relatively large national accounting firm as well as local accounting firms.
Partners are measured by the amount of business that they generate, the referrals that they bring in, and the jobs that they handle. Obviously, their ability to generate more fees has a direct relationship in many of these firms, including my own, to their compensation.
CHAIRMAN LEVITT: You say that audits are increasingly becoming a commodity. I guess you're saying they're a loss leader to an eventual consulting contract.
What led you to this conclusion?
MR. GELFOND: Once again, 35 years of experience has demonstrated to me that there are firms that are anxious to get their foot in the door, and ultimately then sell other kinds of services to that firm, and if those services can be consulting services, they can be tax related to key executives, they can be financial planning, a whole host of other services.
CHAIRMAN LEVITT: As a regulator, have you found that the AICPA is willing and able to consistently or even occasionally take action against its own members who have violated the rules?
MR. GELFOND: I am aware that the AICPA has investigator provisions within its various disciplines.
The problem is it's the state, the State Boards that grant licenses and really have the ultimate authority for either taking that license or really punish it.
Our personal experience, and again I'm only speaking from the State of Colorado, has been that at times the AICPA has not been as cooperative as it ought to be, and in many respects, we typically will find out about an AICPA investigation through amonthly report that is sent out to the public at large, under a column headed "disciplinary actions taken by the AICPA."
CHAIRMAN LEVITT: Do you think that this rule is going to hurt small firms?
You're a member of a smaller accounting firm.
MR. GELFOND: Again, having said I thought I was at Family Feud today, I frankly am at a loss to understand, and again with all due respect to Mr. Shamis, but I really found his remarks to be, frankly, remarkable.
I do not believe that it will in any way hinder our firm. In many respects it may even benefit our firm.
CHAIRMAN LEVITT: I certainly would think so.
If I headed a small accounting firm, I would cheer the Commission on as creating opportunities for me that never before existed.
MR. GELFOND: I look at this, frankly, as an opportunity, particularly in the internal audit functions to step in, and given our experience, to work with management and with their respective independent auditor, let's say a Big Five firm, thatthis is an area that we can frankly look at as a new revenue generator.
CHAIRMAN LEVITT: Mr. Fox, you mentioned briefly that you had concerns of the AICPA's XYZ program.
What specifically concerns you?
MR. FOX: I must be a traditionalist, but I'm very concerned that the value of my license and the public's perception of that license is going to be diminished when it becomes another one of the alphabet soup titles that people in the various professions now use.
We have CMAs, we have CAs, we have CFPs, some of them licensed, some of them not.
And I feel that the CPA license has been unique. It's been something where the public interest has been of prime concern.
CHAIRMAN LEVITT: The AICPA, as all trade groups, I would suppose, should try to balance the interests of all of their members fairly and openly.
Yet, it appears that they're taking a very public position on behalf of three of the Big Five firms in open position to the largest of all accounting firms and one of the other Big Five firms.
MR. FOX: That's a good question. I wish I had the answer.
CHAIRMAN LEVITT: Don't you think if this dialogue is to be constructive, that the trade organization should manifest the kind of balance that would take cognizance of the views of all sides to the debate and stand somewhat removed from partisan aspects.
MR. FOX: You mentioned something earlier that I wanted to applaud and that is the public interest versus the ability to generate more income.
And a member, a public member of our board this morning said he's wondering if the word "greed" is starting to come into the lexicon.
As we were riding into the airport this morning, we were comparing the desire and the need of the professionals to make more money to the public interest. I think is something of concern to a number of us.
I guess the question is how much money is enough money for the best and the brightest to accept a position in the area of public accountant.
As a traditionalist, I guess that I can make a pretty good amount of money as an auditor, and if the Commission allows certain other areas such astaxes, which historically are areas that are complementary to the areas that we typically see in the audit and certain other areas, I think we can still have a very good nearby area where professionals can practice and maintain the independence that you're trying to protect.
Because of the limitations on our speech, I wasn't able to get into it, but I hope you will take a look at my comments concerning nearby versus one-stop shopping.
CHAIRMAN LEVITT: I certainly will.
COMMISSIONER UNGER: Thank you.
I don't know if you touched on this, Mr. Chairman, but Mr. Gelfond, you say in your testimony that audit failures are caused by budget constraints. That's one of the reasons that audit failures can occur.
Does the loss leader engagement result in that kind of budget constraint that can lead to an audit failure?
MR. GELFOND: Clearly.
COMMISSIONER UNGER: Do you think that's occurring more and more?
MR. GELFOND: Audit failures occur becauseauditors become careless and in the oversight or reliance on something, they may be taking a shortcut.
Clearly where an audit is low bid, there is that concern.
COMMISSIONER UNGER: That there is a failure as a result of lack of resources devoted to it?
MR. GELFOND: Yes.
COMMISSIONER UNGER: And how prevalent do you think the loss leader engagements in the industry are now?
MR. GELFOND: I think for a number of years it was a lot more prevalent for the number of big firms than they are today.
I think in light of some of the audit failures that occurred in the banking industry, big firms have become a lot more aware of the concern about taking on work just for the sake of taking on work.
But clearly, this is an age old problem. People are out there shopping for the lowest bidder.
COMMISSIONER UNGER: So they could get the much more lucrative consulting business? Or so it appears.
MR. GELFOND: In some instances that's true.
COMMISSIONER UNGER: And how effective isthat tactic?
MR. GELFOND: I find it interesting.
I heard the number bandied around of 20 percent of the fees generated from existing audit clients.
I have no way of documenting that.
It seems rather on the low side to me, but I know for a fact, because having represented large clients, that big firms when they get their foot in the door, try to sell a whole plethora of services to their clients.
Again, there's consulting, it's tax, it's all related to this one-stop shopping services that they could provide.
COMMISSIONER UNGER: Do you think that our current proposal, if it's implemented, and it becomes a rule, could possibly drive some of the big firms out of the auditing business into the consulting business, and sort of change the dynamics of referrals generally?
MR. GELFOND: I listened for two days of the testimony of the panel on audit effectiveness and most of, actually all Big Five firms were represented and they testified on the significance of their auditing business.
So I highly doubt that they would get out of the auditing business. But clearly their consulting practices are valuable and only indicated by the amount of the transactions that have occurred or are to occur.
COMMISSIONER UNGER: Do you have a sense, maybe Ms. Ross could answer this, the extent to which smaller firms provide the consulting services, if at all?
MS. ROSS: I would say that generally they don't provide the broad range of consulting services, but for instance, we had a specialty in the banking industry for a number of years, as long as I've been at the firm and beyond, so therefore we developed a specialty in doing partially outsourced internal audits.
That would be the bulk of the practice that we do, and I think probably most local firms.
You're seeing some local firms getting into investment services but obviously not with our SEC clients, we would never consider that.
Whether or not we do human resources consulting, if we had a client that lost a controller and they narrow their field down to two candidates, they may ask us to interview those two candidates andget our opinion.
Is that human resources consulting?
That's probably something we've done for years with our clients.
It's more of a depth of relationship and experience with our client than trying to generate fees.
My firm is heavily audit-based, we always have been. The consulting services are not something we're into right now.
COMMISSIONER UNGER: What percentage of your revenues are from consulting services?
MS. ROSS: Probably less than 5 percent.
COMMISSIONER UNGER: So have you ever done a loss leader engagement?
MS. ROSS: Not to my knowledge.
The loss leader for us used to be governmental work, because the summertime would not support the number of people we wanted to employ, but we've gotten away from doing that as well.
COMMISSIONER UNGER: Mr. Fox, you had said in your, at least in the written testimony, that the AICPA doesn't reflect your views or the views of many other practitioners or independence. And I know that the Chairman asked you about that a little bit.
What are your views on independence?
MR. FOX: I think it was more the ideas of addressing the appearance of independence and the fact it involves two components not just one.
Earlier today I heard Mr. Elliott say he did believe independence in appearance was important, which is different than what I thought I heard him say previously.
So if that is the position, I think it's important that you see independence in appearance and in fact. And as I think I indicated in my written testimony, independence in appearance is in the eyes of the beholder and I think it's important that the public, the investing public, feel comfortable that we as professionals are providing the kinds of services and the independence that they expect of us.
COMMISSIONER UNGER: Some people support the idea of having enhanced disclosure in proxy or elsewhere about potential conflicts, but if in fact there's concern among investors about the integrity of the financial statements generally and there might be conflicts present or I guess a compromising of the independence, will people have faith in the financial statements to start with as a foundation and will the disclosure be able to cure that lack of confidence inthe financial statements?
MR. FOX: I'd like to let them make that decision, and to see the light of day rather than it not be there for them to make that decision.
COMMISSIONER UNGER: Mr. Gelfond?
MR. GELFOND: If I could comment on that.
There are two aspects of that.
One has to do with getting back to Chairman O'Malley's panel.
It seems like they're waiting for an accident to happen so that they then can change the rules.
They obviously have enough evidence to be concerned, and yet there seems to be this waiting to have the accident occur.
The other part that I just wanted to mention, the second part of the last comment, and that is that I clearly think it is viable and should be changed.
COMMISSIONER UNGER: I'm sorry, that what should be changed?
MR. GELFOND: Your last comment to Mr. Fox.
COMMISSIONER UNGER: Oh, the question was whether, if in fact disclosure after the fact, as it were, the financial statements, they could be perhapscompromised by independence, can disclosing that restore--
MR. GELFOND: I guess I would throw the question back and say if the audit was a million dollars and the consulting engagement was $10 million, you draw your own conclusions as to where the firm might be having its interests best served.
COMMISSIONER UNGER: But generally if the public feels there's an independence issue with respect to the quality of financial statements and that in fact financial statements aren't in fact as reliable as they could be, then what can you do about that?
That's such a fundamental position or perspective--
MR. GELFOND: I think you've taken the appropriate steps to reduce that concern, if not eliminate it entirely.
COMMISSIONER UNGER: Thank you, and I apologize for keeping you waiting for such a period of time.
CHAIRMAN LEVITT: You know, your point, Mr. Gelfond, is very well taken, and if you extend it to those areas which are not clear independenceviolations but are more subtle, are judgment calls.
There are many, many more of those judgment calls that have a far greater impact on public confidence and on the integrity of financial reporting and on the whole issue of managed earnings.
Where is the accountant going to come down on a close call if it doesn't raise legality issues, if they receive $10 million in consulting, and a million dollars for the audit, and isn't it kind of irrelevant where they come down, where will the public believe they're going to come down?
MR. GELFOND: Again, we're back to this area of perception, which clearly the AICPA takes exception to, but I think you and I all know that in the real world, people look at the numbers, the significance of those numbers and that clearly would have, at least I believe in the investing public's eyes, the issue of independence and objectivity.
CHAIRMAN LEVITT: All right.
COMMISSIONER CAREY: Thank you, I only have a couple of questions and I'll address it to anyone who wishes to respond, and that is if you can elaborate more on the points in some of your testimony that two sets of standards will evolve, what will bethe impact on the investing public or the profession, and--
MR. GELFOND: If I could, because I did have occasion to talk with the chief accountant about this--
COMMISSIONER CAREY: And I apologize if any of this is repetitive, because I was off the dias.
MR. GELFOND: There are some very, very large private companies.
As a matter of fact, one of the largest companies in the country is Cargill and they're privately owned.
To suggest you might have a different set of independence rules for that company versus my very, very small SEC client who may only have $100,000 worth of revenue and a couple of million dollars in assets, you know, I believe may have some inappropriate occurrences.
COMMISSIONER CAREY: I'm not sure I understand how that would be caused by the--proposed rule.
MR. GELFOND: You'd have one set of rules for independence for SEC clients, the presumption being that all SEC clients are large, yet there are some very large privately owned companies.
COMMISSIONER CAREY: Would you make the assertion that State Board of Accountancy and other state regulators would probably adopt rules similar to that of the SEC's?
MR. GELFOND: Again, this is only my opinion, but I believe it would have significant influence, yes.
COMMISSIONER CAREY: Which would have a curative effect on the Cargill example, no?
MR. GELFOND: Yes.
COMMISSIONER CAREY: Okay, thank you.
CHAIRMAN LEVITT: Thank you very much.
Panel 7 (Afternoon)
Panel 8 (Afternoon)
I'd like to combine the next two panels, if I might, Graham Ward, Elise Neils, Thomas DeFazio and Richard Stegmeier.
MR. DeFAZIO: Good afternoon. My name is Thomas C. DeFazio. I'm currently the executive vice president and chief financial officer of VirtualCom, Incorporated.
Previously I served as a senior executive and officer of four public companies, two with multi billion dollar capitalization and revenue.
I appreciate the opportunity and I thank you for permitting me to testify today about the relationships between corporations and their auditors.
It's an issue that has been of great importance to me throughout my career.
First to put this in context, let me start by saying I commend the many contributions of the SEC over the years of my career in enhancing the rules that it created what I consider to be a very effective and successful system of checks and balances.
One that makes our capital markets the best in the world. And in particular, I commend the recent efforts that have enhanced the role of audit committees in that system.
My testimony today is shaped as many years as an operational financial and senior executive of four companies listed on the New York Stock Exchange.
Most recently I held the positions of executive vice president, chief financial officer and subsequently president and chief operating officer of Autotote Corporation.
Over the years I have routinely employed the audit and nonaudit services of at least three of what are now the Big Five accounting firms, and in fact, I've retained those same firms to perform many of the nonaudit services that would be proscribed under the proposed rule.
Based on my experience, I unequivocallybelieve that, one, corporate executives must and properly do rely heavily upon their auditors to provide expertise on a variety of issues, and that those executives need the freedom to select the firm best suited for each project.
Second, that the Commission's rule proposal would destroy the benefits that are created by retaining the audit firm for various nonaudit services, and third, that the provision of both audit and nonaudit services has never in my personal experience, compromised the quality of an audit or the auditor's independence.
The written testimony that I submitted to the Commission addresses each of the issues in more detail, and I ask that it be included in the record, but because of the abbreviated time available, I will only summarize the major issues in that report.
First, corporate executives rely heavily upon outside professional assistance and need the freedom to select the best firm for each project.
In many cases, I have chosen to retain the company's audit firm to perform nonaudit services.
I've long considered the audit firm to be a valued and a trusted consultant whenever I need advice.
It's a trusted adviser with integrity, a high ethical and professional standard, who I can rely on to help me fulfill my fiduciary responsibility as chief financial officer and to serve the public interest and the shareholder interests in my company.
Executives decide, and appropriately so, whether to retain the company's audit firm or a different firm on a case-by-case basis. And in my opinion, this discretion to evaluate each case on its own merits, should remain with the private sector users of nonaudit services.
The Commission's proposed rule in many circumstances would limit and impair the executive's ability to choose the best business solution, whether that is to retain the company's audit firm or a completely different firm.
Without that freedom of choice, executives would in some cases be forced to retain their second choice firm for a particular project, simply because the most knowledgeable provider of that service might be prohibited from performing the work.
Indeed, multiple providers could be ineligible for particular projects, because they either provide external audit services or installed systems or were involved in some other area.
Second, the Commission's rule would destroy the benefits that are created by retaining the audit firm for various nonaudit services.
I believe the proposed rule fails to acknowledge the legitimate reasons why executives like myself repeatedly turn to the company's audit firm for professional assistance on a variety of matters.
The rule proposal ignores the value that corporations retain in obtaining their audit firm to perform those nonaudit services.
Executives like myself routinely seek the assistance of their audit firm because the auditors already have a base of knowledge, a requisite familiarity with the corporation's business and that audit firm can in many instances provide valuable advice to executives in need of particular expertise.
Because of that familiarity, the audit firm's more likely to provide a solution that's not only workable, but preferable.
At best, retaining a different firm for every project is inefficient, it's costly and it's more prone to errors of omission for lack of that knowledge.
The audit firm can provide more often than not, the needed expertise quickly and at a lower cost.
Third, the provision of nonaudit services does not jeopardize or compromise the quality of the audit or the auditor's independence.
In fact, I have found that an audit firm's performance of multiple complementary functions can actually improve the quality of the audit.
Can and does.
The audit team gains valuable insights into the structure of a company's system, including specific risks, control issues and what have you from the nonaudit specialists who create or implement systems.
The audit team can then incorporate the insights of those nonaudit specialists into the planning and the execution of the audit that enables them to fine tune the audit and heighten their focus on the areas that are worthy of special attention.
Perhaps most importantly, I believe firmly that the audit firm's added knowledge increases both the company's accountability in the external audit and the audit firm's accountability to the company to provide a quality audit because of its familiarity with its system.
I personally develop higher expectations in terms of the quality of the audit because of thefirm's familiarity with the company and frankly, it takes away any excuses they may have or would have otherwise for lack of knowledge.
So the point is, contrary to the Commission's assumptions, the provision of nonaudit services does not pressure the audit firms to look the other way.
In fact, it actually decreases the intensity and thoroughness of an audit.
CHAIRMAN LEVITT: Thank you very much, Mr. DeFazio, your time has expired.
May I call on Graham Ward, the Institute of Chartered Accountants in England and Wales.
MR. WARD: Thank you, Chairman Levitt, Commissioner Unger. The Institute of Chartered Accountants in England and Wales is the leading professional accountancy body in the United Kingdom and the second largest in the world. We have more than 116,000 members in practice, commerce and the investment community.
We have delegated authority from our government to regulate auditors in the public interest, to set and enforce audit regulations, to authorize individuals and firms to be statutory auditors, and to discipline them, includingwithdrawing their authorization. Our annual report on this activity is laid before Parliament.
The SEC's auditor independence rules have a notable impact on auditing in the United Kingdom, where over 110 companies have additional listings in the U.S. Accordingly, the Institute has been following with interest the SEC's proposals to amend these rules and I welcome this opportunity to comment. In view of the time available, I will restrict my spoken comments to the key points in our testimony.
We fully support your overriding objective of independence in auditing. This objective of independence should be an aim throughout the world. There are,however, some points of principle where we differ from your approach. In outline, we believe that a rule based approach founded on the structure of the U.S. domestic economy and U.S. domestic law is unlikely to be a fair or practical approach to global achievement of sound independence objectives. A more practical and globally transplantable system of regulation is the threats and safeguards framework adopted by the International Federation of Accountants. There is no evidence that the performance of many nonaudit services affects independence.
The accounting profession in the UK is resolute in its commitment to objectivity and independence in auditing. However, the approach to auditor independence adopted in the UK by the International Federation of Accountants and favored in the European union differs from that followed by the SEC. Our ethical requirements on objectivity and independence are based on a framework approach which sets out fundamental ethical principles, a reasoned analysis of the possible threats to these principles and linked to guidance on the safeguards which may be necessary to mitigate those threats.
The ethical requirements are backed by professional education and firm enforcement through our monitoring and discipline processes. We believe that this approach is in practice more rigorous than a detailed rule based approach. It allows for variations in practice throughout the business world and can respond rapidly and flexibly to today's fast moving business environment.
I do think it is worth quoting a leading UK journalist in the field who recently summarized the issue as: "Principles encourage compliance. Regulations encourage deception."
Notwithstanding our differences in approach,we of course share the key aim of insuring that auditors are independent and can to a reasonable and informed observer be seen to be independent. Although we have fundamental reservations about a rule based system, we welcome your intention to update some of the more out of date rules and to establish governing principles to determine what rules should be set. However, we believe that these principles should be enhanced in a number of ways set out in our written submissions.
Subject to some points of detail relating to the specific definitions, we welcome the proposal to rationalize the rules on financial, employment and business relationships. As you may be aware, some of the existing rules have had rather strange consequences when applied in a UK context. However, I would add that the characteristics of many of the investment vehicles caught by the proposal are not always the same in other countries as in the U.S. We have given a number of examples in our submission which I hope will illustrate that the revised proposals may still produce unintended results.
In addition, some of your proposals are likely to conflict with European law.
The other principle aspect of your newproposal with which we do not agree is in respect of the detailed and precise prohibitions intended to be placed on certain nonaudit services. We believe one of the advantages of the framework approach to be its ability to cope with many different circumstances. Detailed rules can be a blunt instrument, sometimes imposing inappropriate solutions or indeed simply missing the problem. The framework approach starts from the premise that when an auditor provides nonaudit services there may be a threat to independence which must be mitigated by adequate safeguards that the auditor will have to demonstrate. That is key. In a few instances such as participation in client management, no safeguards are possible, in which case prohibitions are appropriate. However, except in those few circumstances, we believe that it is important that companies should be allowed to purchase and auditors be allowed to provide additional services if companies decide that's in the best interests of their shareholders.
We believe that the auditors must not be put in a position of having to audit a significant component of the financial statements to which they are linked either because they have generated the information themselves or because they are in anadvocacy position in respect of that information.
It follows from this principle that an auditor should never take management decisions and that it may also be appropriate to prohibit valuation and legal advocacy work that involves an element of subjective judgment and is material to the audit engagement. However, in other areas, adequate safeguards can be put into place to insure that management retains decision making control and the output is subject to proper audit scrutiny.
Blanket prohibitions are inappropriate. The decision on whether no audit services can be provided by the auditor must reflect the circumstances. As to whether the provision of nonaudit services by auditors should be prohibited because it creates economic dependency on the client, we believe that the best way to deal with this threat is through a limit on the proportion of a firm's total fees income that can be earned for all assignments from any one client.
As far as disclosure of nonaudit services is concerned, we endorse the principle of disclosure, subject to some concerns about the very detailed requirements which you currently propose. Nonaudit fees paid to auditors in the UK have had to be disclosed by law for some years and the working partyof my Institute has recently recommended that this disclosure be extended to describe the broad nature though not the full details of the services provided.
Significant strides have been made in terms of the independence and functions of audit committees for listed companies in the UK in recent years. We note similar developments in the U.S. through the work of the Blue Ribbon committee, the SEC and others. Against that background, we believe that adequate disclosure, together with proper attention by audit committees and firm enforcement of ethical guidance should present shareholders with a sensible basis on which to determine whether they are being appropriately served in respect of the provision of professional services.
We understand and share your aim in insuring investor confidence and auditor independence. We firmly believed that an internationally developed framework approach, based on that of the IFAC, which can be applied throughout the world is the best way to achieve this.
In conclusion, I would reiterate that I very much appreciate the opportunity to comment on your proposal and I will attempt to answer any questions you may have.
CHAIRMAN LEVITT: Thank you, sir.
I would urge all panelists to try to stay within the time limit allowed.
All of us have been here for a very long time. I appreciate your courtesy in this regard.
MS. NEILS: My name is Elise Neils and I am managing director of Brand Finance USA, Inc., the American subsidiary of Brand Finance PLC, a London based global brand consultancy and valuation firm.
I am here today to present the results of two studies conducted by Brand Finance that relate to auditor independence in the UK. The first study is an objective examination of audit versus nonaudit fees paid to auditors, and the second study is a survey of UK analyst and company reactions and comments to the first study. In summary, respondents to Brand Finance's survey have fears about a lack of auditor independence based on the first study that showed that the majority of fees paid to auditors is for nonaudit services.
In the first study, Brand Finance researched the annual reports of companies on the FTSE 350 for the years ended 1998 and 1999. In the UK, companiesare required to disclose fees paid to their auditing firms in their annual reports and the fees are distinguished between audit fees and other consulting fees. The FTSE 350 study revealed that nonaudit fees exceeded audit fees and that nonaudit fees are increasing at a faster pace than audit fees. For example, Brand Finances FTSE 350 study revealed that nonaudit fees represented 61.2 percent of total fees paid to auditors in 1998 and increased to 66.9 percent of total fees in 1999.
In our second study, Brand Finance surveyed 292 London equity analysts and 47 London stock exchange listed PLCs on the topic of auditor independence.
Over 90 percent of analysts that responded believe that significant nonaudit fees are likely to compromise audit independence. 76 percent of companies stating an opinion felt that auditor independence is likely to be compromised where significant nonaudit fees are received from audit clients.
Fears of auditor independence being compromised differ greatly according to the type of nonaudit work conducted by the auditor. A significant percentage of respondents believe thataudit independence would tend to be breached where the audit firm was involved in asset valuation, corporate finance, management consulting, treasury management and accounting outsourcing. 59 percent of analysts questioned felt that auditors who provide corporate finance services to their clients would compromise audit independence and judgment. 49 percent of analysts questioned felt that auditors who provide management consultancy to their clients would compromise audit independence and judgment; 46 percent for asset valuation and 38 percent for accounting outsourcing.
50 percent of companies interviewed felt that by providing corporate finance services to their audit clients, accounting firms would tend to compromise audit independence and judgment. Similarly 23 percent for management consultancy, 29 percent for asset valuation and 40 percent for accounting outsourcing.
The majority of analysts interviewed are concerned about the independence of an accounting firm. 61 percent of analysts questioned felt that independent third party intangible asset valuation experts should prepare any such valuations for financial reporting purposes.
Interestingly, only 24 percent of company personnel agreed with the analysts, demonstrating a lack of management concern and perhaps confirming that the reasons why many auditors derive their fees from nonaudit services is that company management may condone the practice.
Analysts are concerned that the acceptance of nonaudit fees by auditors is likely to result in the independence of the audit being compromised. 83 percent of analysts who expressed an opinion believe objectivity is threatened even when the nonaudit fee is less than the audit fee.
In response to the question of whether it would tend to compromise auditor independence if partners or staff in audit firms held shares in their demerged consulting business, the general analyst response was affirmative with 44 percent yes, 30 percent no and 26 percent don't know.
Brand Finance is a global independent brand valuation firm. In our view independence is critical to confidence in our opinions. Not only must we be independent, we must be seen to be independent. The audit is in the same position.
Brand Finance research shows two things. Firstly, that the amount of nonaudit fees has grownsubstantially. The implicit threat to independence is clear. Secondly, it shows concerns among investment analysts that the provision of such services could undermine independence.
CHAIRMAN LEVITT: Thank you very much.
Mr. Stegemeier, Chairman Emeritus of UnoCal Corporation.
MR. STEGEMEIER: Mr. Chairman, thank you for inviting me to be here today as one of only half a dozen business leaders on the panel of 40.
I've come on my own as an independent businessman from UnoCal not representing any audit firm. I testified today because I believe very strongly in the independence and integrity of boards of directors.
I will not comment on the detail of the SEC proposal but rather on its fundamental premise which is that there's a clear and present danger to investors.
To state my viewpoint at the outset, I do not believe that any such danger exists.
I worked for UnoCal Corporation, a midsized international oil and gas company for almost 45 years, serving as its chairman, president, CEO and COO. During the past 20 years, I've also served at varioustimes on nine other corporate board of directors and numerous not-for-profit boards including chairman of the California Chamber of Commerce.
All together, I participated in and/or chaired more than a thousand board and committee meetings including audit committees.
I recognize that meeting attendance does not equate to wisdom, but I believe I've gained a great deal of insight into the hands on day by day workings of real corporations. I will try to be concise and make only four main points.
Number one, rule-making. Is there a need for this new set of rules and will they enhance shareholder value?
During recent years audit committees increasingly have been forced to spend more and more time on rule-making issues in addition to their primary role of corporate financial oversight.
Audit meetings have often been extended several hours in order to have extensive discussions of the legal interpretations and analysis of the many, many proposals brought before us regarding audit.
More often than not the draft proposals have been so vague and ambiguous that audit committees have been compelled to seek outside legal advice toprotect themselves against potential legal actions.
While I recognize and endorse the need to have rules, regulations, and procedures, when does regulatory oversight become micromanagement and a bad substitute for good corporate governance.
The answer to my initial question: there is no need for this new set of rules.
Number two, the audit problem.
Is the concern regarding audit firm independence real or is it merely a perception that has no roots in reality?
We're told that the proposed SEC auditor independence requirements stems from investor perceptions that audit firms will lose their independence if they conduct nonaudit services for the same company.
Long before the SEC brought this matter to public attention, I myself encouraged my fellow colleagues at several companies to begin in-depth discussions of this potentially serious matter.
However, over time I've concluded that the factual evidence has not verified my earlier perceptions and concerns. Occasionally, I've observed cases where the audit firm was given a fairly large nonaudit assignment that was task and timespecific.
We received fair value for our money and there was absolutely no hint of any audit duty compromise.
Now, today you've heard all you want to hear about the AICPA and the public oversight board, but I'm convinced that a new set of regulations, designed to micromanage audit committees, is not only unnecessary but may in fact be detrimental to audit oversight and effectiveness.
In my earlier life as a chief operating officer of UnoCal, I've learned two old adages the hard way: If it ain't broke, don't fix it and don't trade a devil you know for a devil you don't know.
Measured against these principles the proposed rules fail.
Number three, checks and balances.
Do adequate checks and balances already exist?
There are at least five effective checks and balances already in place.
Ultimately, the shareholders of every company are responsible for the direction of that company.
Each year in every company there's aplethora of shareholder proposals, mostly concerned about corporate governance.
If shareholders perceive a real problem, their voices will be heard and appropriate action will be taken, believe me.
On number two, on a regular case by case basis, big institutional investors with their large research staffs analyze the issues and vote their shares based on their professional perceptions of self interest.
It's a 100 percent certainty that they will vote against the ratification of an outside auditor if there's even a slight perception of audit firm impropriety.
Three, the board of directors has a fiduciary and ethical obligation to protect shareholder value.
Failure to do so will result in shareholder revolt and certain defeat of directors and management at the next shareholder meeting.
Four, any audit firm so cavalier and audacious that it would jeopardize its national and even international reputation by favoring its nonaudit services over its audit expertise would soon be destined to oblivion. And finally, there is theominous threat of litigation at the slightest indication of malfeasance or bad judgment by directors, by senior management or by the company's audit firm.
This new set of rules will neither mitigate nor enhance these fundamental factors in the mind of every director.
This is business reality, not academic theory.
In the real world, audit committees comply with but don't rely on rigid rules alone to implement their accumulated wisdom and common sense.
If, on a continuing basis, nonaudit fees are substantially greater than normal audit fees, prudent directors will question management's decisions.
Directors can and will take any of the following actions:
A) ask the audit firm to choose whether it wants to be the audit or the nonaudit service for the company.
B) ask management to put the nonaudit service business out to competitive bid.
And C), replace the audit firm entirely.
This again is the real world. This system works.
Four and lastly, corporate governance.
Will this new set of rules result in improved custody and care by the directors?
Financially, most Fortune 500 company directors are reasonably well off. They don't need the meeting fees or the aggravation of depositions and shareholder discontent.
They give their time and risk their personal life savings because they love business and feel they can make a real contribution to the growth and well-being of the corporation.
They are not mindless robots filling out a true or false questionnaire.
Creative and independent business judgment is a priceless commodity for a successful enterprise.
Many of my colleagues are seriously questioning the wisdom of being a director in today's litigious society.
Some are refusing to serve on audit committees and some will not accept a chairmanship at all.
I fear that the pool of qualified directors willing to serve is shrinking.
Each year CEOs get a number of unsolicited letters from wanna-be directors. Most of these peoplehave little or no business experience. If you read between the lines, it's easy to see that their primary goal is to seek board fees as a source of income.
CHAIRMAN LEVITT: Mr. Stegemeier, could you summarize?
MR. STEGEMEIER: I will give my conclusions right now, Mr. Chairman.
I would caution against rules that are so ambiguous that they are impossible to apply or so rigid and unbending there's no board of director discretion.
If some discretion is allowed, can we determine in advance when it crosses that line?
Must we endure the unnecessary time and expense to educate new consultants merely to satisfy another set of rules addressing a nonexistent problem?
I agree with two of the SEC proposals.
There should be some nondetailed disclosure by corporations of the comparative audit and nonaudit service fees paid to a multi purpose audit firm.
Some companies already do this, and number two, individual auditors and the management team directly above them should not trade stock in their client companies.
This is a no brainer.
Educate the shareholders and let them decide for themselves. If not, the director's tenure is in peril. You can bet your life savings on it. I already have.
CHAIRMAN LEVITT: Thank you very much, Mr. Stegemeier.
I, too, come from the private sector and have chaired and served on a number of audit committees and I, too, am reluctant to substitute rule-making for the private sector process.
However, we are not always able to not take cognizance of circumstances that create the need to consider alternatives and the proliferation of high profile accounting frauds in recent months and years has created, in my judgment at least questions in the minds of investor groups, and I would ask, first of all, whether in the light of cases such as Waste Management, Sunbeam, Microstrategies, Cendant, and W.R. Grace, don't you think it an appropriate topic for the Commission to consider and an appropriate dialogue to take place?
MR. STEGEMEIER: I think I'd have to go back to my original premise that the duty and responsibility falls back on the directors.
There obviously can be cases from time totime in which corporations are poorly served by their directors who don't see the problem that's arising, but I don't necessarily feel that that would change by putting a new set of rules in place. People make mistakes from time to time.
CHAIRMAN LEVITT: What I asked was the proliferation of these cases in recent months, would you not agree that that creates an appropriate cause for a dialogue on this issue?
MR. STEGEMEIER: Absolutely. I agree the dialogue is in place and that's what we're doing today.
CHAIRMAN LEVITT: Now, do you believe in light of your comments with respect to audit committees and the burdens upon those committees, would you feel that today's audit committees are discharging their responsibilities with greater thoroughness than those of say five to ten years ago?
MR. STEGEMEIER: Yes, sir, I think audit committees are much better than they were five or ten years ago and I think much has to do with work your organization has done to insist we have more qualified directors and audit committees.
CHAIRMAN LEVITT: That's constructive, I think we share that feeling.
How many instances do you know of where shareholders have turned down the selection of an auditor?
MR. STEGEMEIER: I don't know of any, sir, but they have that capability.
CHAIRMAN LEVITT: Do you think there has ever been a case where the shareholders have turned down the selection of an auditor?
MR. STEGEMEIER: I don't know that, sir, but I have seen in the last twenty years that shareholder votes for a certain auditor are no longer 99.9 percent, they're sometimes less than that.
CHAIRMAN LEVITT: But from a pragmatic point of view, and I think those of us who have operated businesses tend to be pragmatic about these things, if you see very close to 100 percent of shareholders going along with the auditor recommendation, you probably wouldn't cite that as your foremost argument in favor of the notion that the shareholders do exercise certain judgments with respect to the competence of their auditors.
MR. STEGEMEIER: Perhaps, sir, that's a response to the fact that the directors do their fiduciary duties and sometimes change auditors if they felt they're not getting their money's worth.
CHAIRMAN LEVITT: Do you share the view of the trade group for the industry and certain of the firms, Big Five firms, that perception is irrelevant to public acceptance of the audit?
MR. STEGEMEIER: Perception is a very difficult thing to put any value on and it's hard for me to say whether perception per se should require a company or an audit firm or anybody else to change the way they do things. It certainly should be recognized.
COMMISSIONER CAREY: May I jump in? Would you disagree with the assertion that perception is vital to the confidence that exists in our capital markets?
MR. STEGEMEIER: I don't know.
COMMISSIONER CAREY: But that confidence is based on the perception that our financial reporting system is sound.
MR. STEGEMEIER: I can't speak for shareholders. Obviously I come from the management board side, but I think perception is largely the result of how the company's operating overall.
There can be perceptions about individual bits and pieces and how the direction of a company may change this way or that way, but I think overall,there is a fairly high confidence level in the shareholders of corporations today and the way they're run.
CHAIRMAN LEVITT: You know, I think the study we heard from on your very panel, would suggest that that level of confidence is certainly questioned by some. But I'd like to ask, when you chaired an audit committee, did the auditor ever talk to you about what nonaudit services they were performing?
MR. STEGEMEIER: Yes, sir, they did, on a quite frequent basis. In fact, when we have had audit committee meetings with a number of companies and they were conducting large or small nonaudit functions, we got into some detail with the audit manager and sometimes with the managing director, if he happened to be there, about this very issue.
CHAIRMAN LEVITT: I know that you found that helpful and I think it's very constructive that you agree that we should try to convey that information to the public investor. I think that would go a long way towards addressing this problem.
MR. STEGEMEIER: I think, sir, it would help, let's say, reduce the perception that there are problems if there is better information out there that yes we are talking about these things and if weperceive some kind of problem ourselves we're fully prepared to do something about it.
CHAIRMAN LEVITT: I agree with that.
Now you stated that the proposed rules will have an adverse effect on the quality and effectiveness of the audit committee.
As you probably know, eight of the prohibited services are already prohibited under current SEC and profession rules.
Would you agree that those prohibitions are unlikely to impact audit committee performance?
MR. STEGEMEIER: Sir, I choose not to speak on that subject. I don't know the details of how audit firms are regulated or unregulated vis-a-vis prohibitions, but I think if there are prohibitions already in place and they have been working in the past, I don't have any problem with that.
CHAIRMAN LEVITT: Right. Well, there are eight of the ten and the issue really is to codify those eight and I'm somewhat at a loss to understand why the industry trade group objects to codification of their very rules using their very language.
Now, I greatly appreciate and respect your experience, in the spirit in which you testify. I think you probably recognize that this Commission hasa different mandate and a different responsibility, and that is to protect the public investor first and foremost.
And the circumstance that CalPERS and TIAA-CREF representing some of the largest pension funds in the world, the bulk of shareholders, take such a strong position in favor of this proposal, and the fact that members of the business community representing the CEOs of DuPont, Merck, Techtronics, Pfizer, Johnson & Johnson, all probably colleagues of yours, people you probably know or know of, might suggest this area lacks unanimous resolution, which creates problems when the dialogue comes into a public audience such as this.
So I'm suggesting to you that there are no easy answers.
I share in your feeling that disclosure is a step in the right direction.
I have reservations about whether the recommendations will injure the ability to attract competent directors.
I think not. The same argument was raised when the Blue Ribbon committee made their recommendations, and I think that was a material benefit to the quality of auditing committees, but itis an appropriate dialogue. I've learned long ago, that none of us have a priority on what's right and what isn't, and I respect your views and hope you do mine.
MR. STEGEMEIER: Thank you, sir.
CHAIRMAN LEVITT: Mrs. Neils, based on the work that you've done, do you think the threats and safeguards approach is the most effective way to deal with this problem?
MS. NEILS: No. I believe that rules need to be imposed.
CHAIRMAN LEVITT: Your results are certainly quite compelling. If so many analysts are concerned about this issue, what effect might this have on the cost of capital if the status quo is to be maintained and if this issue which has been debated for nearly 25 years continues to be debated for the next 25?
MS. NEILS: Well, if analysts see it as an issue, certainly it will have an impact on the cost of capital. I'm not sure how it will be impacted, though.
CHAIRMAN LEVITT: Mr. Ward, a number of accounting firms have sold or are in the process of selling their consulting practices.
Do you believe that this will have anyimpact on the quality of the audits performed by these firms?
MR. WARD: There's no evidence that it would have any impact, sir, no.
CHAIRMAN LEVITT: So the argument being cited that consulting services are important, if not vital, to the quality of the audit, would seem to be contradicted by three or four of the Big Five firms divesting themselves of their consulting practice.
Would you not agree with that?
MR. WARD: I think it's a question of what they're divesting themselves of. In many cases they aren't divesting themselves of every single nonaudited service but divesting themselves of things connected with e-commerce and IT. I believe many are looking to retain such things as risk management services with their audit firms.
CHAIRMAN LEVITT: But you would believe that the argument that suggests that the ability to perform advisory services is critical to the performance of a sound audit is questionable in the light of the fact that nearly all of them are selling off their consulting services. Certainly it doesn't reinforce that argument.
MR. WARD: It certainly doesn't reinforcethe argument.
CHAIRMAN LEVITT: I'd like to talk a little bit about the threats and safeguards approach that you say is more practical and globally transportable.
As I understand it, under this approach the auditor would identify the threats to independence, and the auditor would take action to address those threats, is that correct?
MR. WARD: Indeed.
CHAIRMAN LEVITT: If an auditor has sold millions of dollars of consulting arrangements to the client, do you think he is really in the best position to determine what's a threat to independence and what is not?
MR. WARD: I think if the auditor is acting properly, speaking for auditors within the United Kingdom, if they're acting according to our ethical guidance then that's exactly what they would do.
They would be aware that the joint monitoring unit which is the independent practice inspection unit, monitored jointly by my own organization, Institute of Chartered Accountants of Scotland, and send inspectors to the top 20 firms by size covering 90 percent of the companies listed.
Those inspection visits happen every year.
Pretty well the first question that is asked by the inspectors when they're looking at an auditor is in relation to independence.
They will look at the auditor's working papers that identify threats to independence. They will look at the auditor working papers that are looking at safeguards to be introduced in respect to those threats and they will deduce as to whether or not those are appropriate.
CHAIRMAN LEVITT: Mr. DeFazio, I said before that in terms of how this issue impacts the audit, that the decisions auditors make with respect to issues that are not clearly stated are very, very subtle in terms of whether the auditor comes down on one side or another.
Certainly you're familiar with the issue of managed earnings which has been called to public attention in recent months.
I guess when you say you have not encountered a situation where an auditor's independence was compromised by the provision of consulting services, since so much of what an auditor does is played out in terms of degrees of personal judgment, how can you be certain?
MR. DeFAZIO: Well, one can never be 100percent certain of anything in life, I guess you learn that over the years, but certainly my experience has been that the issue and if I may relate to a panel member that was up here before, this panel, the issue in the case of a gentleman or an auditor, if you will, who has a million dollar audit fee and a $10 million nonaudit service fee, is no less an issue if he has no $10 million nonaudit fee and is put into a position of risking the $1 million audit fee for not making the decision that is close, let's say, to the margin in favor of that client.
So the point is that I don't think there's any greater risk of independence because there is another source of revenue than there is when there is no other source of revenue.
CHAIRMAN LEVITT: Okay, Commissioner Carey?
COMMISSIONER CAREY: I have no questions for this panel. Thank you very much for being here today.
CHAIRMAN LEVITT: Commissioner Unger?
COMMISSIONER UNGER: Thank you, Mr. Chairman. I guess I'll pick up where you left off with Mr. DeFazio.
The whole issue of the loss leader relationship is interesting to me. It's nothing knew to the industry but the concept is new to me, but inthe course of your experience, have you ever been on the receiving end of a loss leader engagement?
MR. DeFAZIO: I wish I could say I have, but to my knowledge no, I have not.
I'd like to believe I negotiated an audit fee or any other fee as effectively as I could as a professional, but I do not believe I've ever been the beneficiary of a loss leader fee.
COMMISSIONER UNGER: What does that say to you, what does that suggest to you as an individual, the fact that firms discount substantially their audit fees in hopes of getting consulting fees from a particular client?
MR. DeFAZIO: Well, I don't think there's anything inherently wrong in wanting to grow your business and provide a plethora of services that your firm is capable of performing.
In fact, the question that Chairman Levitt asked of a gentleman on the panel before me from a small audit firm perspective was applauding the proposed rule because his firm would have an opportunity as a small firm to pick up the internal audit function for a client that was now with one of the Big Five.
His motivation is no different than the BigFive firm would be in let's say to use your example providing a loss leader audit fee.
COMMISSIONER UNGER: Except that small firm would be picking up auditing services or an audit contract.
MR. DeFAZIO: I think part of the issue here has to do with internal audit services. It's not only limited to IT consulting as I understand it.
COMMISSIONER UNGER: I think in my mind at least the issue isn't just auditing or consulting, but to what extent can you perform both for a client without compromising one or the other?
That certainly to us is more important that the audit not be compromised.
MR. DeFAZIO: The external audit you're referring to?
COMMISSIONER UNGER: Yes, which brings me to another question I had for you which is you had said in your testimony that to your knowledge, that you had never encountered a situation where an auditing firm, I'm sorry, the auditor's independence was compromised by the provision of other services, is that correct?
MR. DeFAZIO: That is correct.
COMMISSIONER UNGER: So how do you insure that the audit is not compromised or the independenceis not compromised?
MR. DeFAZIO: Well, I think the entire system of checks and balances that are in place apply whether there are nonaudit services provided or not.
COMMISSIONER UNGER: The example you just gave of the one million dollar audit fee.
MR. DeFAZIO: Well, beyond that. I mean, we have the audit committee oversight role, which is another way of having a check or balance against that happening, and again, I don't see if they do their job and I do my job as a senior financial professional what difference it makes.
They should be performing the same role of governance whether there are nonaudit services or audit services to determine if in fact there's a possibility of those audit services being compromised.
COMMISSIONER UNGER: At your particular firm, to what extent do you use your auditor for nonaudit service or your auditing firm?
MR. DeFAZIO: I can't address that in the context of the current firm but in the four firms that I have been with over my long career, I've used them in various capacities.
I have in one instance used the externalauditors to provide internal audit services for a company that was midsized, it was relatively newly listed company that did not have the requisite expertise and could not handle geographic dispersion.
CHAIRMAN LEVITT: The same firm that was the auditor performed the internal audit?
MR. DeFAZIO: Yes, sir.
CHAIRMAN LEVITT: You don't share the feeling expressed by former Chairman Volcker and the Federal Reserve Board and the controller of the currency that that does represent a conflict?
MR. DeFAZIO: No, I do not.
CHAIRMAN LEVITT: It's just as easy to choose someone other than the internal auditor?
MR. DeFAZIO: I think not. I disagree and I think not, because the familiarity that the audit firm already had with the company gave them a distinct advantage of being able to perform what I wanted done in the form of internal audit services.
CHAIRMAN LEVITT: Can you see where an outside observer might look upon that as the auditor auditing his open work?
MR. DeFAZIO: I can see that as a possibility perhaps, but that only causes my expectations on the external audit to be higher thanthey would otherwise be.
COMMISSIONER UNGER: So why can't you comment on this situation with your current firm? Is it a public company?
MR. DeFAZIO: It's a start-up company that really hasn't gotten into this entire--
COMMISSIONER UNGER: It doesn't report yet?
MR. DeFAZIO: Not yet. We're looking forward to the day, however.
COMMISSIONER UNGER: I'll bet. Okay, so you don't have an auditor?
MR. DeFAZIO: No, I didn't say we don't have an auditor, we don't report to the SEC yet.
COMMISSIONER UNGER: I think I'll move on to another witness.
Ms. Neils, how was the survey results that you described to us received by the investor community?
MS. NEILS: Well, it was just recently released, so we haven't really had the reaction yet.
COMMISSIONER UNGER: Have you had the reaction of any of the companies?
MS. NEILS: Yes, some of the companies have responded favorably to the results.
COMMISSIONER UNGER: Mr. Ward, what is theinstitute's experience from the enforcement perspective in terms of the number of enforcement proceedings against auditors?
MR. WARD: I'm sorry, Commissioner, my memory isn't up to the number of proceedings that relate to that.
The disciplinary process of our institute means that we do actually publish where a member is disciplined, be that in so many words from mild such as reprimand to being fined or even expelled, so those things are a matter of public record.
I don't have the statistics with me, but it does happen, it is a real thing that does happen. It's not just theoretical.
COMMISSIONER UNGER: And do you have a sense of what the number of audit failures are from a lack of independence?
MR. WARD: We, I say we, the council have no memory of an audit failure due to lack of independence.
COMMISSIONER UNGER: What do you think of the results of the survey that we heard today?
MR. WARD: Commissioner Carey had some wise words about surveys earlier on during the course of the day.
I have not seen the detail of this survey so I think I would have to say if I were being a responsible professional that I'm not able to offer a full opinion on it, and listening carefully to what was said, I did notice that two of the greatest concerns were identified as accounting outsourcing being done by the auditors and accounts preparation being done by the auditors.
If I may, I will remind you what I said in my opening remarks, that we believe that auditors should not be put in the position of having to audit information which they have generated themselves, so in the case of those two things, the institute would say there is no reasonable safeguard and we would not expect that to happen.
COMMISSIONER UNGER: Thank you. I guess, Mr. Stegemeier, the only thing I had wanted to raise with you was your comment about micromanagement.
I thought it ironic, and I don't like micromanagement either, but I found it ironic that you were sort of maybe alluding to this as being micromanagement, yet you seemed to applaud us for the auditor independence rules that we had passed a year ago, which I thought were micromanagement but had sound objectives.
MR. STEGEMEIER: Well, I go back to the chairman's comments a little bit earlier about going back to the prohibitions and trying to, I think he said, flesh them out. I don't remember his term exactly.
The devil is always in the details and it's the details of rule-making that usually cause the problems with management and directors and so on. That's what I call micromanagement.
For example, I have not had a chance to read this 109-page document, I guess I'm a slow reader, but looking at parts of it with regard to the dollar magnitude which would be reportable, for example, I think the number was $50,000, something like that or 10 percent of the audit fee, that seems like an abominably low number and absolutely would be micromanagement by my definition, because you couldn't begin to educate another consultant to the inner workings of a company for anything like $50,000 for a small consulting job, so I'm speaking generically about micromanagement.
It's that kind of thing that gives managers and directors a problem.
You have to give us some discretion, I think.
CHAIRMAN LEVITT: I have to comment on that.
That's why this process of public hearing and submission of letters and comments during this comment period is a very useful and a constructive process.
I would be inclined to agree with you that the kind of reporting that we should expect from public companies would be relatively broad, and we don't wish to burden investors with meaningless detail, so that I'm not unsympathetic to your grievance on this particular aspect.
MR. STEGEMEIER: Thank you.
COMMISSIONER UNGER: Nor am I, and I thought what you said about the audit committee is probably accurate.
We heard from two witnesses today who have in place what sound like very thorough internal controls with respect to auditor independence in determining the independence of auditors.
Were that all 16,000 public companies had those same strong internal controls I doubt this would be as big of an issue.
MR. STEGEMEIER: I guess I look at just the microcosm of the whole array of public companies out there, but as I say, I speak from my own experience oftwenty years with over about a dozen boards and more than a hundred directors and thousands and thousands of decisions and I've never seen a director take an ethical shortcut.
I guess maybe I'm blessed with the best of the lot. I don't know. I hope so.
CHAIRMAN LEVITT: Again, this is very difficult to define. I don't know that it's an ethical shortcut. It's a judgment call, and I served on enough boards to have experienced the impact of management on a close call with respect to an accounting judgment.
I've seen it and I'm sure if you think about your own experience, you've seen it. That's not unethical, but it is a judgment call which can go one way or another.
MR. STEGEMEIER: True.
COMMISSIONER UNGER: Thank you.
CHAIRMAN LEVITT: Thank you.
MR. TURNER: Thank you, Mr. Chairman. I just have a couple of questions.
Mr. Stegemeier, in your written remarks you made a couple of comments about the panel and the effectiveness of the O'Malley panel.
In that report, it talks about the role of the audit committee and in light of your observations about the audit committee which are relevant it lists a number of factors that the audit committee should consider in deciding whether or not the auditor's services are impeding their independence and cite some services they feel don't contribute to the quality of the audit and impair independence.
Do you have any comments on that piece of the report?
MR. STEGEMEIER: I can't comment because it's a very complex report.
I think there could be certain areas that would I won't say interfere with independence but would have a perception about that some people worry about.
I don't know what those are, but certainly as the Chairman talked about certain prohibited practices, we don't want to touch those, but insofar as your question, I really can't say any more than that.
MR. TURNER: Mr. Ward, over in the UK as I understand it right, the professionals work closely with the department of trade and industry in coming up with a new self-regulatory trade and structure.
MR. WARD: That's right.
MR. TURNER: In which the majority of members on the new auditing standards and the ethics board and review board, a majority of those are all public. Is that correct?
MR. WARD: The majority would be non-accountants, that's quite correct, yes. This system being adopted by the government now was initiated by the professionals under the leadership of my institute.
MR. TURNER: That's what I wanted to ask about.
I commend the profession in the UK for taking such a bold initiative to undertake in that country to initiate a self-regulatory structure that does have a majority of the people representing the public interest and I think that should be noted that the UK has accomplished something that our profession in the United States has not yet been able to accomplish and I commend you for that.
CHAIRMAN LEVITT: I think this has been a very, very productive panel.
Mr. Stegemeier, I'm particularly impressed by the perspective of your testimony, the facts that we differ in some respects.
Nevertheless, you do seem sensitive to our responsibilities, and you do seem, at least sensitive to the notion of codifying what already is on the AICPA's books, its practices, what the industry should follow and should not follow, and you do seem responsive to disclosure, and I think this dialogue has really been wonderful and I thank all of you for being so patient and being here late in the day.
Thank you and we will now have the next and final panel.
Panel 9 (Afternoon)
The next panel, Rajib Doogar, visiting assistant professor, department of accountancy, University of Illinois and David Dasgupta, former AICPA official.
Gentlemen, I appreciate your patience at being with us at this late hour. Please try to stay within the time limit that I believe is allocated.
MR. DOOGAR: Yes, sir, thank you very much, sir. Thank you for giving me an opportunity to appear before the Commission.
I should state that one time I used to be a professional accountant back in India. I was a member of the Fellow Institute of Chartered Accountants of India. I'm also a graduate of the University ofCalcutta and I have a law degree from Pennsylvania University. I came to this country to do my PhD and since then I've been teaching accounting at Pennsylvania University, followed by stints at the University of Notre Dame and the University of Illinois.
Since my thesis, in 1990 or so I started working on it, I've been interested in the question of audit markets and this is an opportunity for me to talk about some of my work.
Audit markets in general and in particular in the United States had some distinctive features that make regulating audit firm activities a tricky task. The three things I'll focus on today is first, as you heard from many people, doing a credible audit produces information also useful for accounting. Society is better off in some respects. This knowledge, once created, is efficiently used. So that the regulation question here is why force another firm to reproduce this information? So that's one part of the question.
But of course there are countervailing forces in the economy.
The Securities Act, that's the second point, the Securities Act mandates audits of all SECregistrants. When demands for audits is mandated, effectively my research shows and other research also shows this, audit fees in such a market need not reflect investors utility for the audit. They need not reflect the value of the audit. For the investors it's a crucial concern, something to keep in mind as we go through my arguments.
Finally, under United States law auditors who are accused of culpability in the failure of a client can settle lawsuits out of court prior to adjudication to a claim on merits. This means even after the auditor lawsuit has been settled, investors need never find out if the quality of the audit should be questioned. Again something obvious, but a very fundamental friction as far as an economist would be concerned.
These two interpretations are relevant to interpreting my research.
Before I present my principal findings, let me make a couple of comments to get the context of my research right as well, because I don't want to oversell what I've done.
U.S. regulators are concerned that auditors tempted by the profits to be made by selling other services to the audit clients, that is what economistscall rent, have gone too far towards efficient use of information and you suspect this costs audit credibility. This is quite plausible and even possible and this is exactly the possibility that I investigate in my theoretical analysis an executive summary of which you already have and I'll be happy to provide the paper on request.
In your recommendations, you proposed restrictions on the scope of a firm's services as a fix for the perceived lack of credibility. Here one question arises. To credibly link specific restrictions on the scope of the firm's services to your goal of enhancing audit credibility, you must argue somehow that rents earned from performing one task are more tainted than rents earned for performing any other task. A simple economic analysis suggests that there is no difference; rents are rents and any rents, whether they arise from nonaudit work or from future audit services, would impair credibility. I don't have a good theory of why the source of the rents should make auditors behave differently, so in my research I do not distinguish between various sources of rents, and that has to be interpreted. My results, what I'm going to say has to be interpreted accordingly. That's the challenge, not the findings.
In response to your proposals you have been told first that the proper scope of firm's services should be left to market forces to decide. Second, you have been told that investor perceptions about audit credibility are not an appropriate basis for action. Analysis of the second and third features I have just highlighted shows that when audits are mandated, that is the market is not free to discipline auditors through audit fees, both of these arguments are defective.
Let's consider why. Under the current rules in the United States, there are good reasons to believe that the market on its own cannot fix the problem of how much and what services an auditor should provide to a client. Markets as you know work best when prices reflect buyers' utilities for goods and services. When you mandate an audit it weakens the link between investors' utility for the audit and the fees paid for auditing. Now they have a monopoly. This creates a divergence between what investors want auditors to do and what profit maximizing auditors might want to do. In my model this shows up as auditors having incentives to produce a mix of more nonaudit services than investors would prefer.
In principle, U.S. regulators may be askedto do something to reconcile auditors' incentives with that of investors and I believe that reflects many of the comments you have heard throughout the hearing, but since this is a problem created by mandating the audit in the first place, short of unmandating the audit there's no real fix for the problem from a fundamental economic perspective.
I'll say one more thing and then I'll conclude and you have the rest of my remarks.
The second finding of my research concerns the implication of the current litigation system for the well functioning of current markets. When a client fails and auditors are sued, in U.S. law auditors have the right to and often choose to settle a case prior to disposal of merits. After such a settlement, investors never learn if the auditor did a good audit, but chose to settle to avoid further costs or did in fact do a bad job and settled to avoid public identification. Again, because auditors' guilt or innocence cannot be established publicly, markets don't have the information required to do a good job.
I'd like to say two more things. It's important to note that in my analysis the effects of information voids, that's what we call it in the jargon, there is no information about actual qualityof the auditor's work, this will affect the functioning of audit markets and its independence, whether audits are mandatory or voluntary, and finally I do agree low audit credibility will in turn theoretically drive up costs of capital affecting the well functioning of U.S. capital markets and the U.S. economy as a whole.
What can you do about it? In my view, academic research is better at explaining than at prescribing. However, the frictions academic research identifies can help you search for remedies. I'd be happy to talk about them.
CHAIRMAN LEVITT: Thank you very much.
MR. DASGUPTA: Thank you, Chairman Levitt, Commissioner Carey, Commissioner Unger.
Thank you very much for affording me the opportunity to testify before this hearing.
I feel it's a privilege for me because looking at the credentials of everybody who has appeared, I am the least credentialed of all and do not have any particular expertise.
But based on what I think as a small investor, I thought this was an opportunity for me toput forth my point of view.
First of all, I think Chairman Levitt of SEC has been doing an excellent job in trying to protect the interests of the small investor such as myself, and I'm sure there are millions of others and the steps or the proposals SEC is considering about this whole issue of auditor independence, of providing, of auditors providing nonaudit services to their audit clients and how it could impair their independence and judgment and objectives about the integrity of financial statements and the overall integrity and trust of investing public in our capital market system.
I would like to summarize what I'd like to put in and I'll just proceed accordingly.
From the perspective of someone like myself, who also at one time worked for the AICPA in the public relations area, and a small investor, the point I think we need to, the point I'm trying to make is, like Caesar's wife, auditors must be above suspicion and beyond reproach.
They have an obligation and a responsibility to provide accurate audited financial statements on which investors can rely on and make investment decisions.
Now, of course, I found during this panel discussion some other articles and discussions that have been in the press about the accounting industry's perspective on this whole issue.
Based on what I have been able to gather and based on what I have gleaned from my own research into these matters, there are basically three self-serving arguments made by, in my opinion, the accounting profession and the trade group.
AICPA proposes every time the SEC comes forth with some suggestions of proposing new guidelines or rules. And the whole idea when the SEC makes these moves is to bolster public confidence in auditor independence and making sure the investor's interests are being served.
I'll just first identify in my opinion what these arguments are, and then think why they are not really conducive to investor's interests.
The AICPA, its trade group have an argument that its better quality audits, if an auditor is also involved in other aspects or knows about or provides other known audit services, because supposedly if you know the entire operations of your client from end to end, the quality of your audit gets better and auditors are, the argument goes, are trained to beobjective, independent, and so the fact that they may be providing nonaudit services to their client is not likely to impair their independence and judgment.
The second argument which frequently comes up is the accounting industry already has built in safeguards to insure auditor independence through entities like the Public Oversight Board and Independence Standards Board, both of which were created under the aegis and therefore the SEC did not try to second guess them and try to impose new regulations on auditor independence.
The third point which I have frequently come across is that the industry's self regulating and it should be allowed to keep on self regulating itself to the AICPA, and so it's unwarranted or unnecessary for the SEC to intervene, and try to impose or suggest new guidelines.
The argument goes like this.
The AICPA is an efficient regulatory body, has a disciplinary panel, full-time staff to investigate allegations or violations, so let it stay the way it is.
Let me respond to this from my perspective and what I think the SEC is doing in this matter is important for all investors, including someone in mysituation.
The first argument that in today's business environment, if you know everything from end to end of your client's business, you can do a better audit job seems a little silly.
If auditors see the great benefits of cross selling nonaudit services to the audit clients, why is it that their consulting colleagues don't seem to see it the same way.
We all have seen over the past years the very unseemly, very unsavory public feud the two units of Andersen worldwide indulged in or engaged in, Arthur Andersen and consulting--
CHAIRMAN LEVITT: Could you try to summarize? Your time has expired.
MR. DASGUPTA: I'm sorry.
The second point is the POB and ISB has been advised, but as far as I've been able to determine, the ISB has not been able to come out with any major findings or major guidelines on insuring auditor independence.
And finally, as far as the self-regulatory aspect goes, the AICPA does not really have much of a clout in enforcing or sanctioning any penalties.
They can issue remand letters and the worstthey can do is expel the member out of the AICPA but they only have clout over their own members and as far as the public goes, there is no way you know who has been reprimanded or sanctioned, because as far as I know and as far as I've been able to determine just by visiting the AICPA's web site ,there is no listing there of any members who have been sanctioned.
The only place as far as I know the names appear in is a member publication called the CPA Journal, which is only available to their own members.
How many non-accountants or non-CPAs that you know of would have access to that publication and b) would know which accountant or which CPA has been sanctioned, suspended or reprimanded for violations.
So my point finally to the SEC is that what you have proposed in terms of clearly splitting and keeping the two functions separate, audit and consulting is the right approach and I believe that is what the investing public expects of SEC and expects that that's how the integrity and transparency of our capital markets system will be preserved.
Thank you very much.
CHAIRMAN LEVITT: Thank you.
Mr. Doogar, I find your study very interesting. I have not read it, I don't know whetherit can be presented in a way that I might understand, but I would like to take a look at it or a summary of it.
You obviously place a great deal of importance in perception, and this is at the crux of the argument we keep hearing over and over again, where is the smoking gun, and I say again and again and again that these issues sometimes are subtle and not fraud, and that very few of us are in the room when those judgments are made or in the minds of those making those judgments.
Do you believe, I think you certainly do believe, that perception does affect investor's behavior?
MR. DOOGAR: Yes, sir, and if I may clarify there are two dimensions to this.
First one is a human dimension, one is of decision-making behind closed doors whereas you pointed out repeatedly in a couple of panels, I was lucky enough to attend, my flight came in late so I missed the earlier part of today's discussion. You talked about, in the earlier panels a dimension that really I don't study. I'm trained to do mathematical economics, I don't study human behavior, but I find that plausible.
Because human beings err and people make judgments, but that's not the source of my concern.
What I'm getting at here, in addition to all those factors, they form the starting point if you like, of suspicion but the perception that I'm talking about, the perception that arises, because after the fact investors can't go in and find out whether the auditor really did something that they shouldn't have done or whether they just settled, because the U.S. litigation system does impose costs on honest defendants too, so it's a delicate issue.
What I'm getting at is a research started in economics only in the last ten years which looks very carefully at what do you need to make markets work.
There's a perception that markets work beautifully. That perception is due to research in the 1950's.
Since the 1950's economic research moved on.
People don't believe that markets are perfect or complete any longer and when markets are neither perfect nor complete, I'd be glad to explain this in more detail later, but to get it out on the record, I gave this paper the theoretical analysis to one of my colleagues, a distinguished economist and I asked him yesterday that I was going to come here.
I said do you have any comments?
He said no comment.
I said any adverse comments?
He said no adverse comments, but regulators must believe that markets are complete if they buy the arguments that markets will govern behavior appropriately.
I identified two frictions. One, as you rightly noticed, is tied to this perception issue. If you would like me to go into that more detail in written comments, I will, and the other is mandate.
Once you mandate the audit it's hard for me to see how investor utility for the audit product per se, who is going to force the value of the audit product per se to be reflected in audit fees when audits are mandated as an economist I don't see that link.
Now, there may be other issues again, there are many people I spoke with here who probably started their professional careers before I started wearing long pants so I won't presume to judge their wisdom.
All I say as an economist I don't see that link, therefore there's a real problem to my mind about how I understand these markets, and what I can teach my students.
CHAIRMAN LEVITT: Good, well, I'd like to hear more about this Commissioner Carey?
COMMISSIONER CAREY: Thank you, Mr. Chairman. My thanks to both of you.
I was intrigued by one comment you made, Mr. Doogar, which is that you can't really distinguish between rents, the rents for audit services and the rents for nonaudit services but if one rent is a higher margin service than the other, isn't that in and of itself a distinction that would make that rent more important?
MR. DOOGAR: Prima facie, I would say yes but it's a delicate issue. In addition to my other crimes, I also taught cost accounting besides financial accounting, and one of the delicate issues there is how do we delegate margins, how do we allocate costs across products and services.
If you think about the theory of pricing multiple products as we know it from economic theory, if a firm can produce two outputs more profitably than it can produce one output, it may be that marginal elasticities of demand may drive appropriate pricing as the FTC has used in the case of railway freight, so that's a very delicate issue.
I don't want to bore you at this time of theevening with jargon.
COMMISSIONER CAREY: Plausible?
MR. DOOGAR: Plausible but a delicate issue.
COMMISSIONER CAREY: They could prefer one rent over the other?
MR. DOOGAR: It could be argued both ways.
One argues that the auditors want a fair rate of return on their human capital, but the only way they recover it from clients who view the audit as a commodity is to sort of hype up the managerial accounting services even though the bedrock of the value added is gone. I don't know.
As an economist, I don't have empirical evidence. I would love for you folks to ask for firms to disclose lots of data so I and my colleagues can write research papers but based on the evidence before me I can't say.
COMMISSIONER CAREY: I don't think that's anywhere in our mission, but we would like to please you.
That's all I have.
CHAIRMAN LEVITT: Commissioner Unger.
COMMISSIONER UNGER: Thank you.
It's funny, we had an economist towards the end of our last panel, last panel of the last day ofhearings also that raised the issues that you raised in terms of the mandate for audits, and in fact that was also really also a fundamental problem and I thought oh, my God, that is such a big issue, but you know, there is some truth to that, and that it is hard to say you must pay for an audit, and it must be truly independent by human beings who are making a judgment call and some very tough calls, so I do find that part of your discussion very interesting.
I guess, I was interested in what you said about investor perceptions constituting an economically legitimate and theoretical basis for regulatory intervention, and so I guess what you're saying is, what we're saying, and that is that the perception of lack of independence is enough for there to be the need for action.
That's what I want you to say. Maybe you're saying something else.
MR. DOOGAR: I would agree with that, but I would also say there are parts of what I had said today that you may not like very much and I want to be very clear about that.
It is important.
Academic research can throw out ideas and then it takes a while to refine them and implementthem as policy. If I can get you to think about why do we really mandate an audit, do we believe that John Bogle and TIAA-CREFF and Warren Buffet can't discipline auditors they think are really doing something shady.
I put my retirement money into TIAA-CREFF, so I really believe they are doing monitoring, so we have to respect that.
Your markets in 1933-34 were children. Then they became teenagers. Now today they're 21 year olds, enough to die for their country and do what they want to do, I don't know, that's the delicate issue.
I'm not sure that just because we have a historical mandate for the audit the time may not have come for folks like you to think about it a little bit.
Let it animate your discussions as you think about what's going on.
But what it's going to force you to think about very carefully is why do you want to regulate?
If you think the auditor wants to use the information and do something that market participants don't like, and if you feel that the profession has sort of not lived up to the mandate that Congress gave it, I would recommend you sit back and think hmm, is there any reason to continue the mandate? I don'tthink we should be prisoners of history.
COMMISSIONER UNGER: I think we can take that away.
I think part of our charter is to preserve the independence, however, and this is probably late for such a philosophical discussion not given the Internet and the possibility of real time reporting information this may not be such an academic conversation in a couple of years.
But back to the mundane issue of regulation.
I was kind of interested in your perspective, as an individual, and maybe I haven't asked this so articulately, but thinking as hopefully some day an individual investor but only a participant in a Thrift Savings Plan right now, that if I were to think that the auditor of a company I was investing in was also providing substantial amount of consulting services to that company, and that in fact might impair their judgment on subtle calls as the Chairman pointed out, maybe nothing terribly obvious in each instance, but perhaps in the totality significantly impacting the financial statements, how would you view this financial statement, even if there was disclosure about the amount of revenues that company was paying to the auditor for nonaudit services.
Would you think that those financial statements had any bearing on the actual financial condition?
Would you think there was still integrity on the financial reporting system?
MR. DASGUPTA: I think a way I would answer the question is, if I were given a situation where company A did the independent audit, and they hired a separate accounting firm to do other nonaudit services, I would have a lot more confidence in the integrity of that financial statement vis-a-vis the one where the same firm is providing both audit and nonaudit services, even though I know that it does not necessarily mean that there's a correlation that this would automatically have some influence on that.
But I think the one point which was made by one of the panelists and I could not disagree more, that in many cases perception prevails and perception clouds your judgment.
So if it seems, if it appears, even if there's the appearance of conflict of interest or appearance that your judgment or your assessment may be clouded by the fact that you also provided other services and probably more lucrative services to the same audit client, I would as a small investor, evenafter all disclosures, would look at it a little more carefully than a situation where the function and where the disclosures clearly say firm A audited our statements but firm B provided some other types of services.
COMMISSIONER UNGER: But even if you couldn't actually pinpoint any particular area where there was an issue, would you just be suspect about the financial statements as a whole?
MR. DASGUPTA: Even if I can't pinpoint it--let me put it this way.
Unlike the other experts, the people who have testified here, some of the very well known names in the industry, John Bogel, the chairman of the TIAA-CREFF and even a few weeks ago I believe the head of consulting practices at PriceWaterhouse, also an article in the Wall Street Journal basically saying the two functions should be split, and if as a small investor or as an ordinary investor, I'm not an expert, but I would obviously be influenced and guided by people who know, who understand these things much better than I do to be guided by their judgments and their analysis of the situation.
Let me put it this way. If Warren Buffet and I know he has talked about these issues over andover again, if he were to write something on this issue that he felt these type of services should not be provided or it would raise perceptions of not necessarily malfeasance, but perceptions of possible impropriety or not exactly kosher, I would give it a lot more credence than all auditors and accountants of the world, even if this were in the Bible and put the stamp or imprimatur on the financial statement, let me put it that way.
COMMISSIONER UNGER: Thank you both very much. I appreciate your longevity and endurance in waiting your turn.
I have no more questions.
COMMISSIONER CAREY: One final thought that's nagging at me, that we were asked again and again by witnesses and by members of Congress and others to produce a smoking gun or empirical evidence that clearly states the need to do this.
I was speaking recently with the CFO and said do you have confidence in the state of auditor independence today? And he said no, and he said it's something that's very, very subtle.
You won't find a smoking gun. What you will perhaps achieve through this rule is the ability of an auditor to go to their management earlier than theywould currently do so, for them not to have the economic pull of lucrative lines of business, and that can mean the difference between an inventory adjustment that results in an altered earnings forecast, and a financial debacle of having to restate the last two years earnings from a profit to a loss, and enormous losses to investors.
So the stakes are quite high and I want to thank everyone here, most of whom have left, for helping us in what I think is a considerably difficult task.
CHAIRMAN LEVITT: Thank you very much, gentlemen, and as we break, I would like to say that the staff work behind this effort has been Herculean.
As tired as the Commissioners may be, the people who brought us here and prepared us so well and stayed through it all and serviced us have just been wonderful, and speaking for all the Commissioners we're deeply grateful to your commitment.
COMMISSIONER UNGER: And that's pretty much all that's left here.
CHAIRMAN LEVITT: Thanks a lot.
(Time noted: 6:50 p.m.)
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