Testimony of James E. Copeland
Chief Executive Officer
Deloitte & Touche LLP
September 20, 2000
Mr. Chairman and Commissioners, I welcome this opportunity to share with you my views on several key issues within the proposed rule on auditor independence.
The limited time we have here today will not permit me to go into great detail on the proposal, but we will be submitting additional, detailed comments in the next few days. I trust those comments will also receive your careful consideration.
For many years, the SEC and the accounting profession have shared the view that the auditor and audit firm have a unique public interest role in our capital markets. We are both genuinely concerned with the quality and efficacy of audits of public companies and the need to constantly improve audit quality to maintain the public confidence in our financial reporting system. That shared view has given us common ground and a long history of working together to make changes and improvements when needed.
In the case of this rule proposal, we also have some common ground: We agree that the existing financial interests and employment relationship rules are sorely out of date and need to be modernized. Our comment letter will provide what I believe are constructive recommendations in these areas.
Where we disagree on this rule proposal are the changes that would significantly limit the services that an audit firm may provide to its audit clients. While intended to serve the public interest, I firmly believe that the unintended consequences of this bright line limitation on services will be significant and far-reaching, resulting in a lessening of the quality of audits.
My concern is that the Commission has not given adequate consideration to the consequences of the proposed rule and has rushed to the judgment that certain non-audit services should be prohibited. In the next few minutes, I would like to cover three major topics:
Let me first address what I see as the fundamental issue.
Perception - the Fundamental Issue
The dialogue during these hearings has often led to a discussion of whether the perception issue exists. While there is no empirical evidence to support the assertion that an auditors' independence is impaired when it provides non-audit services to audit clients - clearly some do perceive this as an issue.
I believe the perception issue exists. Having said that, I believe that the more fundamental question is: What is the most appropriate means of addressing the related risks?
I believe the concern over auditors providing non-audit services stems from three sources. First, is the premise that investors may have less confidence in audits from firms that also provide non-audit services to their audit clients. Second, is the fact that the level of revenue from consulting and advisory services today comprises more than 50% of total revenue of some firms. Finally, the point has been made that providing non-audit services to an audit client creates "economic pressure" on the auditor and might influence decisions. Taken together, these factors could be termed the "perception issue."
The appropriate response to the perception issue is to determine whether the perception represents reality. I thought the Panel on Audit Effectiveness (the "Panel") did a credible job looking into this issue. For the first time, the Panel looked at actual audit engagements where substantial non-audit services were performed. The Panel's findings indicate that the reality does not bear out the perception. In fact, the results indicated no impairment of independence and in one in every four of the cases indicated that audit quality had been enhanced. The Panel also suggested enhancements in the Peer Review Process intended to address perceptions of problems with auditor independence. The profession also has recognized this perception issue, and as a result, has created safeguards to ensure that the perceptions do not become a reality. My own firm completely reorganized itself in 1996 in response to these concerns.
Further, I believe that audit committees, acting as advocates for shareholders, are in the best position to understand and monitor non-audit services. The recent changes under the Commission's leadership have resulted in new audit committee requirements that I believe over time will serve shareholders well. I can personally attest to the fact that audit committees are taking these responsibilities seriously. Unfortunately, there has not yet been enough time to show that these safeguards will work. We should allow all of these new safeguards and opportunity to work before overriding them with drastic and dangerous prohibitions.
Let me comment on the "economic pressure" question: Whether an auditor's judgment could be influenced because of consulting engagements with the audit client? You are right to be concerned about any inappropriate influence on the use of judgment by auditors.
While clients almost always want to "do the right thing," every auditor eventually comes under client pressure while trying to "do the right thing." That pressure exists whether or not we perform non-audit services. Dealing with that pressure is fundamental to what it means to be an auditor and is at the very core of our responsibilities to investors. Our clients pay us and they can hire and fire us - as consultants and as auditors. While an audit partner does not want to see consulting relationships lost, his real concern is with the audit relationship. There are hundreds of situations every year where auditors say "no" to aggressive accounting treatments or the audit uncovers adjustments that are required to make the financial reporting conform more fully to GAAP. Although you don't see these situations because the client complies, they nonetheless occur. And sometimes we lose or resign from clients over these matters.
We take our public interest responsibility very seriously and consciously design and operate our audit practice to make sure that our auditors resist any pressure and get to the right answer. We have extensive consultation networks, second partner reviews, and other resources to provide support for the audit partners dealing with difficult issues so that he or she knows that the firm backs them.
In addition, our reputational capital is at risk on every audit. There is no one client, no one audit fee, and no one consulting engagement that has ever been worth compromising the quality of the audit. Audits are dependent on the integrity, independence of mind and competence of our people. That doesn't change whether we perform consulting work or not. We understand our responsibilities and do our best to act in the public interest each and every day.
I now want to address what I believe will be the defacto restructuring requirement as a result of the proposed rule.
The Defacto Restructuring Requirement - a Devastating Consequence for Audit Quality
Perhaps the worst unintended consequence of the proposed rule is the restructuring or dismantling of accounting firms. This consequence is no longer debatable. We've all read accounts of the proposed sale of some or all of the consultancies of three Big Five firms. While these decisions may be financially attractive, there is a question as to how the impact of these transactions will affect the quality of audits. As one CEO of a firm planning to sell some of its consultancies recently said, "...we genuinely are not sure how successful this new arrangement will be for the audit firm, it would, we believe be a mistake for the Commission to require an even greater array of changes before it and the firms have had a reasonable period of time - perhaps as long as several years - to assess the impact of this change on a firm's ability to maintain a strong, vibrant audit practice that best serves the interests of investors."
The consequences of this restructuring will be significant and I believe will have an adverse affect on the ability to perform high quality audits. This is because it will result in the loss in the competencies of our non-audit professionals. These competencies are essential to high quality audits, particularly in the New Economy, and must be readily available within the firm when needed to support the audit function. This is even more important now that timely quarterly reviews are required by rule.
The truth is, the SEC recognizes that non-audit competencies are necessary to perform a GAAS audit. The Panel on Audit Effectiveness did as well. The profession has learned first hand that, in today's environment, it is nearly impossible to audit complex organizations without specialists in information technology, actuarial sciences, M&A and the like.
The question is: How, in a restructured profession, will these competencies be made available to the auditor? One possibility is to "in source" these competencies by purchasing them from an outside firm. But this raises questions about availability, quality control and how the independence of the audit team will be maintained.
I believe retaining these competencies within the firm is the best approach. That way they operate under our supervision, follow our quality control policies and are bound by our independence requirements. While we prefer this approach, under the proposed rule, firms such as ours will be less attractive as a career choice. As to non-audit professionals, the best specialists are not willing to simply support audits. They also want to hone state-of-the-art skills in the marketplace. As to our auditors, the career paths become more limited and therefore, less attractive. Today, some of our brightest consultants have audit backgrounds. This is talent I do not want to lose.
Let me address another consequence of the likely restructuring of the accounting profession -- the impact on our ability to attract and retain top resources.
What about the talent pool for accounting students entering the audit profession? We are already experiencing a decline in the numbers and qualifications of students entering the accounting programs at the university level. Just this week, Business Week reported that the number of accounting graduates has declined about 20% between 1996 and 1999. That concerns me greatly. We have historically been able to offer talented new entrants to our profession the opportunity to move to other areas of practice within our firms based on their interest and capabilities. Those other areas include many significant services that are an adjunct to audit services as well as the consulting practice. The narrowing of the opportunities outside of audit will lessen the attractiveness of a career with our firm.
In the debate around the impact of consulting on auditing, the "25% statistic" has been either misused or misunderstood. This ratio represents the percentage of SEC audit clients that receive consulting services from their audit firm in any one year. Over a period of several years, most of the firm's clients avail themselves of the consulting services of their audit firm. I have another problem with the 25% statistic. The point has been made that only 25% of audit clients currently receive non-audit services from their audit firm. Therefore, as the argument goes, the provision of non-audit services is not essential to the conduct of an audit or material to the operations of the audit firm. In addition, some claim that this statistic indicates that consulting services are not necessary for an audit. The fact is, that while we perform consulting or advisory work for a minority of our audit clients in any one year, we use these competencies to help us do a quality audit on almost all of our audit clients.
I now would like to turn to what I see as a global regulatory inconsistency.
Global Regulatory Inconsistency - an Inadequately Considered Implication of the Rule
My concerns about the proposed rule are not limited to the effects within the United States. In fact, I believe the proposed rule will have a substantial negative impact on the global capital markets. The potential impact of the rule is significant and far-reaching. By creating a standard for the "appearance" of independence that fails to recognize legitimate cross-cultural perceptions and traditions of auditor independence, and which in many cases would directly conflict with audit firms' statutory obligations in other countries, the proposed rule would significantly increase the barriers to cross-border capital formation. In this era of increased emphasis on reducing trade barriers, the proposed rule would have the opposite effect -- undermining global efforts to harmonize accounting and financial reporting standards.
The rule does not appear to reflect consultations by the Commission with its regulatory colleagues in other nations. This contradicts more than a decade of efforts by the Commission to harmonize, not fragment, policies that might adversely affect cross-border capital flow. This is particularly surprising given the Commission's recent efforts in regards the adoption of the International Disclosure Standards, the concept release on International Accounting Standards and the restructuring of the International Accounting Standards Committee.
The proposed rule takes a completely divergent approach from independence rules in other countries, including recent proposals by the International Federation of Accountants and the European Commission. Given the global nature in which audit firms and their clients operate and the globalization of the capital markets, including the recent significant increase in cross-border activity, the global implications of the rule should be carefully evaluated before any action is taken.
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My firm and the entire accounting profession have a long history of responding positively and quickly to suggested improvements to audit quality and ethical behavior in order to better protect the public interest.
There is no crisis that would indicate that action to limit scope of services is required at this moment in time. Accordingly, I urge the SEC to go forward with the modernization of financial interests and family relationships issues included in the proposed rule, but to set aside the portion of the rule dealing with scope of services.
Today, some firms have voluntarily chosen to divest themselves of what they currently refer to as their consulting practices. Accordingly, the marketplace has presented the SEC with an opportunity to field test multiple firm models. Use the next two to three years to test the various models and ample means to monitor the quality of audits and the relationship to non-audit services, as well as consider the many significant global implications. There is no reason why the harmonization of independence standards is not possible. And it is clear that such harmonization, rather than a patchwork of conflicting standards, would better serve the investing public.
In the meantime, I think it goes without saying that your concerns have our full attention. I hope we will have the opportunity to work together with you in a cooperative manner to jointly propose improvements if and when needed.
Thank you and I would be pleased to respond to any questions you may have.