John H. Biggs
Chairman and Chief Executive Officer TlAA-CREF
Securities and Exchange Commission
July 26, 2000
Accountant Independence: A Simple Rule
I appreciate having an opportunity to attend this hearing, and to express in person my full support of the Commission's proposed revision ofits Auditor Independence Requirements.
My company, TlAA-CREF, manages $300 billion for its participants, investing $1.5 billion in new fixed income every month and far more in new common stock. Essential to these investments is our reliance on the audited financial statements of the borrower, stock issuer, or entrepreneur. Our analysts necessarily assume that those statements have been audited by an independent, disinterested, and highly professional auditor from the outside. And most of the time that assumption is correct. But recent exceptions including fraudulent and deliberately misleading financial statements have caused serious concern among investors.
It seems the old concept of "independence" no longer fits the practices and culture of today's accounting firms. Prior to the buildup of non-audit professional services in accounting firms, the focus was on one primary question: Did the audit professional have any direct financial interest in the company? To answer this question satisfactorily, the accounting profession developed far-reaching (and, I believe, excessively refined) rules on what members of the firm could or could not invest in.
The accounting profession started with the obvious: engagement auditors should not own common stock in a company they are auditing. From this basic premise, the rules were then extended to all other members of the firm and to various relatives of the auditors. Eventually the spouse of a professional colleague in a totally different office was not allowed to own a mutual fund in a 40l(k) plan as long as some distant auditing relationship existed with a sponsor, a manager, or any other service provider to the mutual fund.
In meetings with audit committees, the outside auditor would go into excruciating detail to show the comprehensive extent of their prohibitions. Directors of companies could then be lulled into the confidence that the auditor had true "independence."
Meanwhile, a genuine threat to independence emerged from the growth of non-audit management services. Today these consulting services are extremely profitable, growing faster than any other part of the accounting profession. Such services, in effect, have been "owned" by the audit professionals, but it is clear that such a relationship with its inherent conflict cannot endure. Those who are "owned," i.e. management consultants, are reluctant to see their economic surplus taken by their audit partners.
The Arthur Andersen breakup is a recent example of this industry transformation, but it's not the only one. Most of the other Big Five firms are busily exploring ways to separate their management consulting and audit capabilities and capture the capital value of this fast-growing consulting component. For example, Ernst and Young proposes selling their consulting practice but keeping a financial interest in it. Other firms have suggested a variety of sales and controlling mechanisms.
This frenzy of activity is not confined to the larger firms. Small accounting operations are also players as they sell out to major firms that wish to benefit from the "cross-selling" of other financial services by their controlled auditing firms. American Express and H.& R. Block are leading examples of companies that follow this acquisition strategy. Simply apply the ten "cross-selling" to the vital and independent role of the auditor, and it's easy to see how professionalism has been compromised.
This conflict between auditing and non-auditing services went largely unnoticed until recently, when Chairman Levitt correctly focused on the independence issue. While agreeing that we should relent in the minute rules governing ownership of company securities, he has set up the Independence Standards Board to deal with the question. This is a major step in the right direction. Let's hope the new board comes up with some workable solutions.
Assuring independence within firms that offer consulting services is a Gordian knot that can easily be cut. My own suggestion is to allow the firms to do what they want. Let them pursue their self-interest, as long as they abide by one unalterable rule: independent public audit firms should not be the auditors of any company for which they simultaneously provide other services. It's that simple.
For the past eight years TIAA-CREF has maintained a strict view of professional independence. This is our rule: When we need professional services in management consulting, we hire someone other than our auditors to do the job. For example, we bring in the consulting arm of a different accounting firm, or perhaps someone totally unrelated to the accounting profession. Our Board Audit Committee faces no questions on our accountants' independence. Committee members never wonder whether our auditors are receiving so much in consulting revenue that they dare not challenge management.
We know the arguments against our rule, but the drawbacks include distinct advantages of their own. First, our accounting firm has not developed, say, a general ledger software system for the company. If they had, our financial executives might have been relieved since the audit firm could hardly challenge the quality of that work. More to the point, however, the CEO, the Audit Committee, and the users of the financial statements have lost an independent appraisal of that important system. And the same analysis can apply to a host of other difficult financial management systems for which consulting help might be sought.
A major advantage to this rule is the simple certainty that our auditors are expressing a clear-eyed, independent view of our financial situation. If a contentious issue on financial reporting arises, and the auditing firm refuses to back down before management, company executives may regret not having a "deeper economic relationship" with the auditing firm. On the other hand, when such a relationship does not exist, CEOs, Audit Committees, and the users of financial statements enjoy the confidence of an independent and unblemished view.
There's something else. If adopted by most companies, this rule would bring the accounting profession to a considerably stronger position than it currently holds. Accountants would continue their consulting practices as they wish while enjoying substantial financial benefits. Or they could spin off the related entities and maintain an interest in the stock. Let the audit and consulting partners resolve how to split up the extra returns of lucrative businesses without injecting the public interest.
A powerful argument exists for maintaining management consulting practices within the audit firm. It has to do with the extraordinary complexity of financial information systems in most companies. The auditors including their colleagues need firsthand experience in developing such systems in order to audit effectively modem high-tech accounting systems. But I would encourage them to get that experience while serving non-audit clients.
If CEOs and Audit Committees take their functions seriously, and if they operate under a few simple rules of independence, the rewards are subtle but real. In those quiet meetings with their audit firms they are likely to get reliable answers to questions such as these: "How are we doing?" and "Has that new system really worked as planned?" And they, and their investors, can rest assured that external influences or self-interest have not compromised the critical information upon which they base their financial decisions. What's more, the Independence Standards Board will not have to interpret a variety of complex financial transactions to determine their potential impact on auditor independence.