Testimony of:

Howard M. Schilit
Center for Financial Research & Analysis, Inc.
Rockville, MD 20852

Before the
Securities and Exchange Commission
September 20, 2000

I appreciate the opportunity to address the Commission today and fully support its efforts to tighten the auditor independence rules to improve the quality of financial reporting. Investor confidence is hurt with discloses of conflicts of interest between the auditor and the company being audited. Moreover, even an "apparent" lack of independence of auditors hurts the investing public. Hopefully, the Commission's initiative will be embraced by the auditing profession and investors' confidence will return.

There are three parts to my testimony:

My background - academic and professional

My observations about the problem

Proposed solution

My background:

As a PhD student twenty years ago, I wrote a dissertation entitled, An Empirical Study on Auditors' Independence. After interviewing several hundred auditors, I concluded that auditors, in general, lacked familiarity with audit independence rules and voiced disagreement with such restrictions.

Upon completing my studies, I began an academic career teaching thousands of this generation's accountants and auditors. One overarching goal in my teaching was to stress the "gray" areas in accounting and the need to understand the substance of transactions, regardless the legal form.

My research interests centered around "quality of earnings" and accounting irregularities in financial reports. In 1993, I authored a book entitled, FINANCIAL SHENANIGANS: How to Detect Accounting Gimmicks and Fraud in Financial Reports.

For the last seven years, independent research organization, Center for Financial Research & Analysis (CFRA), has helped institutional investors detect early signs of operational problems and/or aggressive accounting practices in the financial reports of public companies.

My observations about the problem:

What have I learned during this twenty-year journey, first as a doctoral student, then a teacher, an author, and finally "an accounting watchdog?"

1. The problem involving auditor conflicts and auditors' failure to detect accounting gimmicks and other problems has grown dramatically in the last generation.

2. Auditors have shown little interest in cooperating with initiatives to reduce investors' concerns about perceived conflicts of interest. Rather than embrace proposed regulations to allay investors' concerns, (or proposing reasonable alternatives of their own), the accounting profession regularly digs deeper trenches, refusing to come out and work to solve the problem.

Proposed Solution:

To be successful, a three-pronged approach should be undertaken to solve the problem:

Tighten and simplify the rules: The Commission should make every effort to work with the accounting profession to enact clear guidelines concerning the appropriate behavior of auditors and prohibited activities. This has been the Commission's approach and I believe they are on the right path.

Step up training of the auditors: Regardless of any new SEC-sponsored rules, I believe the auditors lack sufficient insight and training to notice accounting chicanery. The profession emphasizes that lack of independence in appearance has never be linked to any financial debacle. This statement, I believe is not worthy of debate because the more important point is often ignored. That is, auditors fail investors when they lack the ability to detect indicators of financial distress and/or financial shenanigans. The Commission and the accounting profession should work together to elevate and improve training programs so that auditors will consistently detect early signs of accounting problems to better serve the investing public.

Establish and mete out tough sanctions for deviants: The Commission should enact tough sanctions for accounting firms and individual practitioners who fail to take prudent steps to detect obvious signs of accounting shenanigans. The penalties should be severe and hit the auditing firms in their pocketbooks when an audit failure is proven. Thus, an audit failure related to a software firm might result in the accountants becoming ineligible to add new software audit clients for a six-month period. Only by both speaking tough and acting tough, will the Commission do an effective job of policing the accounting profession.

Concluding Thoughts: The current hearings on auditor independence reminds me of King Solomon's statement in the book of Ecclesiastes that `there is nothing new under the sun." For a generation or more, widely-publicized financial debacles have been followed with fingers pointed at the auditors and their apparent lack of independence. Becoming quite skillful, the profession proclaims its innocence and cavalierly states that "no proof exists" that lack of independence in appearance led to any financial debacles.

I'm frankly tired of this cat and mouse game. There is an undeniable problem - auditors have failed investors and creditors detecting problems at Cendant, Sunbeam, Oxford Health, MicroStrategy and scores of others. Let's stop pointing fingers or proclaiming innocence. The Commission should establish a code of behavior for auditors that helps re-establish investors' confidence. The accounting profession should view every accounting-related financial debacle as both a tragedy and an opportunity to learn from it. And finally, the Commission should hand out meaningful penalties to auditing firms when they fail to adequately train their staff and when they participate in botched audits.

Thank you for the opportunity to offer these observations and suggestions. I will be happy to answer any questions.