Testimony of Ralph V. Whitworth

The U.S. Securities and Exchange Commission
September 13, 2000
The Independence of the U.S. Audit Profession

Mr. Chairman and Commissioners my name is Ralph Whitworth. I am Managing Member of Relational Investors LLC, a private investment manager specializing in strategic block investments in publicly traded U.S. companies. I am also Chairman of the Board of Apria Healthcare Group Inc. and a director of Mattel, Inc., Sirius Satellite Radio, Inc., Tektronix, Inc. and Waste Management, Inc. While I hold these various posts, I am not representing those entities here today but rather expressing my personal views on a subject of critical importance to investors.

Thank you for giving me the opportunity to testify before you today. I commend you for holding these hearings and for your proposed rulemaking. This effort flows logically and necessarily from your earlier commendable work on audit committees and your staff's work on the phenomenon of "managed earnings". Your work impacts powerful interests and you have no doubt come under pressure as you move closer to a final rule. Though I do not agree with every detail of the proposed rule, I strongly believe you are on the right track and I encourage you to push on.


Auditor independence goes to the very essence of our capital markets and is inextricably linked to the efficiency and robustness of our capitalist system. Social theorists and economists offer many explanations for the incredible strength and efficiency of the U.S. economy and its life blood capital markets. A primary distinguishing feature of American capitalism relative to virtually all other models throughout the world is our stringent system of financial reporting and the central role played by the audit profession in infusing that system with credibility and integrity. This role even spills over to popular culture ensuring the integrity of such American traditions as the Oscars and the Miss America Pageant.

When investors read the heading "Report of Independent Auditors" in company annual reports and when they are asked to approve "Outside Independent Auditors" on most companies' proxy cards each year, those words are pregnant with enormous meaning-independence, integrity, objectivity and security. Unfortunately, today in all too many cases those words should be punctuated with a giant asterisk. Unbeknownst to investors who rely on them, these "independent" firms may have powerful business relationships with the company which far outweigh, in economic terms, the audit function.

I have long subscribed to Justice Brandeis' oft repeated quote that "sunlight is...the best of disinfectants," but sunlight alone will not suffice here. It is both the fact and appearance of auditor independence that infuses our capital markets with integrity. The credibility of American "numbers" has a direct and material impact on capital costs and the efficiency of our markets. Therefore, when striking a balance between my bias toward unfettered enterprise and the competing interest of efficient capital markets I have concluded that prophylactic solutions are indicated. The public interest in the continued vigor and optimization of our capital markets far outweighs any constraint well-reasoned prohibitions on non-audit services may impose on the accounting profession. Considering the imprimatur of trust that the audit profession injects into the conduct of its work and the broad public interest in efficient capital markets, it is reasonable to draw analogies to standards of independence common in our judicial system or for public officials. In these areas, appearances of conflicts are as damaging as conflicts in fact.

Because of the importance I place on the appearance of independence in the external audit function, I start from the presumption that all non-audit services for audit clients should be prohibited. This presumption should only be overcome where some overriding reason, independent of cost and convenience, says that the external audit firm is uniquely qualified or situated to perform the non-audit services.

Prohibitions on non-audit services and enhanced disclosure alone will not go far enough in addressing auditor independence. The value of the audit relationship itself creates a dynamic that can, and I believe in many cases does, compromise auditor independence. As a part of this process, audit committees must assume a heightened level of responsibility for ensuring the independence of external auditors. It must be clear to external auditors that they work for the audit committee. This means that the audit committee should approve all assignments (both audit and non-audit) for the external auditor and be integrally involved in negotiating fees and other features of the relationship. The audit committee should also put in place processes designed to uncover and prevent undue pressure from management on external auditors.

As with most things in this increasingly complex world, as soon as one gets past the theory of auditor independence the proverbial "devil in the details" brandishes its horns. My experience serving on seven public company boards over the past ten years and particularly my experience serving on and chairing audit committees tells me that prohibitions on non-audit activities must be approached very carefully. Line drawing in some areas can be very difficult and there are special circumstances where the external audit firm may be uniquely situated or qualified to perform non-audit functions. I will attempt to illuminate these observations below in addressing the specifics of your proposed rule.

Because of the inherent complexity of a regulatory scheme that relies heavily on prohibiting non-audit services, I offer an alternative scheme at the close of my testimony. This alternative mandates certification and disclosure by the audit committee combined with a bright-line limitation on the amount of fees for non-audit services.

The Proposed Rule

Here are my comments on the specifics of the proposed rule:

Bookkeeping: Auditors should not be keeping the books they audit and therefore in general should not be allowed to provide such services to audit clients. An exception should be considered for one-time assignments in emergency situations. In the wake of the Waste Management/USA Waste Services merger many of the company's field controllers became seriously behind in basic bookkeeping functions threatening the quality of our financial closes and our internal controls. In response, we marshaled an emergency team of accountants from both our external and internal audit firms to help bring the books up to date.

Financial information systems: These services should be prohibited for audit clients. These are often large, long-term or ongoing projects. The competition for these projects is fierce and creates an unhealthy dynamic when the external auditor is simultaneously pitching projects of this size and nature and certifying a company's books. This being said, the firm that provides these services will no doubt find it useful to consult with the external audit firm, which will have specialized insights into the function of business processes and financial information systems. Some allowance should be made for external auditors to be appropriately compensated for this type of consultation, however, the audit committee should approve any such assignment.

Valuations, appraisals and fairness opinions: These activities should be prohibited for audit clients. I do not understand why an external audit firm would be uniquely qualified for such services. In the absence of an overriding reason for the external auditor's involvement, this type of activity should not be allowed to cloud the relationship of independence.

Actuarial services: Again, I see no overriding reason why external auditors would be uniquely qualified or situated to perform these services, therefore this work should be prohibited for audit clients.

Internal audit: When this function is outsourced it should not be to the external auditor. Beyond independence concerns, sound process demands separation of these functions. Nonetheless, where the internal audit function is not outsourced, particularly with small companies, it may be useful for the audit committee to call on the external auditor to provide resources for carrying out internal audit tasks. Importantly, the external auditor should not lead or supervise these projects. Any services provided in this area by the external auditor should be approved and monitored by the audit committee.

Management functions: External auditors should not perform management functions, defined as assuming decision making or supervisory authority over the business affairs of the company.

Human resources: In the case of audit clients, external auditors should be prohibited from performing human resource functions or providing human resource consulting services. In crafting a rule, care should be taken not to prohibit employees of the external auditor from making recommendations for personnel or advising management or the audit committee on personnel issues arising from the audit process.

Broker dealer or investment banking services: External auditors should be prohibited from providing these services to audit clients. I see no overriding reason why external auditors are uniquely qualified or situated to provide these services and the provision of such services are rife with potential conflicts. Consideration should be given for allowing due diligence services related to mergers and acquisitions, as the external auditor is very well suited to advise management and the board on the financial systems, processes, and controls of an acquisition candidate. I also think that it is appropriate for the external auditor to advise management and the board with respect to tax and structural issues related to business transactions. Services in this area should be approved in advance by the audit committee and care should be taken by the committee to ensure that independence is not compromised by the provision of such services.

Legal services: In general, the external auditor should be prohibited from providing legal services to audit clients particularly for legal opinions or matters of litigation and transactional work. The Commission should use care in crafting such a prohibition, as the external auditor's advice and counsel to management and the board, flowing from the audit function, may at times be difficult to distinguish from "legal" advice depending on how broadly that concept is defined. This may ultimately be best left to the judgement of the audit committee with the Commission strongly discouraging the use of external audit firms for traditional legal functions.

Expert services: I do not see an overriding reason for external audit firms to offer expert opinions to audit clients, therefore this activity should be prohibited. As mentioned above, I do think it is appropriate for the external audit firm to be involved in due diligence related to mergers and acquisitions.

A Possible Alternative

A regulatory scheme relying primarily on prohibiting non-audit services to audit clients necessarily leads to major definitional and enforcement problems. This threatens to embroil the Commission's staff in parsing definitional issues surrounding external auditors' activities rather than devoting resources to more pressing enforcement issues.

With those concerns in mind, the Commission should consider an alternative scheme centering on audit committee certification of external auditor independence and disclosure of non-audit services and fees. Under this alternative, those requirements would be coupled with an effective cap on fees for non-audit services.

This alternative would require the audit committee to annually certify the independence of the external auditor and describe the certification process and criteria in the annual proxy statement. This certification would be required before the company or the auditor could use the designation "independent auditor" in the company's disclosure documents. This would be accompanied by a requirement that non-audit services and related fees be disclosed in the annual proxy statement.

Those requirements should be overlaid with a rebuttable presumption that an external audit firm which in any year received non-audit fees exceeding fifty percent of the cost of external audit services would not qualify as "independent" for purposes of the subsequent year's disclosures. Additionally, regardless of the reason, an external audit firm, which received fees for non-audit services exceeding one hundred percent of the cost of external audit services for the same year, would not qualify as "independent."

One can imagine variations of this general approach. Though perhaps in some ways more draconian than an approach relying on service-by-service prohibitions, this alternative certainly would provide a simpler and more readily understood (by the investing public) regulatory scheme, while at the same time following the Commission's traditional reliance on disclosure.

Regardless of what form the final rule takes, the audit committee should also ensure that the external audit partner's compensation is not tied to the amount of non-audit fees and ensure that the external audit assignment is not used as a loss leader for non-audit work. The alternative regulatory scheme outlined above, with its effective cap on non-audit fees, would help mitigate these problems as well.

This alternative places the onus for ensuring external auditor independence squarely on the audit committee and keeps accountability at the board level where it belongs.

Again, thank you for the opportunity to testify on this critical topic. I compliment you for all the hard work you and your staff have devoted to this rulemaking. Your effort to ensure a thoughtful and evenhanded process is obvious. I would be happy to answer any of your questions now or in the future as your work continues.