Testimony of
Sen. Howard M. Metzenbaum (Ret.)
Chairman, Consumer Federation of America

on behalf of
Consumer Federation of America
Consumer Action
Public Citizen

Regarding Revision of the Commission's Auditor Independence Requirements
(File No. S7-13-00)

before the
Securities and Exchange Commission
September 20, 2000
Washington, D.C.

I come before you today in my capacity as Chairman of the Consumer Federation of America, a non-profit consumer advocacy organization.  I also have the privilege of speaking for two other consumer organizations, Consumer Action and Public Citizen, which I serve as a member of the board.  Our organizations, which together represent tens of millions of individual consumers, have a strong interest in investor protection issues related to auditor independence.

Our nation's current prosperity and future financial security are tied up, as never before, in our financial markets.  For that reason, whether they know it or not, Americans are enormously dependent on independent auditors, both to ensure the reliability of the information they use to make individual investment decisions and to ensure the efficiency of the marketplace in assigning value to stocks.  

Stock prices are simply the response of buyers and sellers to information about public companies.  Some of the most important information investors rely on is contained in companies' financial statements.  It is the auditors' job to ensure that these financial statements are prepared according to generally accepted accounting principles and, therefore, are reasonably reliable.  Day in and day out, auditors must make decisions, i.e., to write off or capitalize a purchase, to depreciate over 5, 10, or 20 years, to write off or capitalize new program development, training programs, developmental efforts.

The faith that the markets place in the pronouncements of auditors is founded on the auditors' independence.  That independence is what allows them to bring an appropriate objectivity, even skepticism, to their examination of the company books.  If auditors' independence is called into question, then the reliability of the financial statements of public companies is also called into question.  

There's no doubt about it, auditors today are less independent than they were just a decade ago.  Having transformed themselves into multi-disciplinary professional services firms, the nation's biggest accounting firms now get more revenue from non-audit services than from their core business of auditing.  And the disparity is growing rapidly.  Of particular concern for auditor independence is the recent and rapid increase in the marketing of non-audit services to audit clients.  Can anyone reasonably argue that there isn't a conflict when an auditing firm is simultaneously trying to sell the audit client on a multi-million dollar consulting contract?  All the more so if the consulting contract stands to produce far greater profits for the company than the audit or if the auditor's success within the company is dependent on his or her ability to cross-market non-audit services.

The fact that some auditors, perhaps even most, may not succumb to the pressure because of a commitment to professional independence is not the point.  The point is that practices such as these raise serious questions about the independence of the audit, and that is bad for investors, bad for the financial markets, and bad for the reputation of the auditing profession.

Critics, including leaders within the accounting profession, have raised questions about the adequacy of existing independence standards for decades, particularly in light of the growing provision by auditors of non-audit services.  The Commission has studied the question for years.  Chairman Levitt and his fellow commissioners are to be congratulated for recognizing that the time has come to act.

The rule proposed is based on a simple, and appropriate, premise.  Markets hate uncertainty, and the actual state of mind of the auditor can rarely, if ever, be known.  In that context, the appearance of a conflict of interest in an auditor can be as damaging as an actual conflict.  Therefore, practices that would seem to a reasonable, informed person to create a conflict of interest are unacceptable.  From there, the rule proposal offers four fundamental principles that govern determinations of independence.  It then specifies a number of services an auditor might offer that would create an unacceptable conflict of interest if provided to an audit client.  

In light of the degree to which the proposed rule simply codifies and brings clarity to existing Commission interpretations and to standards recognized by the industry, it may seem surprising that it has met with such violent opposition from some in the accounting profession.  This becomes less surprising, however, when you look at how dependent some of these firms have become on revenue from non-audit services.  These opponents have built their case around four key arguments, none of which holds water:

1)  Auditors gain crucial knowledge about the firms they audit when they also serve those firms in other capacities.  Armed with that knowledge, they are able to perform better audits.

While we agree that, in a perfect world, more detailed knowledge of an audit client should result in a better audit, this is far from a perfect world.  In fact, any improved access to information that may result from serving the client in a variety of capacities is outweighed by the conflict of interest that results.  In some instances, the auditor may ignore the conflict and produce a better, more informed audit.  In other instances, the auditor may succumb to the conflict and compromise the quality of the audit.  In every instance, the reliability of the audit will be subject to question because of the conflict.

2)  Audit firms will be unable to attract top specialists in areas such as information technology if they aren't able to market consulting services to audit clients.

Although it may not be as interesting and attractive as consulting, auditing is still a well respected, very well compensated profession.  It is therefore unlikely to suffer a dearth of talented experts anytime soon.  But even if you accept the questionable argument that the lure of consulting is necessary to attract the best experts, the proposed rule does nothing to prevent audit firms from attracting top talent.  After all, firms will still be free to offer those experts ample opportunities to use their skills in consulting for non-audit clients.  

3)  Audit firms would be forced to sell their consulting units.  When they then rehire the same consultants to assist in the audit, they would have no control over their compliance with independence standards.

This argument starts with a false assumption -- that the rule will force auditors to sell their consulting units -- and builds to a faulty conclusion.  While a clean break between audit firms and consulting firms may be an attractive prospect, there is nothing in this rule proposal that would force that outcome.  In fact, though it has won them no thanks from the rule's opponents, the SEC has not proposed to simply ban auditors from providing non-audit services.  The proposed rule fully preserves auditors' ability to provide non-audit services to non-audit clients.  It even preserves the ability of auditors to provide audit clients with some non-audit services that the Commission believes would not unduly compromise auditor independence.

Having started from a phony premise -- that consulting units will have to be sold -- the opponents now attempt to throw scorn on the proposal by claiming that those firms will likely simply turn around and hire the same consultants as outside experts to assist them in the audit.  Only now, the argument goes, they won't have any control over the experts' independence.  The result, they imply, is more questions about independence, not fewer.  

This ignores the fact that the expert who is assisting in an audit of his or her own work or the firm's work for the audit client is hardly independent, regardless of whether he or she meets all other tests for independence.  It also assumes that auditors will have no ability to write conditions about independence into their contracts with outside experts.  Finally, it ignores the fundamental conflict that exists when a firm is simultaneously auditing a client and competing for a consulting contract from that client.  Such a situation creates the very real danger that the client will pressure the auditor to lighten up in its scrutiny of the firm's accounting if it wants a shot at the potentially more profitable consulting contract.  When the bulk of the audit firm's revenues come from non-audit services, the pressure to go easy might not come just from the audit client.  

4)  Finally, and this is offered as the real clincher, opponents note that the SEC can offer no proof that an audit has ever been compromised by the provision of non-audit services to the audit client, and, therefore, the rule is unjustified.

As more than one person has noted, independence is a state of mind, and no one can see with absolute certainty into another person's mind.  Therefore, unless the compromised auditor is careless enough to leave a paper trail, or guilty enough to come forward with a confession, the SEC may never prove that a bad audit resulted from a lack of independence.  

If absolute proof is missing, however, there are plenty of cases that raise questions in a reasonable observer's mind.  Massive audit failures at Cendant and Sunbeam, Microstrategy and Waste Management, to name just a few of the most prominent recent examples, have all raised questions of whether consulting ties or incentive compensation for cross-selling consulting services may have compromised the audit.  Unless the practice of serving audit clients in dual capacities is checked, those questions will only grow.  The rule is needed to eliminate this growing uncertainty about auditor reliability in the face of eroding independence.

As a parallel effort to defeat the rule, opponents have attempted to slow it down -- hoping, presumably, for a more favorable political climate after the November elections.  What's the rush? they ask.  But a more compelling question is, why wait?  A problem has been identified.  It has been carefully studied by the Commission and numerous outside experts.  A measured and well thought out proposal has been put forward.  Ample opportunity for comment and debate is being provided.  It is time to act.  Speaking for consumers across the country, we urge the Commission to move forward expeditiously with this important rule proposal.