Public Hearing Addressing
REVISION of the COMMISSION'S AUDITOR INDEPENDENCE
Comment File No. S7-13-00
New York, New York
September 13, 2000
I want to thank Chairman Levitt and the other Comissioners for the privilege and
opportunity to participate in today's public hearing concerning the Commission's
proposed revision of auditor independence requirements. Based on my study of the
Commission's proposed rule, I believe it to be worthy of consideration and adoption
and I express my full support for this vital and timely initiative.
The views that I express today are based on my thirty-six years of professional experience, including service as an audit and review partner for two major public accounting firms. In addition, for the past sixteen years, I have served as an expert witness and testified in numerous large legal action involving auditing, financial reporting, auditor independence issues, and accounting fraud. Throughout this experience. I have evaluated the audit work and compliance with professional standards, including independence standards, of all of the Big 5 accounting firms.
I will be restricting my testimony today to one major issue that the Commission has addressed in its proposed rule and will attempt to be brief.
Several of the major accounting firms have already challenged the Commission's proposed revisions to the auditor independence rules while others have given at least partial support. Based on history and the contentious nature of the independence issue, a satisfactory self-regulatory resolution will very likely not be possible. The battle lines have been drawn and it is abundantly clear that the S.E.C.'s proposed rule is the only vehicle by which to resolve this critical issue. The proposed rule is timely and should be carefully considered, finalized and adopted without delay because investor confidence in financial reporting and the nation's auditors is at stake. The importance of strengthening auditor independence cannot be over emphasized.
Based on my personal involvement as an expert witness and consultant in almost fifty legal actions involving audit failures, I have concluded that the underlying cause of the majority of such failures was compromised auditor independence. The auditor's lack of independence in these cases involved the auditors auditing their own work, functioning as management, acting as advocates or cheerleaders for their clients, and entering into business relationships that resulted in mutual interests with their clients. Further, in many of these cases of compromised independence, the audit firm had performed significant levels of non-audit services.
For decades, there have been significant and legitimate concerns by Congress and many professional groups about the performance of non-audit services by accounting firms for their audit clients. Further, such non-audit services have continuously expanded over the years until they now constitute the major portion of the revenue of the nation's largest accounting firms. As a result, the auditing practices of these large firms are now secondary in terms of revenue, profitability and importance. Despite the ever expanding role of non-audit services and its negative impact on auditor independence, there has been no effective resolution of this critical issue during all this time.
The overriding concern about non-audit services for audit clients is that investors and users of financial statements may conclude that non-audit service relationships could erode auditor independence. Thus, even if an auditor is independent in fact, investors and users of financial statements could conclude that the auditor does not have the appearance of independence. If so, the auditor's independence is compromised because, under professional standards, the auditor is required to be both independent in fact and in appearance.
A common practice among the large accounting firms is the use of audit engagements as a "loss leader" to obtain more profitable engagements involving non-audit services. Throughout my career, I have seen numerous instances of major firms accepting audit engagements at marginal profits or even losses in order to obtain more profitable consulting engagements. In many of these audit engagements, the accounting firm's realization rate (amount paid to the auditor compared to the time/dollars invested by the auditor) ranged from less than 30% up to a high of only 45%-50%. Such realization rates clearly produce marginal profits or even losses for the accounting firm. These loss leader engagements can and do motivate auditors to reduce necessary audit work and to take risky short-cuts including, among other things, placing reliance on uncorroborated management representations.
Further, not only have I seen such reduced audit work on many specific engagements, but I have also observed numerous instances where the auditor failed to make appropriate judgments in order to appease the client and, thus, protect the consulting relationship. Why would an accounting firm do such things? The answer is quite simple. In audit engagements where the auditor is not being paid for a large portion of the time invested in the audit, the only manner by which the auditor can recoup such investment is to provide profitable non-audit services and to be sure not to annoy the client and lose the relationship.
At this point, I would like to share with you a specific example of how non-audit services can compromise auditor independence and the disastrous effect that they can have on a particular audit. A few years ago I was retained as an expert witness and consultant in a very high profile audit failure in which there had been a significant fraud perpetrated by top management that was never recognized or reported by the auditors. The Big 5 firm that performed the audit was performing so many non-audit services for the client that it was actually difficult at times to distinguish whether the firm was functioning as the auditor or client management.
Such non-audit services included, among others, the following: (1) providing bookkeeping services at certain locations of the client; (2) assisting in obtaining significant financing for the client, including negotiating on behalf of the client; (3) determining and implementing corporate policies; (4) designing and implementing financial reporting and accounting systems; (5) supporting and defending the client's responses to fraud allegations to members of the press; and (6) establishing accounting principles for the client. As a result of these non-audit services and in order to protect such lucrative arrangements, the Big 5 firm compromised its independence, took numerous short-cuts in its audit work, ignored many red flags indicating the possibility of fraud, and served as an advocate for its client. As a result, the firm failed to properly investigate, detect, and report a significant accounting fraud and embezzlement by top client management. As a direct result of the fraud, the client filed for bankruptcy and investors lost many millions.
As I have just illustrated, I strongly believe that there is a direct link between the performance of non-audit services for an audit client and the loss of auditor independence. My recommendation to the Commission, therefore, is for the S.E.C. to initiate a complete ban on all non-audit services for audit clients. This approach will provide investors with maximum confidence regarding auditor independence. I believe that anything short of a complete ban will be fraught with problems and more difficult to enforce. If in its collective wisdom, however, the Commission decides not to adopt a complete ban on non-audit services to audit clients, then I urge the Commission to adopt new rules to halt the practice by accounting firms of accepting loss leader audit engagements to obtain more lucrative consulting arrangements. It is time to solve this problem once and for all. The credibility of auditor independence and reliability of financial reporting is at stake. Thank you.