Comments on the SEC's Proposed Auditor Independence Standards,
SEC File No. S7-13-00

Charles C. Cox
Kenneth R. Cone
Gustavo E. Bamberger

Lexecon Inc.

September 25, 2000

Table of Contents

Executive Summary

I. INTRODUCTION

II. THE SEC PROVIDES NO SYSTEMATIC EVIDENCE THAT THE PROVISION OF NON-AUDIT SERVICES BY AN AUDITOR TO ITS AUDIT CLIENTS REDUCES AUDITOR INDEPENDENCE OR HARMS FINANCIAL MARKETS.

A. There is No Evidence that U.S. Financial Markets Have Been Harmed by the Increase in Non-Audit Services Provided by Audit Firms.

B. There is No Evidence that Other Financial Markets Have Been Benefited by the Types of Regulatory Restrictions Proposed by the SEC.

III. THE SEC'S CLAIMS THAT THE PROPOSED AMENDMENTS WILL GENERATE BENEFITS ARE UNSUBSTANTIATED.

A. Claimed Benefits to Investors.

B. Claimed Benefits to Issuers.

C. Claimed Benefits to Other Consulting Companies.

D. Claimed Benefits to Public Accounting Firms.

IV. THE SEC FAILS TO CONSIDER THE COSTS OF ITS PROPOSED AMENDMENTS.

A. Potential Costs to Issuers and Shareholders.

1. Loss of Economic Benefits from Restricting the Combination of Auditing and Consulting.

2. Transition Costs Imposed by the Proposed Regulations.

3. Costs Due to Regulatory Burdens and Unintended Consequences.

4. Summary

B. Potential Costs to Accounting Firms.

V. THE SEC'S PROPOSED RULE IS MISGUIDED AND OVERBROAD.

A. The Proposed Rule Does not Address the SEC's Stated Concerns

B. Disclosure is a Less Costly Alternative.

VI. CONCLUSION.

Executive Summary

The Securities and Exchange Commission ("SEC") has solicited comments on its proposed rule amendments regarding auditor independence. The proposed amendments would, among other things, identify certain non-audit services that "if provided to an audit client, would impair an auditor's independence."¹ We have been asked by Arthur Andersen, Deloitte & Touche, KPMG and the American Institute of Certified Public Accountants to comment on these proposed amendments.

We find that the SEC has failed to analyze properly the costs and benefits of its proposal, and that the best analysis possible under the time constraints imposed by the SEC does not support its proposal. We also find that the SEC could adopt a much less intrusive set of regulations that would address its concerns about auditor independence while allowing the competitive marketplace to determine the appropriate degree of separation between audit and consulting services.

The SEC proposal represents a major change that would affect thousands of public companies in the United States, billions of dollars of consulting and auditing services and tens of thousands of consulting and auditing jobs. Yet the Commission fails to cite even a single piece of empirical evidence that any problem exists to justify its proposed amendments. Instead, the Commission appeals to "common sense," arguing that "there can be little question about the effect of these impairments [from the provision of non-audit services] on investor confidence. Gradual decreases in investor confidence may not be measurable, but their cumulative economic impact could not be more palpable."²

This "evidence" cannot justify a sweeping regulatory change. First, "common sense" suggests that, while the U.S. securities markets may suffer from certain faults (possibly including "irrational exuberance"), they certainly do not suffer from a lack of investor confidence. On the contrary, the growth of consulting income at accounting firms has taken place during a period when participation in equities markets by individuals, both directly and through mutual funds, has reached new heights, and during a period when U.S. companies have been able to raise unparalleled quantities of new capital. There is simply no evidence that investors have lost confidence in U.S. equity markets.

The lack of investor concern about auditor independence should come as no surprise, because there also is no reliable evidence that the provision of consulting services by accounting firms inhibits honest financial reporting by public companies or professional and thorough audits by accounting firms. The U.S. financial and legal systems provide powerful disincentives to fraud, including an aggressive enforcement program at the SEC and an extremely active and aggressive plaintiffs' bar. Even after years of growth, non-audit, non-tax fees from audit clients constitute only about 10 percent of revenue for the "Big Five" accounting firms. There is no evidence that these firms would jeopardize their reputations for revenues that account for only 10 percent of their overall business.

The experience of other countries also fails to support the SEC's claim. While the United States and the United Kingdom both allow auditors to consult with their audit clients, such consulting is banned in certain other countries, including Belgium, Italy and Japan. Yet it is widely believed that financial reporting in these markets is less transparent and satisfactory than financial reporting in the United States. And certainly equity markets in these countries play a less important role in corporate finance and attract less individual participation than does the U.S. market. Of course there are vast differences across these countries, but the fact remains that the experience of other countries provides no support for the SEC's view that consulting by accounting firms has harmed or handicapped the U.S. market.

Evidence from the United Kingdom also fails to support the SEC's theory that restricting consulting activities by auditors would allow issuers "to attract capital at lower rates of return."³ This theory suggests that public companies would purchase less consulting from their auditors if they were required to disclose this consulting in their financial reports. But the U.K. imposes exactly this reporting requirement, and a higher percentage of U.K. public companies than of U.S. public companies appear to purchase consulting from their auditors. Again, there is simply no evidence that either companies or investors view consulting as a material conflict of interest.

The SEC does not even attempt to measure the costs of its proposal. Accounting firms have consistently built large and profitable consulting businesses. Such economic success does not occur at random - it follows from low costs and economic efficiencies. Furthermore, even when accounting firms have "spun off" parts of their consulting operations, they have typically kept substantial pieces of the business and have continued to act as "incubators" for new consulting operations. The kind of efficiencies that drive this repeated, consistent success can be expected to provide lower costs to customers, profits to the consultants, and career opportunities that help audit firms attract high-quality employees. These economic advantages would be eliminated or substantially reduced by the SEC proposal. If the costs in lost synergies and scope economies of the proposed regulatory prohibitions amounted to as little as one or two percent of the total value of services performed, these costs would range from $90 million to $240 million annually.

In addition, the SEC proposal could reduce the number of effective competitors providing audit and consulting services for a given public company. Many public companies employ multiple consultants. If public companies are not allowed to purchase consulting services from their auditors, then a public company in the market for a nationally recognized auditor might often find at least several of the five potential candidates unavailable. For example, if a major audit client currently uses three of the Big Five accounting firms as consultants, the proposed rule could effectively force the audit client to choose between the two remaining accounting firms for its auditor.

The SEC proposal also would create an ambiguous and open-ended regulatory framework that is likely to impose a large and complex regulatory burden. Ambiguous regulations - such as the proposal that accounting firms cannot implement a hardware or software system "that is or will be used to generate information that is significant to the audit client's financial statements as a whole" - create costs because firms must re-design their businesses to conform with the regulations and must resolve or litigate the inevitable disputes. Because accounting firms earn billions of dollars from their consulting operations, ambiguous rules are likely to result in substantial costs of "avoidance" and litigation. The enormous resources spent by U.S. public companies to minimize taxes provide a sobering example of the costs created by complex and ambiguous rules.

As has been widely documented by the economics literature, the greatest costs of regulation are often the "unintended consequences" of well-intentioned rules. In particular, regulation inevitably reduces the ability of businesses to adapt and change as their environment changes, since regulation rarely keeps pace with changes in technology and commerce. U.S. accounting firms presently have world class technical and business skills and attract large numbers of highly qualified employees - in no small part because of their consulting activities. Regulations that suppress or handicap these advantages could easily have significant unintended consequences, both on audit quality and on the U.S. economy in general. Certainly the open-ended nature of the proposed regulations increases the likelihood of unintended consequences.

The SEC proposal reflects a "command and control" mindset that is both unnecessary and counterproductive. If investors displayed material concern over auditor independence, then public companies would have an incentive to publicly announce policies of not hiring their auditors for consulting - since these policies would presumably give them easier access to capital markets. In general, the market should find the "right" level of consulting by accounting firms. The regulatory process, however, has no such self-correcting features.

The SEC has not made a case for why any change is necessary, particularly in light of the recent enhancements in the involvement of corporate audit committees in safeguarding auditor independence. But the SEC plainly has failed to demonstrate the need to go any further than requiring appropriate disclosure of information regarding non-audit services by the public company audit client. If the SEC feels compelled to impose new regulations, it could employ a disclosure approach, as does the United Kingdom, which requires public companies to disclose the amount they spend to purchase consulting services from their auditors, but does not prohibit such purchases. U.S. securities regulation relies on a fundamental premise - that accurate disclosure and reporting will permit investors to reach efficient decisions. There is, thus, no justification to go forward with a command-and-control set of regulatory prohibitions.

I. INTRODUCTION.

We find no economic support for the stated view of the Security and Exchange Commission ("SEC") that its proposal to impose a regulatory ban on an auditor's provision of certain non-audit services to its audit clients will benefit the U.S. economy. Our analysis is based on the preliminary evidence that we have been able to gather and the preliminary studies that we have been able to complete in the short time available. We recommend that the SEC undertake a more complete investigation of these issues - and provide time for others to do the same - before it attempts to implement the proposed amendments.

The heart of the SEC's concern appears to be that since the auditor independence rule was last amended in 1983, the Big Five accounting firms have rapidly expanded their non-audit businesses, and that this increase has reduced investor confidence in U.S. equity markets.⁴ In contrast to the SEC's concerns, however, the period since the last amendment to the auditor independence rule coincides almost exactly with what has been called "clearly the most dramatic bull market in U.S. history [beginning in July 1982]."⁵

All regulatory restrictions on companies' actions - like the SEC's proposed amendments - may generate benefits for, and impose costs on, the U.S. economy. Thus, to justify the proposed amendments, the SEC should demonstrate that the benefits that could be expected to be generated by the additional restrictions exceed the likely costs that they would impose on society. As we discuss in this report, however, the SEC has failed to demonstrate that its proposed amendments will generate any substantial benefits. Furthermore, the SEC has failed to investigate the likely costs that would be imposed on accounting firms, investors, and the U.S. economy. Indeed, the SEC ignores the costs that the proposed amendments will impose on investors. We explain later in this report why the proposed amendments may impose substantial costs on society.

The remainder of this report is organized as follows. In section II, we discuss why the economic evidence provides no support for a claim that the proposed restriction would generate substantial benefits for the U.S. economy. In section III, we show that the benefits that the SEC claims will be generated by the proposed amendments are unsubstantiated or based on flawed economic reasoning. In section IV, we describe the likely costs to the U.S. economy of the proposed rule amendment. In section V, we explain why the SEC's proposal is misguided and overbroad. Finally, we summarize our findings in section VI.

II. THE SEC PROVIDES NO SYSTEMATIC EVIDENCE THAT THE PROVISION OF NON-AUDIT SERVICES BY AN AUDITOR TO ITS AUDIT CLIENTS REDUCES AUDITOR INDEPENDENCE OR HARMS FINANCIAL MARKETS.

The SEC argues that the provision of non-audit services by an auditor to its client can affect auditor independence in two principal ways. First, "[l]arge non-audit engagements may make it harder for auditors to be objective when examining their client's financial statements." Second, "[p]roviding certain non-audit services to an audit client can lead an audit firm to have a mutual or conflicting interest with the client, audit its own work, advocate a position for the client, or function as an employee or management of the client."⁶ The SEC appears to concede that there is no systematic evidence that the provision of non-audit services by an auditor to an audit client harms audit effectiveness or reduces auditor independence. Instead, the SEC relies on "common sense" to support its position that investor confidence has been harmed by the large increases in non-audit services provided by public accounting firms.

We disagree that it is "common sense" that investor confidence has been reduced by the provision of non-audit services to audit clients. The SEC's claim appears to be based on the idea that an audit client could, in effect, threaten to buy fewer consulting services from its auditor if the auditor insists on "mak[ing] a judgment that works against the audit client's interest."⁷ (The SEC's claim also implies that directors and officers will violate their fiduciary obligations.) But this argument presumes that a threat to buy fewer consulting services from the auditor is credible. If an audit client has engaged its auditor for a large and complex consulting project (and these are the types of clients that the SEC appears to be concerned about), then "pulling the plug" on the consulting project could be enormously costly to the audit client. In that case, any threat by an audit client to reduce or discontinue its use of the audit firm as a consultant likely would be empty. Although we believe that empirical evidence is necessary to evaluate the SEC's proposed rule, even the "common sense" hypothesis advanced by the SEC cannot be relied on to support the proposal.⁸

The SEC's concerns about auditor independence are based on the rapid increase of accounting firms' non-audit businesses since 1983, and the effect that this increase purportedly has had on investor confidence. Indeed, the SEC claims that although "[g]radual decreases in investor confidence may not be measurable, . . . their cumulative economic impact could not be more palpable."⁹ If, as the SEC claims, these effects could not be more "palpable," it is incumbent on the SEC to document that investor confidence has been reduced by the growth of the accounting firms' non-audit revenues. The SEC has failed to do so. As we discuss in the rest of this section of our report, the economic evidence we have reviewed is inconsistent with the SEC's concerns.

A. There is No Evidence that U.S. Financial Markets Have Been Harmed by Increases in Non-Audit Services Provided by Audit Firms.

The SEC last amended its auditor independence requirements in 1983. Even in 1983, however, auditor independence was a potential issue because an audit client pays its auditor. That is, an auditor always has an incentive to take actions that favor its audit client so that it will retain the client's audit business. Thus, the concern that an auditor's independence may be compromised because it receives substantial payments from its clients is not new. Nevertheless, the system of safeguards in place is effective in almost all cases.

Indeed, a recent study commissioned by the Auditing Standards Board of the American Institute of the American Institute of Certified Public Accountants concludes that "there were no independence violations at all among national firm auditors" during the years 1987-1997. The study specifically found that "[d]espite the recent scrutiny of the independence of the Big 5 audit firms . . ., the present study did not identify a single case of fraudulent financial reporting from 1987-1997 that involved a non-independent Big 5 auditor."¹⁰

Moreover, since 1983, consulting revenues earned by accounting firms from their audit clients have grown relative to audit revenues. If the annual increases in consulting revenues had had even a gradual effect on investor confidence, we would expect that the cumulative impact of these changes would have been observable by now. That is, if increases in the provision of non-audit services by audit firms reduce investor confidence, then large increases in the provision of non-audit services over a 15-year period should have had some observable impact on investor confidence by now. In particular, we would expect that the purported reduction in investor confidence would have increased public companies' cost of capital.

The SEC has presented no evidence of a lack of investor confidence in U.S. financial markets, or of an increase in the cost of capital caused by a reduction in investor confidence. Indeed, the period since 1983 has been one of enormous growth in these markets, characterized by historically high stock prices; large increases in participation by individuals; and large increases in the use of stock markets by large and small public companies to raise capital.

For example, it has been widely reported that price-earnings ("P/E") ratios for stocks in the United States have reached unprecedented levels in the last few years.¹¹ Whether the level of these ratios is a matter of concern has been widely debated. However, whatever the explanation for current P/E levels, we are unaware of any explanation that relies on a growing lack of investor confidence. Indeed, high P/E levels suggest that investors are highly confident.

It also has been widely reported that the number of individuals investing in stocks, whether directly or indirectly, also has reached unprecedented levels. For example, in 1982 - before the large increase in non-audit service revenues received by public accounting firms - there were 6.2 million equity mutual fund shareholder accounts in the United States; by 1998, the number of such accounts had grown to 119.8 million.¹²

We would not expect to observe these market facts if there were widespread concern among U.S. investors about the integrity of the financial reporting system, including audit integrity.

B. There is No Evidence that Other Financial Markets Have Been Benefited by the Types of Regulatory Restrictions Proposed by the SEC.

The provision of some or all non-audit services to audit clients is prohibited or severely restricted in several major economies. Auditors are not allowed to provide any non-audit services in Belgium, Italy and Japan, for example, and auditors cannot provide tax or management advisory consulting services in Japan.¹³ If U.S. investors would be likely to benefit from the proposed regulations, then investors in countries with non-audit restrictions presumably are better off than U.S. investors with respect to the quality of information available to them. Although it is difficult to make international comparisons, the SEC has presented no evidence that U.S. markets are less successful than those in these other countries, or that investor confidence is greater in those countries than in the United States. If the SEC's position were correct, it should be possible to identify substantial benefits to investors generated by restrictions on the provision of non-audit services in these countries. Thus, before touting this benefit, the SEC should conduct such an analysis.

Instead, the available evidence indicates that the restrictions in other countries do not result in greater investor confidence or higher-quality financial information. By many measures, U.S. financial markets are more successful than those in other countries. For example, in 1999, market capitalization of listed companies as a percentage of GDP was higher in the United States (191 percent) than in Japan (103 percent); Belgium (75 percent); and Italy (63 percent).

III. THE SEC'S CLAIMS THAT THE PROPOSED AMENDMENTS WILL GENERATE BENEFITS ARE UNSUBSTANTIATED.

The SEC claims that its proposed rule may benefit four groups - investors; issuers; other consulting companies; and public accounting firms. As we discuss in this section of our report:

• the SEC's claim that investors will benefit from the proposed amendments is unsubstantiated;

• the SEC's claim that issuers will benefit from the proposed amendments ignores issuers' ability and incentive to avoid any costs that a real or perceived lack of independence would impose on them;

• the SEC's claim that other consulting firms will benefit from the proposed amendments ignores that the benefit to a few firms would be generated only by imposing greater costs on the U.S. economy;

• the SEC's claim that the public accounting firms will benefit from the proposed amendments is based on an error in economic reasoning.

A. Claimed Benefits to Investors.

The SEC argues that the proposed amendments will result in benefits that will "inure primarily to investors." The SEC does not, however, provide any evidence of any tangible benefits to support its claim.

The SEC relies, in part, on interviews conducted by Earnscliffe Research & Communications ("Earnscliffe") for a report to the U.S. Independence Standards Board to support its claim that investors are concerned about the provision of non-audit services by auditors to their audit clients. In particular, the SEC reports: "In conclusion, Earnscliffe reported that, "Most [interviewees] felt that the evolution of accounting firms to multi-disciplinary business service consultancies represents a challenge to the ability of auditors to maintain the reality and the perception of independence. . . . "¹⁴ However, Earnscliffe also reports that "[a]lmost everyone interviewed felt that the challenges of auditor independence would not be solved by writing new 'bright line' type policies," like those the SEC now proposes.¹⁵

The SEC cites the first phase of the Earnscliffe study, completed in November 1999. Earnscliffe has since produced a "Phase II" report (completed in July 2000), which also does not bear out the SEC's claim that investor interviews suggested that investors had substantial concerns about the provision of non-audit services to audit firms. According to Earnscliffe, "[i]n short, [investors] were saying that they felt that the level of risk was modest, the track record was pretty good, and the checks and balances seemed to be appropriate and functioning reasonably well. Clearly, people would not argue against more safeguarding, but neither was this sample agitating for more protection."¹⁶ Also, Bruce Anderson, the leader of the Earnscliffe study, was quoted as saying that "[t]here's no groundswell of demand by either individual investors or executives for the prohibition-type approach favored by the SEC."¹⁷

The SEC's concerns also are not borne out by a recent study conducted by a Panel on Audit Effectiveness (known as "the O'Malley" study) at the request of the Chairman of the SEC. The conclusions drawn from the study include:

• After a detailed analysis of audit engagements, the Panel concluded that it was "not aware of any instances of non-audit services having caused or contributed to an audit failure or the actual loss of auditor independence." (5.8)

• A majority of the Panel's members emphasized that "for about a century CPAs have been providing valuable non-audit services without these services being linked to audit failures." (5.43)

• A majority of the Panel concluded that "[i]n the absence of compelling evidence of a problem," a ban on the provision of non-audit services by an accounting firm to an audit client "is unwarranted and could well have a negative effect on audit effectiveness." (5.26)

• A majority of the Panel concluded that such a ban is "potentially punitive to clients, shareholders, and auditors." (5.49)

• The Panel unanimously concluded that "[o]n a quarter of the engagements in which non-audit services had been provided, . . . those services had a positive impact on the effectiveness of the audit." (5.18)¹⁸

The available information, thus, does not support the SEC's claims that the increase in accounting firms' non-audit revenues have had a negative impact on investor confidence. Indeed, there are many reasons why non-audit work for an audit client would not reduce an auditor's independence.

• There continues to be an active plaintiffs' bar in the United States, which provides an aggressive policing of securities "fraud";

• auditors are subject to large penalties and risks;

• audit firms have substantial interests in maintaining their reputations;

• institutional investors and analysts have an incentive to monitor auditor independence, and thus provide another set of checks and balances.

The economic benefit that an accounting firm derives from being selected a company's auditor depends on the expected tenure of the audit assignment, and it is widely known that public companies rarely change auditors - the average tenure of an audit client-auditor relationship has been estimated to be 19 years.¹⁹ If consulting engagements are shorter lived, on average, than audit engagements, then the total expected benefit from being a company's auditor may exceed the total expected benefit from the client's consulting business, even if consulting fees exceed audit fees in any one year. Thus, the SEC is claiming, in effect, that the Big Five accounting firms would endanger their reputations for the profits that are generated by non-audit consulting business that accounts for at most 10 percent of their total revenues.

Auditors already have strong incentives to maintain good reputations. For example, three studies have documented the significant business ramifications that result when government regulators criticize an auditor. Wilson and Grimlund examine how disciplinary actions by the SEC affect the criticized auditor's market share, as measured by number of clients. They find that criticized auditors suffer a net loss in number of clients. ²⁰ Michael Firth of the University of Colorado examines the impact of 22 United Kingdom Department of Trade ("DoT") investigations from the period 1969-1983 in which the auditor was criticized. He finds that criticized auditors suffer a loss in market share. He writes:

Theoretical developments in the economics literature argue for financial losses to those firms whose products and services deteriorate in quality. The reduction in firm reputation will lead to a loss of rents expected from the previously attained reputation for high quality. These potential losses provide the incentive for firms to maintain their product or service quality and hence maintain their reputational standing. The DoT reports studied in this article appeared to damage specific auditors' reputations, and therefore one would expect some economic losses to flow. The analyses reveal that criticized auditors did lose clients when compared to a relevant control group. We have seen that while the criticized Big Eight firms increased their client base, they did so at a slower rate than the Big Eight firms that were not criticized in DoT reports. In general, the impact was even more dramatic among non-Big Eight firms, where some accountants actually had absolute losses in their number of listed clients. The evidence suggests that the damaged reputation led to a reduction in market share for the audit firms concerned. Further analyses fail to reveal any significant changes in audit fees paid by incumbent clients to the criticized auditors. If there was any upward or downward pressure on audit fees, the net impact is not discernible in tests employed here. The economic losses to auditors due to critical DoT reports appear to be in the form of a reduction in market share.²¹

A more recent study by Larry Davis and Daniel Simon of the University of Notre Dame analyzes 234 initial audit engagements from the period 1978-1988. They find that, controlling for other factors influencing initial audit fees, auditors subject to SEC disciplinary actions in the prior year received lower fees. That is, while clients switching auditors typically receive a discount on their audit fee, they received an additional discount from auditors subject to SEC disciplinary actions in the prior year. Davis and Simon conclude:

The results of this study and those of Wilson and Grimlund (1990) and Firth (1990) provide mounting evidence that auditors suffer financial penalties when they are the subject of government criticism such as SEC disciplinary actions. The findings of Wilson and Grimlund, and Firth, suggest government criticism leads to a loss of market share. The results presented in this paper indicate that disciplinary actions also significantly reduce the fees which affected auditors receive. This is important because, in conjunction with past findings, it indicates that the market for audit services both rewards auditors for establishing a good reputation and penalizes auditors who suffer a loss of reputation. Thus, auditors have direct financial (fee) incentives not only for establishing a reputation for quality but also for taking steps to insure that audit services are provided at a level of quality commensurate with their reputation.²²

In additional to government criticism, auditors confront a very real risk of litigation. Zoe-Vonna Palmrose of the University of Southern California examines 64 trials involving independent auditors from the period 1960-1990 and finds that auditors' reputations are harmed merely by participating in trials, regardless of the outcome.²³

Krishnan and Krishnan note that auditors can offset litigation risk by, for example, improving audit quality and planning, increasing audit fees, and issuing a larger number of modified opinions. Another way is to withdraw from high-risk engagements. Consistent with these observations, they find that companies whose auditors resigned differ from those who dismissed their auditors along the dimensions that capture the probability of litigation, e.g., financial distress, variance in abnormal returns.²⁴

Jones and Raghunandan examine a sample of public manufacturing companies with assets of less than $50 million. In the early period of their sample, they find that Big Six audit firms were more likely than small audit firms to have clients in financial distress or clients in high-tech industries. By the end of their sample period, they find a significant reduction in the likelihood that Big Six audit firms would audit such clients. They suggest the reason may be the increase in litigation costs over their sample period.²⁵

Not only do auditors have strong incentives to maintain a good reputation, their clients have strong incentives to monitor their auditor's reputation. Firth examines a sample of 22 investigations by the United Kingdom DoT that led to criticism of the auditor and studies the stock price reaction of the auditor's other clients to the criticism. He finds that the criticized auditor's clients suffer a wealth loss.²⁶

Franz, Crawford, and Johnson analyze how litigation against an audit firm impacts the market value of its clients not involved in litigation. They document a significantly negative stock price reaction, suggesting that the stock market interprets litigation against an auditor as a signal of lower audit quality and that audit quality is incorporated into the price of a public company's securities.²⁷

The SEC provides no evidence that its proposed rule will benefit investors. The SEC's failure to do so is not surprising in light of the substantial incentives that audit firms have to maintain auditor independence.

B. Claimed Benefits to Issuers.

The SEC asserts that the proposed amendments may benefit issuers in two ways. First, the SEC claims that the proposed amendments eliminate uncertainties "as to when a registrant's auditor will not be recognized as independent."²⁸ Second, the SEC claims that because the proposed amendments will increase investor confidence, an issuer's cost of capital will fall.

As we discuss in more detail later in this report, the proposed amendments do not reduce uncertainty. In particular, because of the expansive definition of an "affiliate;" because of the ambiguous definition of some of the banned services; and because of the SEC's inclusion of a "catch-all" provision as to which non-audit services may be offered to audit clients, the proposed amendments more likely will increase an audit client's uncertainty about whether its auditor will be found to be independent.

The SEC provides no evidence that the uncertainties it discusses are a substantial (or any) concern to issuers. However, even if an issuer had such a concern, the issuer would have the means and incentive to protect itself from any such uncertainty. In particular, an audit client can limit the amount, or type of, non-audit services that it buys from its auditor; the issuer could make public, for example, that it was buying no non-audit services from its auditor. Issuers are sophisticated purchasers of both audit and non-audit services. An issuer thus is in a position to weigh the costs (increase in uncertainty) and benefits (advantages of using its auditor to provide certain non-audit services) of hiring its audit firm as a consultant. If an issuer perceived that buying non-audit services from its auditor increased the company's cost of capital to such an extent that the advantages of purchasing consulting services from its auditor would be outweighed, the issuer would have an incentive to buy fewer, or no, non-audit services from its auditor. This benefit thus appears to be either insignificant or illusory.

The second benefit to issuers claimed by the SEC is that if investor confidence is increased, issuers' cost of capital may fall. But as we have discussed, the SEC has provided no evidence that the proposed amendment would have a substantial effect on investor confidence. If the proposed amendments have no effect on investor confidence, then this claimed benefit to issuers does not exist. Again, to the extent that an issuer is concerned that purchases of non-audit services from its auditor will raise its cost of capital, it would be expected to protect itself from such higher capital costs by limiting the amount or type of non-audit services that it buys from its auditor. The SEC does not need to "protect" sophisticated issuers from their own decisions.

Using information from the United Kingdom, it is possible to investigate empirically the SEC's claim that issuers would benefit from the proposed amendments because the amendments would lead to a lower cost of capital. In the United Kingdom, a public company is required to disclose in its financial statements the fees it pays its auditor for audit and non-audit services. (We discuss the costs and benefits of a disclosure standard later in this report.) If the SEC's claim were correct, then investors should have relatively less confidence in the financial statements of issuers that purchase substantial non-audit services from their auditors. We would therefore expect that public companies in the United Kingdom would be less likely to buy substantial non-audit services from their auditors than public companies in the United States. However, data on audit and non-audit fees from the United Kingdom are inconsistent with the SEC's claims - U.K. companies appear to be more likely to rely on their auditors for non-audit services than companies in the United States.

We base our analysis on all publicly traded firms headquartered in the United Kingdom during the period 1994-97.²⁹ For each company for which annual reports are available, we calculate the ratio of non-audit to audit fees.³⁰ Fewer than 20 percent of U.K. public companies purchased no non-audit services from their auditors. By 1997, 29.7 percent of the U.K. companies paid their auditor more for non-audit services than for audit services; 55.3 percent of the U.K. companies paid their auditor non-audit fees that were at least 50 percent of audit fees; and 74.1 percent of these companies paid their auditor non-audit fees that were at least 25 percent of audit fees. See Table 1.

Table 1

Percentage of U.K. Public Companies with Ratio of Non-Audit Fees to

Audit Fees Paid to Auditor in the Range of:

The data in Table 1 are not, however, directly comparable to the results reported by the SEC for U.S. companies because we understand that the U.K. non-audit fees include tax consulting revenues. We estimate the portion of U.K. non-audit fees that are for tax consulting in the following way. First, we assume that the ratio of tax consulting fees to audit fees for a typical audit client is the same in the United Kingdom and the United States. Second, we assume that in the United States, all tax consulting revenues are for services provided to audit clients (if some tax consulting fees in the United States are earned from non-audit clients, our assumption is conservative).

Based on these assumptions, and data reported by the SEC,³¹ we calculate the average ratio of tax consulting to audit revenue for a U.S. client. For example, in 1997, total audit fees received by the Big Five accounting firms were $6,738 million, and total tax consulting fees were $4,110 million. Thus, the ratio of tax consulting to audit revenues in 1997 was 61.0 percent. Applying this percentage to the U.K. companies, we calculate tax consulting fees for each company and subtract our estimate from non-audit fees. For example, suppose that a company reports audit fees for a particular year of £1,000 and non-audit fees of £700. If the ratio of tax consulting to audit fees in that year in the United States were 61 percent, then we assume that the U.K. company's tax consulting fees were £610 (i.e., 61 percent of £1,000). Then we would estimate that non-audit fees, excluding tax consulting fees, would equal £90 (i.e., £700 minus £610).³²

We repeat the analysis in Table 1 based on our estimates of non-tax non-audit fees. We estimate that roughly 50 percent of U.K. companies purchased no non-tax non-audit services from their auditors. In contrast, over 75 percent of U.S. companies purchased no non-tax non-audit services from their auditors. In 1997, 17.5 percent of the U.K. companies paid their auditor more for non-tax non-audit services than for audit services; 27.3 percent of the U.K. companies paid their auditor non-tax non-audit fees that were at least 50 percent of audit fees; and 36.3 percent of these companies paid their auditor non-tax non-audit fees that were at least 25 percent of audit fees. See Table 2. In contrast, the comparable figures for U.S. companies were 2.1 percent; 4.2 percent; and 7.1 percent.³³

Table 2

Estimated Percentage of U.K. Public Companies with Ratio of Non-Tax Non-Audit Fees to

Audit Fees Paid to Auditor in the Range of:

In summary, the empirical evidence we have reviewed from the United Kingdom is inconsistent with the SEC's claims that the provision of non-audit services by an accounting firm to an audit client raises the client's cost of capital.

C. Claimed Benefits to Other Consulting Companies.

The SEC claims that rivals to the consulting arms of public accounting firms "may receive revenue from certain consulting engagements that, but for our proposals, would have gone to the client's auditor."³⁴ Thus, the SEC claims that these other consulting firms may benefit from the proposed amendments.

Although rivals may benefit from a restriction on an auditor's ability to provide certain consulting services, such a benefit to an individual company reflects a harm, not a benefit, to society.

It is widely recognized that regulation can produce winners and yet result in net harm to society overall. As J. Luis Guasch and Robert Hahn observe, the cost of regulation can be decomposed into transfer costs and efficiency costs: "Transfer payments provide a measure of the winners and losers from regulatory change, while changes in net surplus provide an indication of the overall impact of a regulation on the economy or industry under investigation."³⁵ They use the findings of prior studies to decompose the annual costs of a dozen economic regulations into their transfer cost and efficiency cost components for the year 1988.

International trade regulations are found to produce an annual transfer cost of between $85.6 billion and $110.6 billion, while their annual efficiency cost is $17.3 billion.³⁶ The upper bounds for the annual transfer and efficiency costs of telecommunications regulations are $42.3 billion and $14.1 billion, respectively.³⁷ Agricultural price supports produce a transfer cost of $18.4 billion and an efficiency cost of $6.7 billion.³⁸ The corresponding figures for air transport regulations are $7.7 billion and $3.8 billion.³⁹ For rail transport regulations, they are $6.8 billion and $2.3 billion.⁴⁰ The transfer cost of milk marketing orders and price supports ranges between $900 million and $3.5 billion, while the efficiency cost ranges between $400 million and $900 million.⁴¹ Natural gas regulation has a transfer cost of $5 billion and an efficiency cost of between $200 million and $400 million.⁴² Barge freight regulation has a transfer cost between $600 million and $900 million and an efficiency cost of between $200 million and $300 million.⁴³ The Davis-Bacon Act, requiring payment of "prevailing wages" to laborers on federally-funded construction projects, had transfer and efficiency costs of $500 million and $200 million, respectively.⁴⁴ Credit regulations have a transfer cost of between $150 million and $1.6 billion, whereas their efficiency cost ranges between $50 million and $500 million.⁴⁵ Ocean freight regulations have a transfer cost between $150 million and $220 million, while their efficiency cost lies between $50 million and $80 million.⁴⁶

Overall, Guasch and Hahn conclude that the annual transfer cost for the dozen economic regulations in their study for the year 1988 totals between $172.1 billion and $209.5 billion, while the annual efficiency cost totals between $45.3 billion and $46.5 billion. Clearly, the size of the transfers is enormous and the recipients of the transfers are winners from the regulations. Just as clear, however, is the substantial harm to society, as evidenced by the size of the efficiency costs.

Regulation that keeps banks out of the insurance brokerage industry makes insurance companies winners. Likewise, securities firms are winners from regulations that keep banks out of the securities industry. Yet, society overall is a loser. A study by Amar Gande of Vanderbilt University, Manju Puri of Stanford University, and Anthony Saunders of New York University investigated the impact of commercial bank entry into the corporate debt underwriting market. They found that "underwriter spreads and ex-ante yields have declined significantly with bank entry, consistent with the market becoming more competitive."⁴⁷ Thus, not only were banks the losers from regulation which kept them out of this market, the issuers and shareholders were as well. In fact, the study found that the main beneficiaries of bank entry into this market have been relatively small issuers of below-investment-grade debt.

Thus, although untaxed or unregulated companies may benefit at the expense of their taxed or regulated rivals, it would be inappropriate to conclude that the U.S. economy benefited from the tax or regulation just because the untaxed or unregulated firms were made better off.

If public companies change consultants (or auditors) because of the proposed amendments - and it is the intent of the SEC that such changes occur - "transition" costs will be imposed on the client or new consulting company (which may offer to absorb the transition costs). To the extent that "synergies" or "economies of scope" between an auditor and its consulting arm are lost, society is further harmed by the loss of those benefits. (We discuss economies of scope, and the potential costs associated with their loss, later in this report.)

Finally, because of the proposal's expansive "affiliate" definition, consulting firms that maintain partnerships or joint ventures with an accounting firm may be precluded from providing consulting services to a large number of public companies. Thus, any such firm would not be eligible for the SEC's "benefit" unless they ceased "affiliate" business relationships with accounting firms.

The SEC's analysis of the benefits to other consulting firms is based on flawed economic reasoning that ignores the harm to society from favoring one group of companies at the expense of their rivals.

D. Claimed Benefits to Public Accounting Firms.

The SEC claims that public accounting firms will receive two benefits from the proposed rule. First, the SEC claims that the proposals will "clarify" what non-audit services can be provided by an accounting firm to its audit client without jeopardizing auditor independence. Second, the SEC claims that the proposed amendment could increase competition for non-audit services.

The proposed amendments, however, contain significant ambiguities. For example, the amendments would prohibit an accounting firm from implementing a hardware or software system "that is or will be used to generate information that is significant to the audit client's financial statements as a whole."⁴⁸ It is difficult to think of any major hardware or software system that will not generate information that could be "significant" to a client's "financial statements as a whole." What precisely does this proposed language preclude an accounting firm from doing for an audit client? What does it allow? And most importantly, how does this proposal "clarify" what non-audit services can be provided by an accounting firm to its audit client without jeopardizing auditor independence? This proposal appears to create confusion, not resolve it. Another important ambiguity is introduced by the SEC's inclusion of a "catch-all" provision - this provision leaves unclear which services the SEC may conclude, in the future, that accounting firms are not allowed to offer their audit clients. This type of undefined regulatory standard necessarily introduces uncertainty.

The SEC's claim that accounting firms will benefit from restrictions on their rivals is similar to its claim that other consulting companies will benefit from the restrictions. The SEC's claim that its proposals may increase competition for non-audit services is based on flawed economic reasoning. Currently, a public company faces no restriction on the source of consulting services. If the SEC's proposal is adopted, a public company may be restricted from buying consulting services from its auditor - thus, the number of consulting firms competing for its business may fall by one, which may mean that there is less competition for the client's consulting business. At best, a public company's choice of consulting firm will be unaffected by the proposal. It is flawed economic reasoning to claim that a possible reduction in a public company's choice of consultant reflects an "increase in competition" for that client's business.

Moreover, even if an individual public accounting firm benefited from the proposed restrictions, the U.S. economy as a whole is not benefited. Indeed, the SEC notes that "the overall impact of the proposed restrictions may be to re-distribute the restricted non-audit services among the public accounting firms."⁴⁹ If the SEC's conjecture is correct, it is clear that the accounting firms, in the aggregate, will be harmed. Simply "redistributing" business among different rivals imposes transaction costs but generates no benefits. Again, to the extent that economies of scope between an auditor and its consulting arm are lost, society is further harmed by the loss of those benefits.

In short, the SEC presents no evidence in support of its claim that its proposal will benefit public accounting firms. A regulation-mandated "redistribution" of business among a group of companies results in social costs, not social benefits.

IV. THE SEC FAILS TO CONSIDER THE COSTS OF ITS PROPOSED AMENDMENTS.

The SEC has failed to quantify the costs that its proposed amendments to its auditor independence standards will impose on the U.S. economy. Indeed, the SEC does not appear to even recognize that its proposal may impose substantial costs on investors, who are apparently intended to be the prime beneficiaries of the proposal. In this section, we discuss the potential costs to public shareholders and issuers, and the potential costs to the public accounting firms. The SEC should consider and attempt to quantify these costs.

A. Potential Costs to Issuers and Shareholders.

The proposed rule amendments likely will impose substantial costs on public companies - higher audit or consulting fees (or both); transition costs; and regulatory costs. But costs imposed on issuers are ultimately borne by issuers' owners - that is, by public company shareholders. Thus, the proposed amendments likely also will impose substantial costs on the group that the SEC claims will be most benefited by the proposed rule.

1. Loss of Economic Benefits from Restricting the Combination of Auditing and Consulting.

Public accounting firms have been successful competitors in the provision of consulting services to their audit clients. As a general matter, persistent and widespread economic success does not occur at random - such success reflects some form of economic advantage. For example, supermarkets have successfully marketed a wide variety of food products, but Sears was unsuccessful in markets for financial services. Success by firms that offer a variety of different, but related, products suggests that those firms can take advantage of "economies of scope" - a type of efficiency. That is, it sometimes is more efficient to produce two or more products (or services) within one firm than in different firms. Markets reward firms that combine businesses that can take advantage of scope economies.

Some of the Big Five accounting firms have divested, or announced their intention to divest, part of their consulting arms. The SEC claims that "[i]f efficient and effective audits require the expertise that can be most efficiently maintained through the provision of consulting services to audit clients, these firms would be unlikely to sell their consulting practices."⁵⁰ However, we understand that these accounting firms have continued to offer some consulting services to their clients. For example, we understand that Arthur Andersen currently offers a range of consulting services, despite having separated from Andersen Consulting. Furthermore, other accounting firms, such as Deloitte and Touche, have retained their consulting businesses.

These spin-offs suggest that economies of scope may not exist between audit services and all consulting services (or that economies of scope become less important after a consulting business reaches a certain size), but the retention of at least some consulting functions by each of the Big Five accounting firms strongly suggests that economies of scope between auditing and consulting services are important.⁵¹

To properly evaluate the costs and benefits of its proposal, the SEC needs to quantify the value of the scope economies that would be lost as a result of the proposal being implemented. Currently, the economic value of these efficiencies might be captured by either the auditor, or the client, or both. Thus, elimination of these economic benefits could reduce economic welfare generally, and could specifically harm both the auditing firms and the shareholders of their clients.

Adoption of the proposed amendments could result in:

• Higher consulting costs, since public companies would need to hire consultants who were not already familiar with their business;

• Less effective consulting help, since the consultants would have less expertise and less client-specific knowledge;

• Lack of highly qualified consulting advice, since public companies might decide to forego help on certain projects rather than incur the higher costs of bringing in new consultants.

Several studies find evidence that economies of scope may be significant in the auditing industry. Dan Simunic of the University of British Columbia documents that "audit fees for clients who also purchased MAS [management advisory services] from their auditors are higher than those of clients who did not do so" and "[u]nder the model developed here, this observed fee increase is interpreted as arising from a beneficial knowledge spillover between services."⁵²

Zoe-Vonna Palmrose of the University of California, Berkeley also investigates the effect of the provision of non-audit services on the pricing of audit services and reports:

While the results do not provide unambiguous support for joint supply in the pricing of audit services, the pricing of nonaudit services may nonetheless reflect joint-supply benefits. This is a possible explanation for the small number of companies in the sample using nonincumbents for nonaudit services. Based on the widespread use of incumbents for nonaudit services, it appears that clients perceived they were generally better off (or no worse off) with the joint supply of audit and nonaudit services.⁵³

Rick Antle and Joel Demski, both of Yale University, begin their 1991 article as follows:

The prominence of management consulting services in the largest CPA firms leaves little doubt that there are economies of scope between auditing and at least some types of consulting. The source of these economies of scope has been conjectured to be the result of information produced as a by-product of performing audit work (e.g., Simunic [1984]). This information may be about the benefits to a client from a certain type of consulting project, or it may be about how best to produce desired consulting services and thereby reduce the cost of supplying these services.

Antle and Demski also suggest a second source of these economies of scope - "contracting frictions." They explain:

The particular contracting frictions we study arise from the CPA firm's private information about the costs of performing auditing and consulting for a particular client. We show such private information may give rise to economies of scope, in the sense that the client is better off purchasing auditing and consulting from the same CPA firms as opposed to separate sourcing of the two services. The presence of economies of scope from contracting frictions and private information is shown to depend crucially on the ex ante relation among the costs of the services. In particular, a positive relation between expected consulting and auditing costs precludes economies of scope, whereas a negative relation allows it.⁵⁴

Benito Arruñada of Pompeu Fabra University distinguishes between economies of scope arising from knowledge spillovers and economies of scope of a contractual nature. He writes:

Auditors have provided their clients with many types of service since the time when external auditing began in the nineteenth century up to the present day. The reason why accountants and auditors provide services that complement their principal task is connected, now and in the past, with the considerable economies of scope, or joint production, involved - meaning cost savings obtained when both types of service are provided by the same person or firm. A distinction should be made within these economies of scope between those that originate in the transformation process directed toward the production of information and knowledge, often known in accounting literature as knowledge spillovers, and those arising from making better use of assets or advantages of a contractual nature. Productive economies usually arise from the fact that both types of service need to use the same set of information and/or the same professional qualifications. For example, the information required to evaluate an internal control system is largely identical to the one needed to improve it. Auditors are therefore in the best possible position to advise on renewing such systems. Similarly, an audit necessitates evaluating the adequacy of provisions for paying taxes, which requires substantial competence on the part of the auditor in the tax field as well as in many other areas. Conversely, qualification in all these areas facilitates audit work, and the provision of these services enables the auditor to form a better founded judgment regarding the client. . . . Both types of economies of scope contribute to enhancing the technical competence of audit firms, i.e., their ability to detect shortcomings in accounts.⁵⁵

Arruñada explains that "[c]onsiderable problems arise in quantifying even the most tangible of these economies of scope, especially those related to the improvement of technical competence and professional judgment," but adds, "[m]ost observers, however, accept their existence." Moreover, he contends that these economies of scope "are probably becoming increasingly extensive as the scope of auditing increases and businesses become more complex and their activities more global." As for the empirical evidence on economies of scope, Arruñada writes:

Empirical evidence on economies of scope is of two kinds. Qualitative signs point clearly to their importance: The persistent interest of firms and clients in the joint provision of services, as pointed out by Antle and Demski (1991, p. 1); the fall in service provision after rotation [DeBerg et al. (1991)]; the fact that internal auditors increasingly provide non-audit services (see, e.g., "Internal Auditors and Internal Consulting," Internal Auditor, June 1996, p. 10); and the use of auditing as a loss leader to attract service business. This practice, in the absence of economies of scope, can only be explained as a result of predation (which industrial organization analysts consider implausible...) Measurement of these economies is difficult, however, as the possible interactions are very complex [Gaver and Gaver (1995)], and available data only allow for indirect tests based on audit prices or costs, there being no figures for non-audit services. Most of the studies, however, identify economies of scope as a cause of their observations. This is the case of the seminal work by Simunic (1984), which was followed by Palmrose (1986), Turpen (1990), Davis et al. (1993), Barkess and Simnett (1994), Ezzamel et al. (1996, 1998), and Firth (1997).⁵⁶

Although the limited time available has not allowed us to estimate the magnitude of the loss of economies of scope that would result from the proposed amendments, it is important to realize that even apparently small efficiency losses can result in substantial harm to public companies.⁵⁷ These losses ultimately will be borne by the shareholders of public companies. To illustrate the potential magnitude of these losses, consider that the SEC estimates that "[f]or the five largest public accounting firms, MAS [non-audit] fees received from audit clients amounted to 10 percent of all revenues in 1999"⁵⁸ - about $3.0 billion.⁵⁹ If these companies are forced to switch consultants by the proposed amendments, they will have to turn to higher-cost or lower-quality consultants. If we assume that these audit clients' consulting costs would go up by only one to two percent as a result, these companies would have incurred additional costs of $30 to $60 million in 1999, and additional costs would recur in the future.

Another reason why at least some companies may prefer to purchase auditing and consulting services from the same accounting firm is that a client for which intellectual property is an important asset may want to limit the number of companies that have access to its business secrets. Trade secrets are widely acknowledged to be a type of valuable intellectual property. A 1998 article in Research-Technology Management states, "[i]ndispensable to the manufacture of company products, proprietary information on processes, methods, formulas, machines, and technical data and designs increase the value of any business property." The authors enumerate a long list of examples:

Indispensable to the manufacture of most products, trade secrets are unpatented proprietary information on manufacturing drawings, designs, specifications, test procedures, manufacturing processes, maskworks, schematics, layouts, charts, production data, material lists, quality control records and procedures, research and development files, manuals, technical data, laboratory notebooks, tooling routings, inspection data and processes, equipment lists, picture process sheets, process procedures, equipment prints and specifications, catalogs, price and mailing lists, cost data, business plans, and customer lists.⁶⁰

A 1994 article in Mergers & Acquisitions states:

All companies claim to have trade secrets. These can range from customer lists and supplier contacts, on the one hand, to proprietary research and data, at the other extreme. . . . Trade secrets can be quite valuable and, if properly protected, can retain this value for quite a long time. The most famous example is Merchandise 7X, the formula for Coca-Cola, which has been a trade secret since Dr. John S. Pemberton developed it in 1886. . . . If a company has not taken the steps necessary to protect its trade secret information from disclosure, courts will not enforce any rights in the information and such a "trade secret" may prove to offer no competitive advantage at all.

The author of the study makes the observation that a good way to keep a trade secret a secret is to limit access to it:

The Coca-Cola Co., for instance, restricts knowledge of the Merchandise 7X formula to two company officials, neither of whom is publicly identified. . . Of all the potential breaches of security, plant tours are notorious. If a company allows visitors to regularly view its production areas, it cannot claim that what can be viewed by such visitors is a trade secret. For this reason, Kellogg Co., after 80 years of plant tours, stopped allowing the general public to tour its facilities in 1986. Kellogg had state-of-the-art cereal packaging and processing equipment and believed it had been victimized by industrial spies sent through the tour. Kellogg sought to protect the competitive advantage obtained from such equipment as a trade secret. To keep the trade secret a secret, Kellogg closed its plant to visitors.⁶¹

Numerous other articles make the same point: if you want to keep a trade secret a secret, limit access to it.⁶² For example, an article titled "Supplier Relationships and the Trade Secrets Dilemma" states, "[t]he fact that `secrets shared are more likely to slip away' in the course of business than those kept confidential will surprise few."⁶³

Several articles express concern about consultants' access to a company's trade secrets. Joseph Iandiorio, a lawyer, observes, "[c]onsulting relationships can expose both sides to a great deal of the other's trade-secret, confidential, and proprietary information" and argues that companies should require their consultants to sign agreements safeguarding the firm's trade secrets.⁶⁴ A 1993 article in a magazine for Chief Information Officers also suggests that a company obligate its consultants to protect its trade secrets and copyrighted material.⁶⁵

An illustration of the problems posed by consultants who gain access to a company's trade secrets is the dispute between Wal-Mart and Amazon.com over the latter's hiring away of the former's computer system managers and on-site consultants.⁶⁶ Wal-Mart alleged that Amazon.com engaged in "employee theft" to steal trade secrets regarding its information systems which handle data on sales, inventory, and consumer buying habits.

Thus, public companies that would prefer to limit the number of firms that have access to their proprietary information would be harmed by the proposed rule. They either would have to forgo valuable consulting - which would thereby be expected to decrease shareholder value - or take on more risk of losing confidential information than they prefer.

2. Transition Costs Imposed by the Proposed Regulations.

If the SEC proposals were adopted, and at least some audit firms retained at least some consulting capabilities, some audit clients would be faced with either changing auditors, or changing consultants. Alternatively, every audit firm could dispose of all of its consulting capabilities. In either case, the proposal would impose substantial transition costs on the U.S. economy. Furthermore, in either case, because of the proposal's broad definition of "affiliates," audit firms or clients would need to implement mechanisms capable of conducting extensive "conflict checks" to ensure that no proscribed non-audit services were provided by accounting-firm affiliates to audit clients or their affiliates.

As the SEC's proposal recognizes, there likely are substantial costs to changing auditors or consultants, even if such a change does not sacrifice any economies of scope (and as we have discussed, the economic evidence suggests that scope economies between auditing and consulting are present). For example, it is widely recognized that changing auditors is costly. Linda DeAngelo of the University of Pennsylvania points out that the Commission on Auditors' Responsibilities stated that mandatory auditor rotation would "considerably increase the cost of audits because of the frequent duplication of the start-up and learning time necessary to gain familiarity with the company."⁶⁷ The costs of changing auditors, DeAngelo contends, "properly include not only transactions costs but also any duplication of start-up costs borne by the client." She writes:

Extant empirical evidence is consistent with the existence of significant start-up/transactions costs in the exchange of audit services. In particular, the uniform finding of extant studies [Burton and Roberts (1967), Bedingfield and Loeb (1974), Carpenter and Strawser (1971), Bolton and Crockett (1979), Hobgood and Sciarrino (1972), Financial Executives' Institute (1978), and Coe and Palmon (1979)] is that the rate at which client firms change auditors is low. For example, Burton and Roberts found a change rate of approximately one percent per annum for a sample of Fortune 500 firms for the time period 1955-1963, while Coe and Palmon found a change rate of approximately 2 percent per annum for a random sample of firms listed on the COMPUSTAT tape from 1952-1975. For smaller firms, the auditor change rate is generally higher, but does not exceed five percent per annum. This evidence is consistent with the assumption that client-specific start-up/transactions costs (and therefore quasi-rents to incumbent auditors) are material.⁶⁸

In another article, DeAngelo remarks:

It is well recognized in the literature that initial audit engagements entail significant start-up costs. Arens and Loebbecke (1976, p. 100) provide three reasons for this phenomenon:

1) It is necessary to verify the details making up those balance sheet accounts that are of a permanent nature, such as fixed assets, patents, and retained earnings.

2) It is necessary to verify the beginning balances in the balance sheet accounts on an initial engagement.

3) The auditor is less familiar with the client's operations in an initial audit.

In addition to these start-up costs, DeAngelo contends, there are transaction costs of changing auditors, such as those arising from disclosure requirements. She writes, "[t]he incumbent's advantage arises because new auditors must bear technological start-up costs (which are sunk costs to incumbents) and because of the transaction costs of switching auditors." ⁶⁹

David Williams of Ohio State University begins his article on the potential determinants of auditor change as follows:

Both direct and indirect costs may be incurred by clients when they decide to change auditors. For example, direct costs range from additional client assistance required for the auditor to establish an understanding of the client's operations, industry, and environment during the breaking in period (Berlin and Walsh, 1972), to a potential audit failure resulting from the auditors' unfamiliarity with the client (Commission on Auditors' Responsibility, 1978). Fried and Schiff (1981) discussed that an indirect cost of switching is a higher degree of information risk assigned to financial statements by financial statement users who suspect that the client `shopped around' for a more accommodating auditor in an attempt to manipulate earnings.⁷⁰

Other studies also acknowledge that changing auditors is costly. Healy and Lys note that companies that voluntarily change auditors "incur start-up costs when they replace their audit firm" and that the start-up costs "include the auditor's fee for examining and evaluating the client's accounting system and the costs of the additional time spent by management explaining the system to the new auditor."⁷¹ Simon and Francis conduct an econometric analysis of audit fees paid by companies that change auditors and warn, "[t]hese estimates of fee reductions are likely to understate the actual discount since audit start-up costs are not considered in the analysis but are likely to be nonzero."⁷² Johnson and Lys write: "[a]uditor realignment imposes transaction costs on both the client and the incumbent auditor [DeAngelo (1981), Magee and Tseng (1987)]. Clients lose the opportunity cost of resources (including managerial time) devoted to familiarizing new auditors with enterprise reporting systems and operations."⁷³

As we have discussed, for the audit clients most affected by the proposed amendments, the cost of changing consultants may be substantial (e.g., a consulting company may be in the middle of four-year project to install a new billing or inventory management system). In this case, the proposed amendments, if enacted, could force an audit client to change auditor (instead of consultant). However, for major audit clients, the proposed amendments would limit the client's choices of auditor to at most four - fewer, if the audit client purchased consulting services from more than one accounting firm. For example, suppose that a major public company uses Big Five firm A for IT consulting, Big Five firm B for human resources consulting and Big Five firm C for compliance systems. If accounting firms A, B and C did not divest that specific portion of their consulting operation, the public company could not use A, B or C as an auditor. At that point, the audit client could be forced to choose between the two remaining Big Five accounting firms for its auditor. This reduction in the number of potential auditors could result in higher audit fees for the public company. Furthermore, even if the cost of the audit did not increase, the public company could be harmed by changing auditors. Each of the Big Five accounting firms may have somewhat different levels of expertise in, for example, particular industries. Thus, to the extent that one or more accounting firms are precluded from being chosen as an auditor because of a consulting assignment, an audit client may have to hire an auditor that would not have been its first choice. (This possibility increases in likelihood if an accounting firm with a relatively high level of expertise in an industry also has a consulting arm with a relatively high level of expertise in the same industry - an audit client in that industry would be more likely to want to purchase both accounting and consulting services from this accounting firm, but the proposed rule could force the client to choose between buying auditing and consulting services.)

Alternatively, every Big Five accounting firm might restructure by divesting its consulting arm. The SEC's proposals increase the likelihood of such divestitures for two reasons. First, by reducing economies of scope between auditing and consulting, the proposals would reduce the benefit of one firm offering auditing and consulting services - the costs of providing audit services and consulting services would both rise. Second, the proposals would preclude the consulting arm of an integrated accounting/consulting firm from offering consulting services to a substantial number of firms, which would impose a cost on the consulting arm. Similarly, the accounting arm of an integrated firm would be precluded from offering audit services to its consulting clients. Thus, under the SEC's proposal, the economic value of the integrated firm might increase if it were split into separate accounting and consulting firms.

Such restructurings can impose substantial transaction costs, including legal fees; investment banking fees; turnover costs; costs of business disruption and other related costs. Ernst & Young sold part of its consulting business (to Cap Gemini) for over $10 billion. Press reports suggest that PriceWaterhouseCoopers is considering selling certain consulting businesses to Hewlett-Packard for approximately $17-$20 billion. Transactions of this size generate substantial "deal fees." For example, we have collected information on the deal fees paid by the parties involved in the last three transactions valued at between $10 and $20 billion for which deal fee information is publicly available. The last three such transactions were: Dow Chemical's acquisition of Union Carbide for $11.7 billion; Motorola's acquisition of General Instrument for $10.9 billion; and El Paso Energy's acquisition of Coastal Corp. for $16.0 billion. The total reported deal fees in these three transactions were $19.875 million; $30.0 million; and $20.0 million.⁷⁴ Restructuring also could have other, substantial, costs in the form of unintended consequences. We discuss the costs of unintended consequences in the following section.

3. Costs Due to Regulatory Burdens and Unintended Consequences.

It is widely recognized that regulation is costly and may have unintended consequences. A classic study of the magnitudes of these costs was conducted by Richard Posner in 1975.⁷⁵ Judge Posner estimated that the social cost of regulation of physician services was 31 percent of the industry's revenues.⁷⁶ The social cost of regulation in the eyeglass industry was 24 percent of industry revenues.⁷⁷ The corresponding figures for the milk⁷⁸, motor carrier⁷⁹, oil⁸⁰, and airline industries were 10, 30, 32, and 19 percent, respectively. These enormous social costs reinforce the point made earlier: although regulation can create winners, society overall may be a net loser. Physicians, optometrists, and dairy farmers, for example, were winners from the regulations Posner examined, but as his results clearly show, society on the whole was a net loser.

More recent studies of various regulations also report enormous welfare losses. In a summary article,⁸¹ Robert Hahn reports that international trade restrictions produced an annual welfare loss of $3.5 billion (in 1990 dollars); the Jones Act (which requires ships travelling between U.S. ports to be built in U.S. shipyards, owned by U.S. citizens, and operated by an American crew) produces an annual welfare loss of $2.8 billion (in 1991 dollars); milk marketing orders (an United States Dairy Association price discrimination scheme which raises the price of fluid milk and drives down the price of manufactured milk products) produced an annual welfare loss of between $343 million and $608 million (in 1985 dollars); the Davis-Bacon Act (which requires laborers on federally funded construction projects to be paid "prevailing wages") produced an annual welfare loss of $200 million (in 1988 dollars); and corporate average fuel economy standards produced a $4 billion welfare loss between the years 1978 and 1989. Once again, the enormous magnitudes of these welfare losses clearly demonstrate that, although certain special interests undoubtedly gain from these regulations, society as a whole is harmed.

In general, the interaction between regulators and those they regulate has been described as "a cat-and-mouse game"⁸² and "regulatory dialectic."⁸³ An economist at the Federal Reserve Bank of Cleveland, João Cabral dos Santos, illustrates this cat-and-mouse game in the case of the Glass-Steagall Act by describing how banks have devised ways to get around, for example, interstate branching restrictions, prohibitions on interstate banking, and limitations on permissible securities activities. He writes:

The regulatory back and forth described here has been - and will continue to be - costly. Besides the resources involved in developing innovations and enacting legislation to prohibit them, further costs will be incurred once the regulatory barriers that inspired these innovations have been repealed. The reason is that some of these innovations will become inefficient. . . . As the history of the movement to interstate banking shows, the cost-benefit analysis of a regulation is incomplete unless it considers the costs of the regulatory cat-and-mouse game it might engender. . . . A regulation that on its surface may contribute to the banking system's efficiency and stability can also harbor hidden costs and perverse outcomes if it fails to factor in banks' incentives and reactions.⁸⁴

The unintended consequences of regulation also may impose substantial costs on the U.S. economy. For example, a recent U.S. General Accounting Office study on air pollution warns, "[i]n addition to the potential difficulty of complying with multiple regulations, efforts to comply with one program by controlling emissions of a pollutant from a single facility can have the unintended effect of increasing emissions of other pollutants from elsewhere in the same facility."⁸⁵ An article by Bryan Anderson and William Casey explains how the viability of an emissions allowance market may be unintentionally threatened by state public utility statutes requiring a utility to obtain approval from the public utility commission prior to selling any utility "property" above a certain dollar amount, or prior to purchasing the "property" of another utility.⁸⁶ Robert Crandall of The Brookings Institute discusses corporate average fuel economy standards, which had an unintended negative effect on vehicular safety.⁸⁷ Using the results of Greene,⁸⁸ Crandall calculates that the welfare cost per gallon of gasoline saved soars from 30¢ to 41¢when the effect of safety is included, an increase of 37 percent. The increase is smaller, from 59¢to 63¢(or 7 percent), when he uses the results of Leone and Parkinson,⁸⁹ but the general conclusion remains the same: the unintended consequences of regulations may significantly raise their cost.

The unintended consequences of a regulation may be quite surprising, as demonstrated by Martin Summer, who constructed a game-theoretic model to explore the impact of imposing mandatory rotation of auditors. Mandatory rotation has been advocated as a means of enhancing auditor independence on the grounds that the client will be unable to influence its auditor by threatening termination. Summer's model shows, quite to the contrary, that if auditors can acquire a reputation for independence because the public can learn whether or not an auditor is trustworthy, regulation by rotation rules would impair auditor independence, rather than enhance it.⁹⁰

The danger of imposing regulatory burdens, and of unintended consequences, are of particular concern in situations where regulations are ambiguous. The SEC's proposed amendments are vague and unclear, particularly the definition of an "affiliate," and thus would be difficult to enforce. In particular, the proposed amendments apply whenever an "accountant provides certain non-audit services to an audit client or an affiliate of the client."⁹¹ "Affiliate of an audit client" is defined as "an entity that has significant influence over the audit client, or over which the audit client has significant influence, including the audit client's parent and subsidiary."⁹² The "significant influence" test is described in the proposed amendments as including relationships such as "representations on the board of directors; participation in key policy decisions; material intercompany transactions; interchange of personnel"; and any direct or indirect investment in 20 percent or more of a company's voting stock.⁹³ Under the SEC's proposal, we understand that this definition also would be applied to "affiliate" firms - thus, if an affiliate has a "significant influence" over a second company, that company also would be affected by the SEC's affiliate definition. This aspect of the proposed amendments promises to generate considerable controversy and confusion.

Complying with ambiguous regulations can be enormously costly. As one example, consider the costs of complying with the U.S corporate tax laws, which are generally recognized as ambiguous. Public companies paid over $5.7 billion in tax consulting fees to the Big Five accounting firms in 1999, and this total does not include tax consulting done by other companies (e.g., law firms), and the internal resources that corporations expend on complying with the tax code.⁹⁴

Later in this report, we discuss the likely costs of SEC's proposal on accounting firms. These additional costs - such as a loss of skills and competencies by the accounting firms, which may lead to less effective audits, which may lead to more litigation - also are an unintended consequence of the proposed rule.

4. Summary.

The SEC presents no estimates of the costs its proposal would impose on public companies. As we have discussed, these costs could be substantial, and would arise from a variety of sources - lost economies of scope; transition costs; and the costs of regulatory burdens and unintended consequences. The SEC should estimate each of these costs.

B. Potential Costs to Accounting Firms.

The proposed amendments also could impose a variety of costs on public accounting firms. (Some portion of these higher accounting firm costs ultimately would be borne by shareholders of public companies). The SEC should measure these costs.

The proposed regulations might force accounting firms to duplicate the expertise that already exists within accounting firms, since the accountants would not be permitted to use their expertise for consulting. This change might require hiring and training of additional personnel.

The proposed regulation might reduce the ability of accounting firms to attract and retain highly qualified employees by restricting consulting-related compensation and career development opportunities. This phenomenon could reduce audit quality. If audit quality is reduced, more engagements might become "high risk." As we have discussed, prior research has found that auditors may respond to the increased risk by increasing audit fees, issuing a larger number of modified opinions, or withdrawing from high-risk engagements.⁹⁵

The proposed regulations might reduce the opportunities for accounting firm personnel to acquire valuable knowledge and expertise through consulting work. The absence of such knowledge and expertise might reduce audit quality. Reductions in audit quality may result in more litigation and higher insurance costs.

For each of these reasons, the costs of conducting an audit may increase. These higher costs likely will be borne, at least in part, by audit clients, and thus ultimately by shareholders. Although we have been unable to estimate such higher costs due to time limitations, we note that even a small increase in audit fees would impose substantial costs on the U.S. economy. For example, total audit fees paid by public companies in 1999 exceeded $9 billion.⁹⁶ If the costs of an audit were to increase by one to two percent as a result of the proposed amendments, the total cost to the U.S. economy would have been $90 to $180 million in 1999. That annual cost of $90 to $180 million would likely increase in the future.

V. THE SEC'S PROPOSED RULE IS MISGUIDED AND OVERBROAD.

As we discuss in this section of our report, the SEC's proposed rule fails to address its purported concerns. The SEC claims that it is concerned about the dollar value of consulting services that audit clients purchase from their auditors, but its proposed rule prohibits accounting firms from offering certain types of services. Furthermore, the proposed rule is overbroad - the SEC's concerns could be addressed at substantially less cost by adopting an appropriate disclosure approach.

A. The Proposed Rule Does not Address What the SEC's Stated Concerns.

The potentially large costs of the SEC's prohibitionary rule are particularly troubling given that the proposed amendments do not address the SEC's stated concern. The SEC claims that it is concerned that the possibility of obtaining large consulting assignments from an audit client can endanger an audit firm's independence. For example, as we have discussed, the SEC claims that "[l]arge non-audit engagements may make it harder for auditors to be objective when examining their client's financial statements." But the SEC proposed to limit the type of services that an audit firm can supply to its audit client, not the total amount that the audit firm can collect from its client for non-audit services.

The SEC's discussion of its concerns is based largely on the increasing magnitude of total non-audit fees collected from audit clients, but it has not attempted to determine what percentage of those fees are generated by services that would be affected by its proposal. Thus, the SEC has provided no basis to determine how its proposal will affect the total dollar amount of non-audit fees collected by the accounting firms from its audit clients.

It is clear, though, that under the SEC's proposal, accounting firms can continue to collect billions of dollars in non-audit fees from their audit clients. In particular, the SEC proposal explicitly exempts tax services. According to the SEC, "[t]ax services are unique, not only because there are detailed tax laws that must be consistently applied, but also because the Internal Revenue Service has discretion to audit any tax return."⁹⁷ But the SEC's explanation for why it exempts tax consulting services is a non sequitor - the IRS can audit only the tax returns of a public company, not its audited financial statements. If, as the SEC claims, it is large payments by audit clients to audit firms that raise concerns, payments for tax consulting services should raise the same concerns. That is, according to the SEC's reasoning, large tax engagements also make it harder for auditors to be objective about the client's financial statements.

As we have discussed, the SEC reports that, in 1999, 10 percent of the Big Five firms' revenues were attributable to non-tax consulting engagements with audit clients. In the same year, tax consulting revenues were 19 percent of total revenues for these firms.⁹⁸ We do not have information on the extent to which the firms' tax consulting revenues were derived from audit clients. However, if over half of tax consulting revenues are from audit clients, then tax consulting revenues from audit clients are of similar magnitude, or even larger, than non-tax consulting revenues from audit clients. Nevertheless, the SEC proposal would permit the provision of tax consulting services by accounting firms to audit clients.

B. An Appropriate Disclosure Approach Would be a Less Costly Alternative than the SEC's Prohibition Proposal.

As we have discussed, the SEC's proposed amendments likely will impose substantial costs on U.S. shareholders, issuers and the public accounting firms. Because the SEC has failed to demonstrate that the proposed amendments will generate substantial benefits to the U.S. economy, it has not made a case for why any change is necessary, particularly in light of the recent enhancements in the involvement of corporate audit committees in safeguarding auditor independence. To the extent that the SEC believes that the provision of non-audit services by auditors creates a "perception" problem, we submit that the SEC should develop educational programs to alleviate any "perception" problems instead of imposing a costly regulatory approach to address a purported problem for which there is no evidence.

But the SEC plainly has failed to demonstrate the need to go any further than requiring public companies to make an appropriate disclosure of non-audit services acquired from their auditors. Although we express no view on the merits of a disclosure standard - or what would constitute an appropriate form of disclosure - it is clear that an appropriate disclosure standard would impose fewer costs than the SEC's current prohibition-style proposal.

A disclosure approach will impose fewer costs than the proposed amendments - for example, a disclosure approach likely would result in fewer lost scope economies; fewer transition costs; and a lighter regulatory burden than the SEC's proposals. Thus, if the SEC feels compelled to impose new regulations, it could employ a disclosure approach. For example, the United Kingdom requires public companies to disclose the amount they spend to purchase consulting services from their auditors, but does not prohibit such purchases. Moreover, U.S. securities regulation relies on a fundamental premise - that accurate disclosure and reporting will permit investors to reach efficient decisions. There is, thus, no justification to go forward with a command-and-control set of regulatory prohibitions.

We add, however, that if the SEC decides to recommend a disclosure approach instead of its current proposal, the costs and benefits of requiring this type of disclosure should be carefully considered before moving forward. It is important to note that even a disclosure approach can impose costs on issuers, and thus shareholders. For example, the amount of consulting that a public company purchases may be information that the company considers confidential. If an audit client were forced to disclose its non-audit purchases from its audit firm, it may decide to turn to another consulting company (which it would not have to disclose), even if the alternative consulting company is a higher-cost or lower-quality provider of consulting services. Similarly, the company could choose to forgo buying consulting services, even if it would be efficient to do so in the absence of mandated disclosure

VI. CONCLUSION.

The SEC has proposed amendments to its auditor independence standards that would affect thousands of public companies in the United States, billions of dollars of auditing and consulting services and tens of thousands of auditing and consulting jobs. The SEC has proposed this approach even though it produced no evidence of a problem requiring corrective regulatory action. In addition, we find that the SEC has failed to analyze properly the likely costs and benefits of its proposed rule amendments.

First, the SEC has failed to show that the proposed rule is a solution to an existing problem - the SEC has provided no systematic evidence that the provision of non-audit services by an auditor to its audit clients reduces auditor independence. We find that there is no evidence that U.S. financial markets have been harmed by the large increase in non-audit services provided by audit firms since 1983, the last time that the SEC's auditor independence standards were changed. In addition, we find that there is no evidence that other financial markets have been benefited by the types of restrictions proposed by the SEC. In particular, we are unaware of any evidence that financial markets in countries that prohibit the provision of non-audit services by an accounting firm to an audit client are more successful than those of the United States. We also find that the SEC fails to substantiate its claim that its proposed amendments will benefit shareholders, issuers, other consulting firms or public accounting firms.

In addition to its failure to provide evidence that the proposed amendments will generate benefits, the SEC also has failed to investigate the likely costs of its proposals. We find that the proposed rule will likely result in the loss of scope economies; impose transition costs on audit clients and audit firms; and introduce an ambiguous and potentially costly regulatory regime. Indeed, if the costs in lost synergies and scope economies of the proposed regulatory prohibitions amounted to as little as one or two percent of the total value of services performed, these costs would range from $90 million to $240 million annually. We would also expect substantial transition costs as a result of the proposed rule. Finally, we find that a disclosure standard would be less costly than the SEC's current proposal.

We conclude that there is no economic support for the SEC's belief that its proposal to limit the non-audit services that an auditor would be allowed to offer its audit clients will benefit the U.S. economy.

Footnotes

1 . 65 Fed. Reg., 43,148.

2 . 65 Fed. Reg., 43,155.

3 . 65 Fed. Reg., 43,184.

4 . The eight largest public accounting firms in 1983 were often referred to as the "Big Eight." Because of a series of mergers since then, the Big Eight became the Big Six, and later the Big Five. We use "Big Five" to refer to these firms throughout the 1983-1999 period.

5 . Robert J. Shiller, Irrational Exuberance, at 5.

6 . 65 Fed. Reg., 43,154.

7 . 65 Fed. Reg., 43,154.

8 . In a recent working paper, Michael J. Ferguson, Gim Seow, and Danqinq Young, "The Effect of Nonaudit Services on Audit Quality," June 2000, claim that the joint provision of non-audit and audit services to a client by its auditors reduces audit quality. Their study is based on data from firms in the United Kingdom. We have collected the data described by the authors of this study, but we have been unable to replicate their sample of firms or their results. In particular, we do not find the statistically significant relationship between the ratio of non-audit to audit fees and "discretionary" working capital accruals that Ferguson et al. report.

9 . 65 Fed. Reg., 43,155.

10 . Mark Beasley, Joseph Carcello, and Dana Hermanson, "Fraud-Related SEC Enforcement Actions Against Auditors:1987-1997," AICPA August 2000, at 2, 32 footnote 5.

11 . See, for example, Shiller, at 8.

12 . Shiller, at 35.

13 . The provision of non-audit services is not prohibited in other countries, including Australia, Canada, Ireland, Luxembourg, the Netherlands, Sweden, and the United Kingdom. See Benito Arruñada, "The Provision of Non-Audit Services By Auditors: Let the Market Evolve and Decide," International Review of Law and Economics 19, pp. 513-531, 1999.

14 . 65 Fed. Reg., 43,153 (footnote omitted).

15 . Earnscliffe Research & Communications, "Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity," November 1999, at 33.

16 . Earnscliffe Research & Communications, "Report to the United States Independence Standards Board: Research into Perceptions of Auditor Independence and Objectivity - Phase II," July 2000, at 44-5.

17 . Bloomberg, "SEC Audit-Independence Tack Seen Lacking CEO, InvestorSupport," August 2, 2000.

18 . "The Panel of Audit Effectiveness: Report and Recommendations," Exposure Draft - May 31, 2000.

19 . See Dopuch, King and Schwartz, "An Experimental Investigation of Retention and Rotation Requirements," John M. Olin School of Business, July 10, 2000, at 2.

20 . Wilson and Grimlund, "An Examination of the Importance of an Auditor's Reputation," Auditing: A Journal of Practice & Theory, Spring 1990.

21 . Firth, "Auditor Reputation: The Impact of Critical Reports Issued by Government Inspectors," Rand Journal of Economics, v. 21, no. 3, Autumn 1990, at 386.

22 . Davis and Simon, "The Impact of SEC Disciplinary Actions on Audit Fees," Auditing: A Journal of Practice & Theory, v. 11, no. 1, Spring 1992.

23 . Palmrose, "Trials of Legal Disputes Involving Independent Auditors: Some Empirical Evidence," Journal of Accounting Research, v. 29, Supplement 1991.

24 . Krishnan and Krishnan, "Litigation Risk and Auditor Resignations," Accounting Review, v. 72, no. 4, October 1997.

25 . Jones and Raghunandan, "Client Risk and Recent Changes in the Market for Audit Services," Journal of Accounting & Public Policy, v. 17, no. 2, Summer 1998.

26 . Firth, "Auditor Reputation: The Impact of Critical Reports Issued by Government Inspectors," Rand Journal of Economics, v. 21, no. 3, Autumn 1990.

27 . Franz, Crawford, and Johnson, "The Impact of Litigation Against an Audit Firm on the Market Value of Nonlitigating Clients," Journal of Accounting, Auditing & Finance, Spring 1998.

28 . 65 Fed. Reg., 43,184.

29 . Our analysis includes public companies that were audited by non-Big Five accounting firms. However, we believe that including non-Big Five accounting firms in our analysis does not affect our conclusion that U.K. public companies appear to buy more non-audit services from their auditors than U.S. firms.

30 . For some firms, audit fees are listed as "not available" - we exclude these firms from our analysis. For firms where non-audit fees are listed as "non-available," we make the conservative assumption that non-audit fees equal zero.

31 . 65 Fed. Reg., 43,196.

32 . If the estimated tax consulting fees exceed the reported non-audit fees, we assign a value of zero to the (non-tax) non-audit fees.

33 . 65 Fed. Reg., 43,197.

34 . 65 Fed. Reg., 43.184.

35 . J. Luis Guasch and Robert Hahn, "The Costs and Benefits of Regulation: Implications for Developing Countries," World Bank Research Observer, v. 14, no. 1, February 1999, at 141.

36 . See Hufbauer, Berliner, and Elliot, Trade Protection in the United States: 31 Case Studies, Institute for International Economics, 1986.

37 . See Wenders, The Economics of Telecommunications: Theory and Policy, Ballinger, 1987.

38 . See Gardner, "Protection of U.S. Agriculture: Why, How, and Who Loses?" Department of Agricultural and Resource Economics Working Paper 87-15, University of Maryland, College Park, 1987.

39 . See Morrison and Winston, The Economic Effects of Airline Deregulation, Brookings Institution, 1986; and Morrison and Winston, "Enhancing the Performance of the Deregulated Air Transportation System," Brookings Papers on Economic Activity: Microeconomics, 1989.

40 . See Winston, "Conceptual Developments in the Economics of Transportation: An Interpretive Survey," Journal of Economic Literature, v. 23, no. 1, 1985.

41 . See studies cited in MacAvoy, Federal Milk Marketing Orders and Price Supports, American Enterprise Institute, 1977.

42 . See Loury, "Efficiency and Equity Impacts of Deregulation," in Robert H. Haveman and Julius Margolis (eds.), Public Expenditure and Public Policy Analysis, Houghton Mifflin, 1983.

43 . See Litan and Nordhaus, Reforming Federal Regulation, Yale University Press, 1983.

44 . See Thiebolt, "The Davis-Bacon Act," Labor Relations and Public Policy Series Report 10, Industrial Research Unit, Wharton School, University of Pennsylvania, 1975; and Hahn and Hird, "The Costs and Benefits of Regulation: Review and Synthesis," Yale Journal on Regulation, v. 8, Winter 1991.

45 . See Litan and Nordhaus, Reforming Federal Regulation, Yale University Press, 1983.

46 . See Jantscher, Bread Upon the Waters: Federal Aid to the Maritime Industries, Brookings Institution, 1975.

47 . Gande, Puri, and Saunders, "Bank Entry, Competition, and the Market for Corporate Securities Underwriting," Journal of Financial Economics, v. 54, no. 2, October 1999, at 165.

48 . 65 Fed. Reg., 43,168.

49 . 65 Fed. Reg., 43,184. This conjecture is inconsistent with the SEC's claim that the proposed amendments would benefit non-accounting providers of consulting services.

50 . 65 Fed. Reg., 43,186.

51 . It is also possible that one or more of the actual or proposed consulting arm divestitures was a response to the SEC's concerns about auditor independence. If so, then the divestitures may not reflect a lack of scope economies between auditing and consulting.

52 . Simunic, "Auditing, Consulting, and Auditor Independence," Journal of Accounting Research, v. 22, no. 2, Autumn 1984, at 699-700. This finding is inconsistent with a theory that audits are used as "loss leaders" to attract consulting business.

53 . Palmrose, "The Effect of Nonaudit Services on the Pricing of Audit Services: Further Evidence," Journal of Accounting Research, v. 24, no. 2, Autumn 1986, at 411.

54 . Antle and Demski, "Contracting Frictions, Regulation, and the Structure of CPA Firms," Journal of Accounting Research, v. 29, Supplement 1991, at 1-2.

55 . Arruñada, "The Provision of Non-Audit Services by Auditors: Let the Market Evolve and Decide," International Review of Law and Economics, v. 19, no. 4, December 1999, at 513-4.

56 . Arruñada, at 515. The full cites for the studies referred to by Professor Arruñada in the last quote are: Antle and Demski, "Contracting Frictions, Regulation, and the Structure of CPA Firms," Journal of Accounting Research, v. 29, Supplement 1991; DeBerg, Kaplan, and Pany, "An Examination of Some Relationships Between Non-Audit Services and Auditor Change," Accounting Horizons, v. 5, March 1991; Gaver and Gaver, "Simultaneous Estimation of the Demand and Supply of Differentiated Audits," Review of Quantitative Finance and Accounting, v. 5, 1995; Simunic, "Auditing, Consulting, and Auditor Independence," Journal of Accounting Research, v. 22, no. 2, Autumn 1984; Palmrose, "The Effect of Nonaudit Services on the Pricing of Audit Services: Further Evidence," Journal of Accounting Research, v. 24, no. 2, Autumn 1986; Turpen, "Differential Pricing on Auditors' Initial Engagement: Further Evidence," Auditing: A Journal of Practice & Theory, v. 9, no. 2, Spring 1990; Davis, Ricchiute, and Trompeter, "Audit Effort, Audit Fees, and the Provision of Nonaudit Services to Audit Clients," Accounting Review, v. 68, no. 1, January 1993; Barkess and Simnett, "The Provision of Other Services by Auditors: Independence and Pricing Issues," Accounting and Business Research, v. 24, 1994; Ezzamel, Gwilliam, and Holland, "Some Empirical Evidence from Publicly Quoted UK Companies on the Relationship Between the Pricing of Audit and Non-Audit Services," Accounting and Business Research, v. 27, 1996; Ezzamel, Gwilliam, and Holland, "The Relationship Between Categories of Non-Audit Services and Audit Fees: Evidence from UK Companies," presented to the 21^st Congress of the European Accounting Association, Antwerp, Belgium, April 6-9, 1998; Firth, "The Provision of Non-Audit Services and the Pricing of Audit Fees," Journal of Business Finance and Accounting, v. 24, 1997.

57 . An empirical estimate of the costs of lost scope economies likely would take at least many months to complete, especially because of the ambiguities in the proposal as to which non-audit services would be prohibited by the proposed rule. Such an analysis could not appropriately be undertaken within the 75-day comment period allowed by the SEC. However, we strongly urge the SEC to perform a thorough analysis, including quantification, of the likely costs and benefits of any final rule.

58 . 65 Fed. Reg., 43,153.

59 . 65 Fed. Reg., 43,196.

60 . Gudmestad and Gudmestad, "Protecting Intellectual Property During Divestitures and Acquisitions," Research-Technology Management, v. 41, no. 5, September/October 1998.

61 . Bloom, "Does the Target's Brainpower Provide a Competitive Edge?" Mergers & Acquisitions, v. 28, no. 4, January/February 1994.

62 . See, for example, Glueck and Mittelstaedt, "Protecting Trade Secrets in the 70s," California Management Review, v. 16, no. 1, Fall 1973; Epstein and Levi, "Protecting Trade Secret Information: A Plan for Proactive Strategy," Business Lawyer, v. 43, no. 3, May 1988; Marx and Manela, "Protecting Confidential Information in High-Tech Companies," Personnel Administrator, v. 31, no. 5, May 1986; Sookman, "Keeping Secrets," Computing Canada, v. 14, no. 5, March 3, 1988; Lans, "Can You Keep the Lid on Your Trade Secrets?" Marketing News, v. 28, no. 18, August 29, 1994; Orum, "Trade Secrets Made Simple," Beverage World, October 1995; Winston and Winston, "Safeguarding Customer Lists," Target Marketing, v. 21, no. 5, May 1998.

63 . Budden, Jones, and Budden, "Supplier Relationships and the Trade Secrets Dilemma," International Journal of Purchasing & Materials Management, v. 32, no. 3, Summer 1996.

64 . Iandiorio, "Confidentiality and Consultant Agreements," Journal of Management Consulting, v. 8, no. 1, Spring 1994

65 . Marzouk, "Keeping Secrets," CIO, v. 6, no. 18, September 15, 1993.

66 . Laabs, "Wal-Mart Settles `Employee Theft' Suit with Amazon.com," Workforce, v. 78, no. 6, June 1999.

67 . American Institute of Certified Public Accountants, Report, Conclusions, and Recommendations of the Commission on Auditors' Responsibilities, 1978, at 108-109.

68 . DeAngelo, "Auditor Size and Audit Quality," Journal of Accounting and Economics, v. 3, no. 3, December 1981, at 190; 188-89. The full cites for the studies referred to by Professor DeAngelo are: Burton and Roberts, "A Study of Auditor Changes," Journal of Accountancy, April 1967; Bedingfield and Loeb, "Auditor Changes - An Examination," Journal of Accountancy, March 1974; Carpenter and Strawser, "Displacement of Auditors When Clients Go Public," Journal of Accountancy, June 1971; Bolton and Crockett, "How Independent Are the Independent Auditors?" Financial Analysts' Journal, November-December 1979; Hobgood and Sciarrino, "Management Looks at Audit Services," Financial Executive, April 1972; Financial Executives' Institute, "The Annual Audit Revisited," Financial Executive, March 1978; Coe and Palmon, "Some Evidence of the Magnitude of Auditor Turnover," unpublished manuscript, New York University, 1979.

69 . DeAngelo, "Auditor Independence, `Low Balling', and Disclosure Regulation," Journal of Accounting and Economics, v. 3, no. 2, August 1981, at 119. The full cite to the study referred to by Professor DeAngelo is Arens and Loebbecke, Auditing: An Integrated Approach, Prentice-Hall, 1976.

70 . Williams, "The Potential Determinants of Auditor Change," Journal of Business Finance & Accounting, v. 15, no. 2, Summer 1988, at 243. The full cites to the studies referred to by Professor Williams are: Berlin and Walsh, Corporations and Their Outside Auditors, Conference Board Report No. 544, 1972; American Institute of Certified Public Accountants, Report, Conclusions, and Recommendations of the Commission on Auditors' Responsibilities, 1978; and Fried and Schiff, "CPA Switches and Associated Market Reactions," Accounting Review, April 1981.

71 . Healy and Lys, "Auditor Changes Following Big Eight Mergers with Non-Big Eight Audit Firms," Journal of Accounting and Public Policy, v. 5, no. 4, Winter 1986, at 255.

72 . Simon and Francis, "The Effects of Auditor Change on Audit Fees: Tests of Price Cutting and Price Recovery," Accounting Review, v. 63, no. 2, April 1988, at 267.

73 . Johnson and Lys, "The Market for Audit Services: Evidence from Voluntary Auditor Changes," Journal of Accounting and Economics, v. 12, 1990, at 283. The full cites to the studies referred to by Johnson and Lys are: DeAngelo, "Auditor Size and Audit Quality," Journal of Accounting and Economics, v. 3, no. 3, December 1981; and Magee and Tseng, "Audit Pricing and Independence," unpublished manuscript, Kellogg Graduate School of Management, Northwestern University, 1987.

74 . Securities Data Company, Inc.

75 . Posner, "The Social Costs of Monopoly and Regulation," Journal of Political Economy, v. 83, no. 4, 1975.

76 . Based on Kessel, "Higher Education and the Nation's Health: A Review of the Carnegie Commission Report on Medical Education," Journal of Law and Economics, v. 15, April 1972; and Houthakker and Taylor, Consumer Demand in the United States, 1929-1970, Harvard University Press, 1966.

77 . Based on Benham, "Price Structure and Professional Control of Information," mimeo, University of Chicago Graduate School of Business, March 1973.

78 . Based on Kessel, "Economic Effects of Federal Regulation of Milk Markets," Journal of Law and Economics, v. 10, October 1967; and Houthakker, "New Evidence on Demand Elasticities," Econometrica, v. 33, April 1965.

79 . Based on Department of Agriculture studies cited in Moore, Freight Transportation Regulation, American Enterprise Institute, 1972; and Farmer, "The Case for Unregulated Truck Transportation," Journal of Farm Economics, v. 46, May 1964. Also based on Frisch, "A Complete Scheme for Computing All Direct Costs and Cross Demand Elasticities in a Market with Many Sectors," Econometrica, v. 27, April 1959; and Parks, "Systems of Demand Equations: An Empirical Comparison of Alternative Functional Forms," Econometrica, v. 37, October 1969.

80 . Based on Cabinet Task Force on Oil Import Control, The Oil Import Question, Government Printing Office, 1970.

81 . Hahn, "Government Analysis of the Benefits and Costs of Regulation," Journal of Economic Perspectives, v. 12, no. 4, Fall 1998.

82 . Cabral dos Santos, "Glass-Steagall and the Regulatory Dialectic," Economic Commentary, Federal Reserve Bank of Cleveland, February 15, 1996.

83 . Kane, "Accelerating Inflation, Technological Innovation, and the Decreasing Effectiveness of Banking Regulation," Journal of Finance, v. 36, no. 2, May 1981.

84 . Cabral dos Santos.

85 . United States General Accounting Office, Air Pollution: Emission Sources Regulated by Multiple Clean Air Act Provisions, GAO/RCED-00-155, May 2000, at 5.

86 . Anderson and Casey, "Will Regulation Impede the Market for Emissions Allowances?" Fortnightly, v. 132, no. 6, March 15, 1994.

87 . Crandall, "Corporate Average Fuel Economy Standards," Journal of Economic Perspectives, v. 6, no. 2, Spring 1992.

88 . Greene, "CAFE or Price: An Analysis of the Effects of Fuel Economy Regulation and Gasoline Price on New Car MPG, 1978-1989," Energy Journal, v. 11, July 1990.

89 . Leone and Parkinson, Conserving Energy: Is There A Better Way? A Study of Corporate Average Fuel Economy, prepared for the Association of International Automobile Manufacturers, May 1990.

90 . Summer, "Does Mandatory Rotation Enhance Auditor Independence?" Zeitschrift fur Wirtschafts und Sozialwissenschaften, v. 118, no. 3, 1998.

91 . 65 Fed. Reg., 43,192.

92 . 65 Fed. Reg., 43,193.

93 . 65 Fed. Reg., 43,179.

94 . 65 Fed. Reg., 43,196.

95 . Krishnan and Krishnan, "Litigation Risk and Auditor Resignations," Accounting Review, v. 72, no. 4, October 1997.

96 . U.S. audit fees received by the Big Five accounting firms in 1999 were $9.15 billion (65 Fed. Reg., 43,196), and this total does not include audit fees collected by non-Big Five firms.

97 . 65 Fed. Reg., 43,172.

98 . 65 Fed. Reg., 43,196.