November 2, 2000

Mr. Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C. 20459-0609

Re: Comment File No. S7-13-00 Testimony

Dear Mr. Secretary,

Enclosed please find a research paper detailing analysis and suggestions to
further the effectiveness of the proposed legislation of the auditing profession.  This paper is the result of a semester of study at Bentley College in Waltham, Massachusetts.  This course focused on the process of auditing, Generally Accepted Auditing Standards, and the greater implications of the attest function.  This paper is the result of en entire semester's time and effort spent researching the question of auditor independence when also consulting for the same client.This paper takes an impartial look at the issue, examines several key cases highlighted by the Chairman as impetus to act on the issue, and suggests a novel approach that has yet to be suggested.  I think it offers a new idea that may be beneficial to the discussions, and even a possible solution.I realize that much work has been done in this proposal, and a resolution already be at hand.  I hope this can be of help and further the dialogue between the interested parties.

Very Truly Yours,

Edward C. Bernardo
1819 Beacon Street Apt. 6
Brookline, Massachusetts 02445
(D) 617-563-9911
(E) 617-975-3118

Note:  This attachment is in Microsoft Word 97 format.  If this standard is not compatible with your software, please let me know, and I will send the text in the body of an email submission.

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An Examination of the Independence Issue:

Auditors Who Provide Consulting Services
----------- or ------------
Consultants Who Provide Audit Services

++++++ C. ++++++++

Bentley College
Professor Brian MacIver
August 13, 2000

From nascent beginnings only a century ago, the United States has transformed itself more than any other nation, evolving from a country based on a young industrial economy common to other nations, to a leader in the emerging information economy. As this economy grows through innovation and new ideas, people throughout the country and even the world benefit through added production and enhanced quality of goods and services. This added productivity feeds the world through greater production of food, heals with blockbuster drugs, and educates through increased funding, achievements made possible less by industrial might than by technological innovation. As these achievements are realized, real value is created, benefiting shareholders directly through greater returns on investment, and the world as a whole through a better standard of living. This technology-based, information economy facilitates these achievements, serving as their blueprints. Today, intellectual services and the property they create form the machinery and equipment of the modern corporation, the highest evolution of the economic food chain.

The success of this transformation can be seen in the vast wealth created by those propelling it forward, and even in the mere participants turning the wheels. Ironically, the vast wealth of our nation is represented not by iron horses, rolls of steel, or other tangible vestiges of the industrial age, but by securities, in the form of stocks and mortgage bonds. Yet, securities, a devilishly ironic term, have no intrinsic value in-and-of-themselves. Made of paper, or even simply values in an electronic database, their worth is derived from the underlying assets these documents are guaranteed to represent. Ownership, therefore, is indirect and intangible, the product of some other worth. This connection, or link, of ownership to some valued asset, can be the source of much confusion, error, and even fraud. Yet the entire wealth of our nation rests upon this database of information and the link it represents. Accountants are charged with the oversight of this link, ensuring the accuracy, validity, and completeness of what it represents, and therefore have a crucial, and highly regulated, position within the information economy. Almost like referees, accountants are charged with maintaining an unbiased posture and even professional skepticism when evaluating the financial statements of firms that represent the underlying assets to these securities. In performing this function, auditors serve as the keystone in many ways to the nation's financial health and well being. Given the gravity of this responsibility, these professionals must be beyond reproach or even the suspicion thereof; the country depends upon it. Through the attest function performed in an external audit, accountants for many years have met this challenge and performed with a near perfect record.

The accounting profession not only serves as a guardian of this link, and the intellectual economy as a whole, but participates in it as well. As professionals who dealt almost exclusively with information and the technology used to manage it, accountants were in fact some of the earliest participants in an emerging economy based not on heavy industry but instead information and intellectual property, and have in turn evolved with it. As time passes and technology leads to increased productivity, the economy becomes more efficient, utilizing fewer resources, both human and machine, to achieve the same level of output; a dollar's worth of investment should generate more output in real terms today than it did ten years ago. With these increased efficiencies come increased returns on capital, or at least expectations thereof. Due to better information in evaluating service and price, the economy also becomes more efficient in separating value from anti-value, more easily recognizing and rewarding those that create value. Much like the economy, the accounting functions of auditing and financial statement generation have become increasingly efficient. Recognizing this trend, accounting firms have broadened their services to include non-audit work so they may maintain a value-added model that allows for further growth and appropriate return on invested capital. Specifically, the major accounting practices have all developed significant consulting practices that compliment the audit services they offer to clients. Today, that evolution has been challenged, and now stands threatened in both practice and viability.

On June 30, 2000, Arthur Levitt, Chairman of the Securities and Exchange Commission, submitted proposed rule file number S7-13-00, "Revision of the Commission's Auditor Independence Requirements,"1 a proposal to change the laws governing CPA firms and the services they are allowed to provide to auditing clients. This rule, if passed into law, would prevent CPA firms that audit companies with publicly traded securities outstanding or forthcoming from providing most additional services beyond the audit function, specifically management and information (IT) consulting. This rule would not apply to clients of the CPA firm who are audited by a different, unrelated firm. Given the aforementioned competitive economic environment firms operate in, and the crucial role of the CPA performing audits and attest services on publicly traded companies, this paper will examine proposed rule file number S7-13-00, "Revision of the Commission's Auditor Independence Requirements," the circumstances leading up to and surrounding the issuance of this proposal, and address the concerns of both the SEC and the accounting profession. In examining this issue, this paper will look closely at the case of MicroStrategy Inc. as it relates to the SEC proposal. Finally, this paper will attempt to frame a solution given all the available information.

Michael Saylor had always been accustomed to success. After working as a venture specialist for DuPont for several years, the high school valedictorian and MIT graduate of highest honors and several degrees started MicroStrategy Inc., his own company at age 24.2 For ten years he built the firm to be a successful player in the white-hot business-to-business sector of e-commerce known as database mining. The firm analyzes online transaction data on a real time basis and continually feeds the analysis to its clients.3 After toiling for years in relative obscurity, the firm finally began receiving the recognition of the investing public this spring, and had grown in market capitalization from $2 billion to as much as $17 billion. They had booked three large contracts last fall and began to recognize revenue from them that significantly increased their annual earnings to a forecast of about $225 million.4 The manner in which they derived this number however, was somewhat unconventional: the firm effectively capitalized anticipated revenues from long-term software contracts and recognized them very early, almost in a gain-on-sale technique practiced in the securitization of bank debt. Although somewhat common for the software industry, this violated GAAP and its treatment of revenue recognition. Forbes Magazine was the first to recognize this violation, and ran an article on March 6, 2000 highlighting this error in light of MicroStrategy's towering valuation, at 83 times revenue.5 The rest of the financial press seized on this error, and MicroStrategy stock fell sharply the following day, eventually settling into a trading range of 20-30, about 90 percent below it's highest point of 333. Amid the maelstrom of criticism, the firm consulted with Pricewaterhouse Coopers (PWC), its auditor, and announced a negative revision to its 1999, 1998, and 1997 earnings, taking a charge of $65.9 million and restating a 1999 profits of 15 cents per share into a loss of 51 cents per share.6 The stock promptly declined 141 points, or 68 percent, shaving $12 billion off its market capitalization. When the revision was first announced, the firm and its auditors cited a ruling by the SEC in December of 1999 called Staff Accounting Bulletin (SAB) 101, a ruling that gave four specific guidelines to software companies on how they book their revenues.7 This was odd due to the fact that MicroStrategy's violations were not particularly technical in nature, but instead were based on pre-existing accounting principles. SAB 101 was not germane to this violation. The firm and its auditors then made another announcement the following day, revising their prior remarks and citing Statement 97-2 as the reason for revising their revenues.8 Upon this news, the SEC took notice of the error and announced an investigation into MicroStrategy's revenue revision.

Chairman Levitt, however, took particular interest in this case, and especially in the relationship MicroStrategy had with its auditors when it prepared its financials and a clean audit opinion was provided. Specifically, the SEC is investigating whether PWC's consulting relationship influenced its auditors and allowed for an overly aggressive revenue recognition policy to remain in place upon providing the clean opinion. For many reasons, particularly those mentioned above, this situation presents the greatest concern for regulators and threatens the overall financial system. The independent auditor represents the last defense against material misstatement and fraud. Without this assurance, our markets, the formation of capital, and the economy as a whole would be undeveloped and far less sophisticated. Soon after initiating this investigation, the Chairman proposed rule file number S7-13-00, "Revision of the Commission's Auditor Independence Requirements," on June 30th. Although this issue had been debated for several years, only after the MicroStrategy case was the rule finally proposed for legislation. The MicroStrategy case highlights several major concerns facing the accounting profession and the economy, with the SEC in the middle to resolve the issue to the benefit of the greater investing public.

Central to the MicroStrategy case and the SEC's overall concern is the auditor's ability to remain independent given the dual nature of a relationship that involves both auditing, and consulting. As the auditor, the accounting firm answers to a prescribed set of rules and practices that allow it to remain independent and issue opinions with relative impunity. As a consultant to the client, however, management can exert leverage and influence the accounting firm due to the fact that it pays significant amounts of money in consulting fees. The proposed rule recognizes this fact as a central threat to auditor independence: " may be unrealistic to expect that an auditor can ignore completely what the firm stands to lose by the auditor's action."9 The notion of independence is part of the AICPA's Generally Accepted Auditing Standards and central to the attest function.10 It provides the auditor the free mind with which to develop professional skepticism in auditing a company, and leverage when it feels the need to require a change in accounting treatment of an item in the financial statements. Equally as important, the public's perception of CPAs as independent professionals acting with integrity and the interests of the investing public serves the economy and country as a whole by instilling confidence in the markets, allowing for the formation and efficient allocation of capital, without which growth would stagnate. These concerns are clearly elucidated in the SEC's proposed rule:

Independent auditors have an important public trust. Every day, millions of people invest their savings in our securities markets in reliance on financial statements prepared by public companies and audited by independent auditors. These auditors, using Generally Accepted Auditing Standards ("GAAS"), examine issuers' financial statements and issue opinions about whether the financial statements, taken as a whole, are fairly presented in conformity with Generally Accepted Accounting Principles ("GAAP")... Investors must be able to put their faith in issuers' financial statements... One of our missions is to promote investor confidence in the reliability and integrity of issuers' financial statements...11

Clearly, both the reality and appearance of being independent is crucial to the CPA's ability to carry out the audit function properly. Several aspects of the MicroStrategy case are worrisome in light of this need. PWC relied upon MicroStrategy for referral business. Furthermore, PWC served as a reseller of MicroStrategy software. These business and revenue arrangements erode the appearance of independence, if not the fact.

Needless to say, much of the accounting profession disagrees entirely with these conclusions, and cites a variety of reasons, including some compelling economic realities, that speak to the need for continued allowance of auditors to provide consulting services. The AICPA also stands in opposition to this proposal. The blueprint for the SEC's proposal comes not from the government, but ironically from the accounting profession itself. Upon selling its massive consulting franchise in February for $11 billion, Ernst & Young (E&Y) Chairman Philip A. Laskawy drafted a letter to Chairman Levitt sighting reasons why the SEC should require the other (now much larger) accounting firms to discontinue providing consulting services to their audit clients.12 This was a shrewd move on the part of E&Y, as they allow themselves to enjoy a first-mover advantage should there be a ruling from the SEC, presumably allowing E&Y to obtain the greatest relative price for its consulting franchise, in addition to making a significant attempt at leveling the playing field amongst these now larger competitors. In fact, Nick Land, the E&Y UK Chairman, was quoted as saying "At E&Y the independence issue was initially secondary," and instead goes on to cite "...the need for greater critical mass..." in consulting as the reason why the consulting unit was sold.13 The goodwill towards the SEC will surely won't hurt either. This advice from E&Y should be taken with a grain of salt, however, as it comes from a participant in the very arena on which it is commenting. This advice also lacks independence, and may even be self-serving.

Away from this political quagmire, a careful examination of the facts is much more telling. The SEC has produced no evidence supporting its position that the provision of consulting services impairs audit quality. This lack of evidence has come to light recently, and angered congress.14 Other than the MicroStrategy case, researchers are hard pressed to cite instances where auditors were compromised due to consulting arrangements. One researcher, Douglas R. Carmichael, who served as research director for an SEC sponsored investigation into this issue, had to go as far back as a 1978 audit of Westec Corp. to cite a case where it was concluded that consulting arrangements compromised audit integrity.15 Furthermore, many believe the varied perspectives afforded an accounting firm that audits and consults to add to the quality of the audit. A report prepared by the AICPA Independence Standards Board found in a survey that half the CEOs interviewed felt the audit services to be better when accompanied by consulting services.16

Several other realities make it difficult for the SEC to forcibly split the accounting and consulting professions. As the economy and information technology have become more efficient and sophisticated, the audit function has become less involved. Without consulting, audit firms will have a difficult time growing their business. Increasingly, with sophisticated information systems and internal controls, audit expenses can be minimized. As these processes are streamlined (again, in modern firms with comprehensive information systems and strong internal controls), especially for providers of services that require no manufacturing, work in progress or inventory, auditors find it difficult to add value to their client's situation, and hence create value within their accounting franchises. Without the ability to create value, the business stagnates, and capital departs. CPA firms use their consulting units as the main vehicle with which to create value, and now generate about 70 percent of their revenue from this side of the house.18 This fact begs the question: If the SEC were to require a massive divestiture, what if the firms decided to only consult? Who would conduct the audits? This draconian situation does not represent even today's tense reality, but it is illustrative of the state of the business nonetheless. "We cannot permit the SEC to bomb the profession back to the Stone Age," A quote from the AICPA Chairman Robert Elliot sums up the current mood.19 One other related economic reality has also been shaping the industry. The SEC should bear in mind that the profession has attracted fewer young entrants in recent years. For the first time ever, the number of people taking the CPA exam fell by 40 percent from 1992 to 1998.20 The audit function is an incredible way to learn a business or industry, but frequently doesn't captivate forever. Firms that have consulting practices can offer the best and the brightest new challenges and reward top performers with lucrative positions to keep them in the firm. This side of the business provides challenges for creative thinkers. Without this business, it may be very hard for auditing firms to attract new talent. In this respect, a forced divestiture may have a severely negative impact on the quality of audits down the road. A review of the facts reveals less-than compelling evidence of audit failure due to consulting-related influence. Perception, however, nearly as important, may be somewhat more fragile, and therefore strained by the additional relationship. In fact, one study revealed widespread confidence in the current system, but concern over its direction given the consulting relationship.21 Given these facts and the current, seemingly intractable dilemma, the question remains: What to do about auditors who maintain significant consulting practices?

One novel idea: get a second opinion. When looking at the MicroStrategy case, it appears that the concerns are not over the accountant's inability to measure the details, count inventory, or willingness to overlook a fraud, but instead bend on a major accounting classification or recognition issue. In fact, PWC's ignorance regarding the proper treatment of software revenue recognition almost attests to its innocence. These accountants were not swayed by consulting fees. They were unaware of the appropriate accounting treatment, twice! Nonetheless, the appearance of wrongdoing can be even more damaging. In cases like this, the influence exerted by the client/auditee relationship are most relevant. What if all auditors who also consulted for their audit clients had to have their audit opinion signed off on by another, entirely unrelated accounting firm, effectively a checks and balance system to verify the appropriateness of major classifications and assumptions made and allowed by the auditor? The second opinion chosen should be provided by one of several large firms selected purely at random by lottery, and not included in the lottery for second opinion the following year for that given auditee. In this manner, there can be no interest, care, or influence whatsoever on the provider of a second opinion, as his work is chosen at random, and sure to not be garnered again the following year. This can be cost effective as well. The second opinion needs merely to review the financial statements and the work papers. The high level decisions can be made from there. Furthermore, the requirement of outside approval from an unrelated expert provides leverage and an easy out for auditors requesting that a reluctant client make material change to the financials. The matter would be out of the auditor's hands, and therefore may even lead to better financial statements as acquiescence to the client decline over time.

Ultimately, some may argue that the clients, and the marketplace overall should determine what services are offered to whom. Over time, this method has worked amazingly well. Given the tremendous education and experience an auditor brings, in both technical rigor and business savvy, as well as an understanding a client's business, the auditor can advise in an unbiased manner on a variety of issues. Unlike Wall Street, that stands to make a commission on underwritings and fees on M & A work, the CPA stands as the one unbiased expert with the client's interests first and foremost in mind. Evidence that clients can benefit overwhelmingly from diversified offerings of expertise. Consider Michael Saylor, a technical wizard in his own right. Given his statement: "There are a variety of levers we can pull to satisfy a broad array of interested parties..." it appears that Mr. Saylor would benefit from not only the accounting and consulting advice provided by his CPAs, but also perhaps some legal advice.22 The needs and opportunities are endless.

Footnotes and Bibliography

1Securities and Exchange Commission website:
2MicroStrategy website:
3Securities and Exchange Commission Form 10-K for MicroStrategy, Inc., fiscal year ended 12/31/99, p. 9.
4Bloomberg News, L.P. Interview with MicroStrategy CEO Michael Saylor, 12/8/99.
5Forbes article: MicroStrategy's Curious Success March 6, 2000
6Securities and Exchange Commission Form 10-K for MicroStrategy, Inc., fiscal year ended 12/31/99, p. 13.
7Securities and Exchange Commission website:

Remarks at the 27th Annual AICPA National Conference on Current SEC Developments by Commissioner Isaac C. Hunt, Jr. U.S. Securities & Exchange Commission Washington, D.C. December 7, 1999

8Bloomberg News, L.P. article: PWC's MicroStrategy Audit Comes Under Scrutiny, NYT Reports, 3/24/00.
9Securities and Exchange Commission website:

II. The Need to Preserve Auditor Independence C. The New Business Environment Calls for Modernized Rules 1

10AICPA Professional Standards Compendium section AU 220 document reference SAS 1
11Securities and Exchange Commission website:

I. Executive Summary

12Businessweek article : Cozying Up To The Ref July 31, 2000 pg 85
13Middle East article: Big Five Auditors Squeezed between the U.S. S.E.C. and the e-economy, May, 2000.
14Public Accounting Report: Congress calls S.E.C.'s Bluff on Independence, 6/15/00.
15New York Times article: 3 Big Accounting Firms Assail S.E.C.'s Proposed Restrictions, 7/27/00.
16Accounting Today article: Report Finds Problems with Perceptions of Independence, May 22-June 11, 2000.
17(Reference is omitted in test) Accounting Today article: Levitt vs. the ACIPA, June 12-June 25, 2000.
18Business Week article: Where Have all the Accountants Gone?, 3/27/00.
19Business Week article: The S.E.C. vs. CPA's: Suddenly its Hardball, 5/22/00.
20Wall Street Journal article: CPAs consider Cutting Edge Makeover, July 31, 2000
21Accounting Today article: Report Finds Problems with Perceptions of Independence, May 22-June 11, 2000.
22Bloomberg News L.P. MicroStrategy Revises 1999, 1998 Results; Shares Dive March 20, 2000