Hearing Testimony:
Auditor Independence
UNITED STATES SECURITIES & EXCHANGE COMMISSION
PUBLIC HEARING
ON
PROPOSED AUDITOR INDEPENDENCE RULES
Thursday September 21, 2000
8:46 a.m.
United States Securities & Exchange Commission
William O. Douglas Room
450 Fifth Street, N.W.
Washington, D.C. 20549
Before:
ARTHUR LEVITT, Chairman
ISAAC HUNT, Commissioner
PAUL CAREY, Commissioner
LAURA UNGER, Commissioner
P A R T I C I P A N T S
Robert K. Elliott, Chairman
Barry Melancon, President and Chief Executive Officer
Harold L. Monk, Jr., Chairman of the PCPS Executive Committee
- Representing the American Institute of Certified Public Accountants
Stephen G. Butler, Chairman KPMG LLP
Donald C. Smaltz, Independent Counsel
Jack Maurice, Member of the Ethics Working Party
European Federation of Accountants (FEE)
Abraham J. Briloff, Professor Emeritus,
Baruch College
Don N. Kleinmuntz, Professor of Business Administration,
College of Commerce and Business Administration,
University of Illinois at Urbana-Champaign
Urton Anderson, Clark W. Thompson Jr. Professor of Accounting Education
McCombs School of Business University of Texas at Austin
SEC Staff Present
Jonathan G. Katz, Secretary, Hearing Officer
David M. Becker, General Counsel
Lynn E. Turner, Chief Accountant
Mark Ready. Chief Economist
C O N T E N T S
Panel 1
ROBERT K. ELLIOTT
Chairman
BARRY MELANCON
President, and CHief Executive Officer
HAROLD L. MONK, JR.
Chairman of the PCPS Executive Committee
Representing the American Institute of
Certified Public Accountants
Panel 2:
STEPHEN G. BUTLER
Chairman, KPMG, LLP
Panel 3:
DON N. KLEINMUNTZ
Professor of Business Administration,
College of Commerce and Buiness Administration,
University of Illinois at Urbana-Champaign
URTON ANDERSON
Clark W. Thompson Jr. Professor of Accounting
Education
McCombs School of Business
University of Texas at Austin
ABRAHAM J. BRILOFF
Professor Emeritus, Baruch College
JACK MAURICE
Member of the Ethics Working Party,
European Federation of Accountants (FEE)
P R O C E E D I N G S
Panel 1
CHAIRMAN LEVITT: Good morning. I'm sorry that we're getting off to a late start. I know you probably came in early this morning. And I know Commissioner Unger will be here shortly.
But I did want to get started, to say to all of you that I greatly appreciate your very serious attention to these issues. After you sit through testimony for hours and hours and hours and hours, you begin to think you've been at this place more than once.
And, I'm not sure how much light gets thrown on everything and how much passion is wasted passion, and how much intellect really shines through, but we do appreciate your efforts. We do want you to know that we're listening.
I listened very carefully until almost 8:30 last night. My wife would like me to listen less carefully. So take it from there.
MR. MELANCON: Thank you, Mr. Chairman. Bob Elliott is going to start for us.
MR. ELLIOTT: Thank you very much, Chairman Levitt and Commissioner Unger. Thank you for giving us the opportunity for extended testimony after last week's testimony.
I have submitted a statement this morning. I'm not going to read the statement word for word, but what I amgoing to do is go through the highlights using the slides that you have before you.
When we looked at the original proposing release and tried to figure out where the SEC was coming from so that we could respond, we, sort of, read it like this, and this is our best attempt to, sort of, figure out where you're coming from.
You start with a presumption or a statement that audit failures and restatements are up and that there's something wrong with accounting. You then assume, perhaps, that one of the reasons this might be happening is impaired independence of accountants.
And you go from there to looking at why that impairment might exist, and you see these non-audit services which are growing and perhaps believe that some of those services are impairing independence, and, therefore, the proposing release would, essentially, cut them off.
So if that's the argument, then I want to address several of those elements in the argument. I want to start with audit failures. Audit failures have been going on for awhile, and that doesn't satisfy us at all as a profession.
We wish there weren't any. But there have been a few recent ones, alleged audit failures, let's say, because not all of these have been through the legal process, but things like Cendant and Waste Management and Rite Aid, and soforth.
But if you look back in history, you'll see that really there has been an undercurrent of these types of big cases going way back. You have McKesson Robbins back in the '30s and Barcris and Penn Central and Continental Vending and Equity Funding, and so forth.
So it appears to us that when you look at the long-term frequency, the long-term frequency is really rather constant over time. These things sometimes clump, but they're really rather constant over time.
If you look at the measures, as measured by litigation against accountants, it has been running for a long time at the rate of about 3 cases per 1,000, 3 audits per 1,000 in which auditors get sued. Now, that's just criticism.
Many of those cases, of course, the auditors win or get settled for nominal amounts, and so forth. But if you just measure the rate at which criticisms take place, it has been 3 in 1,000 for a long time.
If you look at SEC enforcement actions against accountants over the long period of time that you look at that, you get to one or two cases per 10,000, and that really hasn't changed all that much over time.
So that's the case of audit failures. Our view is that although no audit failures are acceptable, that the rateof audit failures really has not increased substantially.
Then you get to restatements. Restatements have gone up a couple of percentage points over the last couple of years. About 1 percent of registrants restate their financial statements. But there might be other alternative explanations for restatements of financial statements besides just lack of independence.
For example, it might be that auditors and companies are more diligent than they previously were. It might be that the accounting model itself is under stress, and it's more and more difficult to describe a modern enterprise using GAAP financial statements.
It could be, in some cases it has been, that the SEC has asked for a restatement because the SEC has retroactively changed the accounting rules, things like IPR&D, and so forth. So that would result in more restatements.
It could be that -- while we don't like to say this it could be a matter of competence rather than independence. It could be problems like that. And finally, of course, it could be an increased degree of SEC activism in calling for these restatements.
So we think that the rate of restatements is unacceptable at about 1 percent of registrants, but we think that you really have to look underneath the covers to findout what the reasons for that are, and there are other alternative explanations besides independence problems.
I'd like to talk about investor losses because, from time to time, we hear that one restatement or one audit failure and there's a huge break in market prices. And I want to illustrate that this way with a particular company.
Here is a Company X with a market capitalization, and let's say that the intrinsic value of Company X is about $10 billion, as shown on this slide.
Let's say that the stock price looks like this over a period of time. It goes up at point A. Let's assume that something has happened, whether it's aggressive accounting or whether it's a product development that market is rumoring, and so forth.
It begins to depart more from the intrinsic value at point A, B, goes all the way up to point C, and at point C something happens. Maybe the financial statements are restated, or something else becomes public, and the price drops all the way down to point E, which is an over-shoot of the intrinsic value and then recovers to the intrinsic value at point F.
Now, the reason I point that out is that the newspapers are likely to report that there has been a $35 billion loss in this case from point C down to point E.
But if you look at the individual investor,somebody who invested at time A and sold at B, C or D made money. Somebody who invested at A and sold at F broke even. Somebody who invested at B and sold at D broke even.
If you add up all the gains and losses for all the trades over this entire period, they cancel each other out. There is no net loss or gain.
That's very different from a hurricane coming up the Florida coast and wiping out $35 billion worth of real estate. That is a real $35 billion loss.
Now, I don't mean to say that there are no losses in this case because what happens is investors interpret this situation as volatility in the market. This causes them to demand compensatory returns. They increase their demanded rate of return on capital.
That drives up the cost of capital and creates drag on the economy and, therefore, these types of cases must be minimized. There's no question about it. This situation is completely unacceptable.
But I just wanted to point out that you have to differentiate between real economic losses and transfers of wealth and how they affect the economy.
Let's move to the next point, which is the question of the non-audit services. I think there are various ways you can think about financial statement audits and non-audit services for accounting firms.
Here on this slide the up and down axis represents the revenue of an accounting firm, and the other axis represents the time. And what you see is that over time revenues from audits of financial statements have remained flat.
The reason for that is very simple. Every company that's registered with the SEC has been required to have an audit for many years. There's not much new company formation, and therefore, since already 100 percent of the market is audited there's not much room for growth, and so you'll see rather flat audit revenues.
Over this period of time, though, what you see is growth in non-audit revenues, and the reason for that is that there is no lid on this marketplace. There is no cap on the amount of help that companies might need in order to adapt themselves to the new economy.
In fact, the only thing that's constraining the growth here is the availability of qualified consultants. So over this period of time, let's say from a generation ago, when auditing was two-thirds of revenue, to today, where auditing is, perhaps, one-third of revenue. Things have changed in this way.
And it's very easy to look at this and say the non-audit work is possibly in conflict with the audit work, and that's one view of the world. But I want to propose adifferent view of the world, and that view is that if you look at the services provided by these consulting firms it's not a totally broad range of consulting.
The name "management consulting" covers a huge array from engineering to architecture to legal consulting to marketing, brand building, lobbying, a very broad array of consulting. But the type of consulting that's done by accounting firms is largely in the area of improving information systems.
And improving information systems is complementary to the audit, which is the improvement of one type of information. And when you look at it in that way, the majority and, in fact, the vast majority of the work that's done by these accounting firms is actually in the service of information integrity, and probing the quality of information available to managers of the enterprise, and then the information that they can make available to shareholders.
Now, that doesn't cover everything that's done. Accounting firms do some other work, besides information integrity. Of course, they don't do it for any client for which it would be create an independence problem. That goes without saying.
But when you look at it this way, it's a very different picture. Most of the revenues here are actually in the service of information integrity, which is in the serviceof investors and ultimately the public interest.
Let's look at those information integrity services. The first one, of course, is the financial statement audit. That's the historical one. But the other services that these firms are doing largely fall into these types of categories -- electronic commerce, information systems integration, enterprise resource planning systems, enterprise networks, executive information systems, information and knowledge management systems, activity based cost and management and financial information systems.
This would cover a large part of the work of accounting firms, and this is work is all devoted to improving the quality of the information infrastructure of these companies, which is ultimately to the shareholders' benefit and the economy's benefit.
COMMISSIONER UNGER: Is that a ranking in terms of --
MR. ELLIOTT: No. It's not a ranking, Commissioner.
COMMISSIONER UNGER: It's not alphabetical either, is it?
MR. ELLIOTT: No. It's not alphabetical. It's the order in which I thought of them. But financial information systems is at the bottom. Let me focus in on that because the proposing release would severely restrict the ability towork in that area if there's -- if there would be an effect on the financial statements.
I think that's based on an assumption that somehow the auditor might be perceived as auditing his or her own work, and I want to make a point about that.
And that is that if you have a company that has certain transactions, what ever they are, things like purchase and sales, cash receipts and cash disbursements, these are determined by the company. These exist in the real world, and the accounting system doesn't create or destroy them. They are a fact of the company's existence.
You also have a set of management decisions that management has to make about the accounting which are built into the system, and what comes out is a set of financial statements at the end.
The important thing to realize is that given these transactions and management judgments there's really only one set of financial statements that can come out at the end. It isn't colored or shaped by the accounting system.
It's not like one accounting system produces green financial statements and another produces red. The information is the information.
Now, the accounting system might be something like that, which is pretty complex, and this accounting system has a lot of people at desks with a lot of paper and pencils, isvery inefficient, and it takes a long time to get the results.
But it produces exactly the same results as a system that looks like this, which is much more simplified and streamlined, which operates much more efficiently and quickly, which provides the financial information to management cheaper, better and quicker, but it's still the same information.
The design of the system itself does not color the information, and I think it's very important to understand that. You cannot look at these types of consulting engagements and conclude that somebody might think that there is a problem here because your own release says that the test should be reasonable, individual and full possession of the facts.
And I think when you have full possession of the facts, you begin to realize that there is nothing wrong with this. And I would point out that Mr. Laskawy yesterday testified there is no reason to think that this type of system design work would actually impair independence.
Let's move on, then, to a different possibility for these audit failures and restatements, and that might go to the question of competence. In other words, the financial statements might be wrong, to the extent they're wrong, not just because of lack of independence but because ofcompetence issues.
That leads me to look at a good audit as a three-legged stool which has to be supported by three legs. It will fall without any of the three.
The first is objectivity. The auditor must be objective, or else the audit is worthless. The second is competence. We could have a perfectly objective person, but if this person doesn't know how to do audits, we won't get a good result.
And the third thing is diligence. We can have a very objective person who is very competent but who fails to come to work in the morning. So we really have to have all three of these things working for us. If any leg fails, the stool falls.
But you have to drill down below this and look below objectivity, and what you'll see is that breaks down into two sub-legs. There are two ways in which objectivity could be established for the audit. One is by integrity, and the other is by independence.
You could imagine a person with perfect integrity whose judgment could never be swerved by any interests whatsoever. So even if this person were not independent, he or she could still be objective.
Now, not too many people have perfect integrity, but on the other side let's say there's a person withimpaired integrity but who, however, has no interest whatsoever, no interest in the company, the financial statements, any other work, or what not, perfectly independent. That would be sufficient.
Perfect independence or perfect integrity would be sufficient. In the real world, you don't get perfection on either of these legs and so what you deal with with a normal level of human integrity and sufficiently high level of independence so that the two of these things working together create objectivity.
Each of the other legs also breaks down into two areas. For example, competence breaks down into education and experience, and these things are also compensatory. A little more education can make up for a little less experience, and so forth.
And diligence is a function of worth ethic and incentives. Somebody with an excellent work ethic but lousy incentives would still do the job. Somebody with a lousy work ethic but good incentives would do the job. A balance of those does it.
Now, when we look as policy-makers and within our members of the institute, our member firms, when they think about producing good audits, they have to think about all of these various areas.
They have to manage all of them, the competency ofpersonnel, the incentive structures, independence, integrity, all of these things. To the extent that we invest in one of these, to those dollars not available for the others.
So for example, we recently committed to put $25 million into independence tracking systems. That shores up one of these legs, the independence leg, but those 25 million are then not available for, let's say competency improvement because there's a fixed bankroll.
So I think it's very important to realize that these things are tradeoffs and that, when you think about them, you have to think about them as tradeoffs. Now, with that in mind, let's look at the costs and benefits of independence, because it is a cost/benefit tradeoff, and the proposing release makes some comments on cost and benefits.
But I want to extend that analysis here. On the left/right axis here, we have auditor independence ranging from none to total. Now, auditor independence is not a binary variable. It's not a question that you're either independent or not independent.
You can think of somebody at the left end who is not independent, somebody who works for the company, has stock options with the company, is deeply in debt, so on and so forth, is completely dependent.
At the right end of the scale, you can think about somebody who is totally independent as an auditor, let's sayis selected at random from a pool, paid by the government and has no other interests whatsoever.
So you could be anywhere on that spectrum. What happens to that person on the right if he or she accepts a cup of coffee? Well, you come off of the green from total independence. So it's a continuous variable.
The up/down axis, then, represents cost. And we have to look at that in this type of way. If auditors were, in fact, totally not independent, there would be cost to the economy.
There would be cost in terms of loss of confidence in the capital markets. There would be cost in terms of poor financial statements leading to capital mis-allocation. There would be a drag on the economy if we didn't have auditor independence.
As the auditor becomes more and more independent, that cost goes down until, if you had perfect independence, there would be no such cost imposed by lack of auditor independence. If that were the end of the story, we would stop there. We would say perfect independence is required.
But it's not the end of the story. There are costs of independence. There are costs of setting the rules, observing the rules, peer reviewing them, enforcing the rules.
There are costs on firms in terms of foregoneopportunities that the firms have that their people want compensation for. There are costs to companies who forego scale and scope economies in their work.
So there are costs, and those costs come up. So the total cost to the economy, then, is the sum of those two, and what you have to look for is the point at which that's minimized. And in this particular case, it's minimized a little short of perfect independence.
If we go further than that, we actually increase the costs on the economy, and it's suboptimal. So it becomes a question of these tradeoffs. Now, I point out that although this chart is only illustrative, it is very representative of what Congress decided in 1933 and '34, when they decided that auditors would be in the private sector.
They could be paid by their clients, and they could do some non-audit work as well. So that's not perfect independence. Congress was aware of that, and you might think that this chart represents that picture fairly well.
But if auditor independence costs rose more steeply -- I don't say that they do -- excuse me, Commissioner?
COMMISSIONER CAREY: Congress did not have anybody to foresee the mix of revenues as a very hold on an auditing firm's independence as represented by today's situation.
MR. ELLIOTT: I agree that they couldn't. My onlypoint is at the time they made the choice, the statutory choice, they knew that auditors accepted fees and did other work. How that's changed in the future might change the cost/benefit relationship, but the fact is that this is what it looked like more or less in 1933 and '34.
If it costs much more -- I don't say it does, but if it costs much more to create auditor independence, you'll get a very different curve and a very different optimal point. The point is that you have to make those cost/benefit tradeoffs to know that what you're doing is right for the economy.
Let me turn to the question of if we have too much independence, that is, if we force these firms to strip back to, let's say, statutory auditors, this will have an effect on the competencies that are required.
And I want to point to the competencies that are required to do a good audit today under today's GAAP. But increasingly in the future as companies become more and more post-industrial, a good auditor has to be much more than a green eyeshade person with a bachelor's degree in accounting and auditing. A good auditor has to understand the industry dynamics in which the client is playing, the competitive forces, changing bargaining power between buyers and vendors, new entrants, new technologies, these types of things.
The good auditor has to understand the businessstrategy to see whether it's a winning strategy, must understand the electronic commerce strategy because it changes the way in which the company relates to its customers and vendors. It changes logistics lines. It changes the way the company looks.
The good auditor has to be able to think about risk management. These companies are using increasingly sophisticated strategies to manage risk -- financial instruments, options, futures, swaps -- statistical methods of managing these things, and if the auditor doesn't have at least the same level of capabilities that the client has, the auditor is not going to be able to do a good audit of these types of issues.
Some of the values on balance sheets require actuarial valuations. For example, mortgage loans on the left side of the balance sheet or, on the right side of the balance sheet, life casualty and health reserves need to be thought of actuarially.
We have increasing importance of intangible assets. We have to know more and more about how the company is managing its information and knowledge management systems. We have to know more about its networking and linkages with its customers and vendors because it affects how assets and liabilities are generated and accounted for and where transactions and borders between enterprises occur.
These are competencies that are absolutely required in order to do a good audit today but would they be effectively eliminated under the provisions of the rule. It would be impossible to keep world class talent in these types of areas under the rule, if it were enacted.
So that leads us, then, to the conclusion that this view that audit failures and restatements are increasing and that that shows impaired independence, and that must be fixed leads to a different view of the marketplace.
And that's one that we're actually talking about, the potential obsolescence of financial statements. Let me say a few words about that. Today's financial statements reflect industrial era assets.
They reflect the inventories, raw materials, work-in-process and finished goods, the machinery that works on the inventories, the buildings in which the machinery sits, the land and, basically, the tangible assets of the industrial era.
But today's companies run on a very different set of assets. They run on intangible assets. They run on information and knowledge, research and development, the capacity for innovation, relations with vendors and customers, organizational learning capacity.
And the interesting thing about all of these assets -- and these are assets of the company even though noton the balance sheet -- is that they're not reflected in the financial statements.
A way of thinking about this is that over time as we've moved from the industrial era to the information era, the importance of tangible assets to companies has been going down while the importance of intangible assets has been going up.
At the left end of this diagram, think about United States Steel. The assets they require are, basically, coal, iron, steel mills and railroad cars. At the right end of this picture think of Microsoft where the essential assets of the company are the intangible assets -- the knowledge and know-how of the employees, brand name, market share, customer loyalty, and these types of things.
So where we are right now as a profession, because of the way GAAP and GAAS are set up and the way SEC rules operate is the product that we're providing to investors is periodic historical cost basis financial statements.
We have to compare that, though, with how these investors are used to getting other information in other domains. Instead of periodic information at the end of the year or quarter, they're used to logging onto the internet and getting the information on demand.
Instead of looking backward, they want to be right up to the minute. Instead of looking just at cost, they wantto know just the value of enterprise assets. Instead of looking at just financial information, they want comprehensive information that tells them more about the enterprise.
And instead of a set of statements -- a balance sheet and an income statement -- they want to be able to drill down, get the information they want in the format they want it. These possibilities are permitted by today's technology, and they're delivered in many other information domains, but they're not delivered in our information domain.
And if we stay on the left side of this picture, the relevance of today's annual audited financial statements will continue to decline. We must move to the right side here to serve investors.
Where we are right now is that over the period of the 20th Century, financial statements have become more informative to investors as accounting and auditing standards have improved. But late in the century, as the economy switches to post-industrial, the informativeness of financial statements is going down, as shown in this graph.
This is the information received by investors from financial statements. This is the information they receive from other sources. Early in this century and even when the SEC was formed investors got a large percentage of the information they needed -- they never got it all, but theygot a large percentage from the financial statements.
Today they get a small and decreasing share of the information that they get from the historical financial statements. One of the problems this relates to I think I can best give you by way of analogy.
Think of a cave man. A cave man has a very limited vocabulary. It has words like run, stone, hunt, meat, eat, fire, sleep, very simple vocabulary.
COMMISSIONER UNGER: How do you know this?
(Laughter)
MR. ELLIOTT: Our profession is a very old one. It's a very limited vocabulary, and if you would ask a cave man, let's say, to describe something more modern like a gun or a steam engine or a computer, that vocabulary would be insufficient.
Now, my story has a point here. What I'm saying is that the GAAP vocabulary today has a limited set of words. It has words like cash, inventory, plant, debt, revenue and cost. And that vocabulary is insufficient.
It's inadequate to describe a company like Intel or Microsoft or Cisco or Amazon or even, for that matter, what you might think of is a traditional manufacturing company like Motorola, because when you buy products you're paying very little for the tangible inputs in there. You're paying much more for software, research and development, networking,and so forth.
So what we see is a problem with GAAP. It has not kept up with the times. It has not become post-industrial. Therefore, what we're looking at is the question why has GAAP not kept up?
One of the reasons is that corporate preferences are not in favor of that. Another is that the SEC really has a role in GAAP, and I want to come back to those two points. Why is GAAP out of date?
In the first place, the standard-setting system is designed to be very deliberative. That makes it slow. It doesn't catch up very fast. And the conversion to a post-industrial economy is really something that's only 10 or 15 years old.
The second thing is that the business community doesn't lobby for changes in accounting standards, as you know. In fact, they lobby generally against that, and they have some legitimate reasons, things like the cost of implementation, things like informing their competitors, things like the fact that they've written contracts under the old accounting rules.
They have legitimate reasons, but the fact is that many times they don't want to change. And finally, we have innovation is discouraged. It's discouraged by the SEC's attitude, which is not friendly to innovation in financialreporting, and it's discouraged by the potential for litigation, and so forth.
So what we have is a picture, then, that looks like this. The left side is what's, sort of, implied in the release. The right side we believe is probably something that investors really need to focus on.
And I will point out that yesterday in his testimony, Mr. Schiro pointed to the fact that today's financial statements do need to be modernized to catch up to the new economy.
What we're talking about here is that these obsolete financial statements might actually be part of the cause for audit failures, accounting failures and restatements because it's impossible for these companies to well describe their enterprises using the limited vocabulary of GAAP.
The system is under stress, and it's our expectation that if the system had a richer vocabulary or better able to describe these companies that there would be fewer problems with the marketplace being disappointed by gaps between their expectations and the information that's produced by the companies.
If we're going to move to improve these obsolete financial statements and move into this new era that I'm talking about, that has implications for the competence thatthis profession can bring to bear.
And if that competence is supported best by the rendition of these non-audit services at the frontiers of knowledge and development, then we will be in a position as a profession to support the FASB, the IASC, the SEC in modernizing accounting and auditing standards and principles and practices.
But if we lose that as a profession, if we lose that capability and are not at the leading edge, we will not be able to participate in those changes. That leads us to our recommendations to the SEC today.
The first recommendation is that rather than issuing the pronounced rule is to rely on the ISB, as the SEC said it would do, in Financial Reporting Release No. 50.
The second is for the SEC to change into an attitude of encouragement both to the FASB and the IASC to focus on the new economy and what needs to be done in order to better account for these companies in the new economy.
The third recommendation is to encourage registrants to experiment with different ways of getting their information out on the internet more timely, use of XBRL, for example, to reduce the resistance and impedance between the production of the information and the ability of investors to find, acquire and successfully use it.
Fourth, we encourage the SEC to encourage theprofession to move in the direction of real time auditing. It is not going to be helpful if in the future companies are reporting their information on the internet in real time and the annual audit comes by nine month later and the auditor says there were errors in the financial statements, but don't worry. We found them and corrected them. It's too late. People have already used the information to make decisions.
In order to best support these investors, we need real time assurance, and that means investments in technology by the profession, and we ask that the SEC encourage moving in that direction.
And finally, we recommend that the SEC encourage registrants to experiment, to experiment with new types of disclosure that would be more informative to investors, and one way to encourage them would be to give them some form of safe harbor, if they met certain standards, for example, to encourage them to experiment.
So these are the recommendations that we have, and I want to wind up by saying that in the public interest it's absolutely essential to have sound financial markets. In order to have that, it's essential that we require good accounting transparency so investors can see exactly what they're buying or thinking of buying.
That accounting transparency depends on new methods, a new breadth of information beyond just the limitedvocabulary of today's GAAP, new channels -- the internet instead of the U.S. Mail -- new timeliness up to real time and real time assurance.
These are the requirements, and we cannot do these without a vital auditing profession. And that is the public interest that we are here today to advocate before the SEC. Thank you very much. Mr. Melancon.
MR. MELANCON: Thank you, Bob. Chairman Levitt, Commissioner Hunt, Commissioner Unger, Commissioner Carey, thank you for the opportunity to be here.
Let me first say that the AICPA is happy to be here to dialogue with you on the various issues that are before us today. We are committed and have been deeply committed to auditor independence and remain so in the future. You can rest assured of that. It is a core value, a core value of our profession.
The reputation of all auditors demands it. High-quality audits require it. And the strength of our financial markets depend upon it. This dialogue and these hearings is not about the importance of independence. It is about how to achieve it.
And it is about ensuring that the profession will be able to continue to perform its responsibility to the public interest in the future as well.
We are in full agreement on the imperative ofauditor independence. We can and do disagree about what approach best serves the public interest and the highest quality of independent audits of public companies, but just because we object to the rule proposal does not mean we disagree with the objectives.
Expressing one's independent view is in the highest tradition of this country and, we would hope, welcome by this SEC process. The very purpose of these hearings is to hear from interested parties, including those who disagree. Just because we oppose this rule proposal does not mean we do not respect the SEC as an institution.
We can and should conduct our dialogue in a spirit of mutual respect, accepting that the Commission and the profession are both seeking to do the right thing. In that spirit, we are fully prepared to work with you to find a solution to these issues.
One vital area where we not only agree but applaud your efforts is in corporate governance and audit committees. Mr. Chairman, without your personal leadership we would not have achieved the major reforms which have occurred in the last two years in this area.
This is just one manifestation of your devotion to protecting investors of this country large and small, and it has been an issue that has been on the agenda for improvement for an awful long time, and we commend the Commission formoving forward in that area.
The accounting profession has a proud history of working in the public interest, a history of over 100 years. All of our members are required to maintain independence from their audit clients. We have a detailed and regularly updated set of independence rules, interpretations and ethics rulings. These requirements apply to audits of public and non-public entities.
AICPA member firms that audit SEC registrants are also required to join AICPA's Practice Section which has adopted quality control requirements designed to promote both quality and auditor independence.
Member firms of this section, SECPS, have been required for over two decades to participate in a program of peer review, of compliance with independence as well as audit standards and guidelines.
In a spirit of transparency, the SEC has access to peer review working papers and quality control inquiry files. These reviews have identified lessons to be learned that serve to improve the quality of future audits.
The AICPA is committed to a self-regulatory program that focuses on protecting the public interest, in reliable financial information and in enhancing the credibility of financial reporting through the audit.
I think Bob Elliott covered a lot of those issuesin the future view of financial reporting. Without question our self-regulatory system has been an integral part of the best and strongest financial reporting system in the world.
The profession understands that the public's trust is hard earned and easily lost. For precisely this reason the AICPA has supported or initiated numerous efforts over the years to strengthen the financial reporting system and the profession's independence requirements.
A complete recital of these projects will be in our written comment letter. I would be remiss, however, if I did not mention the leadership role played by the AICPA in connection with the formation of the bodies such as the POB and the ISB.
Our support for the Commission's commendable initiatives to enhance and improve performance of audit committees and our contributions to the work of many high-level bodies which have, from time to time, studied the issue, including the Cohen Commission, the Jenkins Committee, the Elliott committee, Kirk Panel and the O'Malley Panel.
I want to pay particular attention to the ISB, on whose board I serve. The AICPA was a party to the creation three years ago of this promising partnership between the SEC and the profession. We have supported it ever since and are committed to its success. And we are pleased that much progress has been made on effort fronts.
In fact, we view the ISB as the primary place for the profession and the SEC to dialogue on independence matters. The ISB has adopted, by unanimous vote, standards mandating disclosure to audit committees of information that could have a bearing on auditor independence, addressing the difficult issue of the independence implications of audits involving investment company complexes and providing guidance on an auditor's employment with a client.
In addition, the ISB has prepared exposure drafts of new standards on financial interest and audit clients, family relationships between persons employed at accounting firms and client employees, and appraisal and valuation services.
Although we are gratified that the Commission's proposal on financial interest and family relationships are based on the ISB's work, we urge the Commission to drop this part of the rule making and rely on the ISB.
Most importantly, as contemplated at the ISB's formation, substantial work has been done to develop a new conceptual framework for auditor independence, the predicate for replacing the present rule-based system with one which is based on principles.
Supporting the ISB is fully consistent with the Commission's discharging of its statutory responsibilities. It would have to approve the new framework by a new rulemaking. The only issue is when and how it exercises its authority.
We submit the public interest is best served by allowing the ISB processes to continue as we agreed three years ago. We understand or understood the public members of the ISB at the July hearing to say the SEC should make the ultimate policy choices about non-audit services.
If the ISB were allowed to complete its work, the SEC could do just that, in fact would do just that, based on a fully developed framework. The ISB conceptual framework project is key to the creation of the principle-based approach to auditor independence that the SEC and the AICPA agree to entrust to the ISB.
But if the proposed rule were adopted with its dense thicket of prescription and prohibitions, this project would be moot. After all, what would be the point of developing a conceptual framework for a principles-based approach when the SEC would have just adopted a sweeping rule based on regulation, which would crowd out any new framework.
As our past actions demonstrate, the AICPA is fully committed to a careful and thorough review of the rules governing auditor independence. We have a long track record of working in cooperation with the SEC to make these rules more effective.
Indeed, the SEC's own expressly stated positionover a period of many years has been to turn to the AICPA's independence standards for guidance absent a clear conflict with an SEC rule or interpretation.
Having reaffirmed our commitment to an independent auditing profession and our desire to work together with the Commission in the public interest, however, we regret that we cannot support the proposed rule. And there are many reasons for our position.
Before I discuss these concerns I should explain how we see the rule. To be direct, we believe the proposed rule would limit drastically the ability of accounting firms to provide services other than audit and tax, and even some tax services could be prescribed. This would be achieved through the interaction of four components of the proposal.
An expansive list of prohibited non-audit services, the adoption of vague open-ended principles and a catch-all provision which allows for the prohibition of virtually any activity based on the regulator's perception of appearance.
A new definition of the term "affiliate" of an accounting firm which would result in imputing to the firm the activities of virtually any entity with which the firm has any commercially beneficial relationship. And the nature of the new rule's mandatory across-the-board proxy disclosure of detailed information about non-audit services.
As a result, the net impact that these fourelements have an impact on the profession's ability to continue to meet the public interest, and, therefore, we are concerned, particularly from a long-run perspective.
Let me put this in no uncertain terms. In its current form, this proposal will do significant harm to the ability of our members to provide quality auditing services in the 21 Century and, therefore, harm the public interest.
There are divergent views among the 340,000 members of the AICPA, as any large organization would have. And you have heard divergent views in this hearing.
We are here in opposition to the rule proposal with the full support of our board, which reaffirmed that support in a board meeting just last Friday, and with the deepest concern for the ability of our profession to continue to serve the public interest perform audit services of the highest quality in the future if this rule is adopted.
I'd like to also point out that many commentators in these hearings have offered different looks at these particular rules, including some who are members. We pledge to take a look at all of these suggestions just as I know you will.
What you have heard from all five firms in these hearings is that in one form or another they have concerns with the current rule. We support the right of each firm to give you its views, and we remind you that the AICPA alsomust speak on behalf of the 75 largest firms in the country other than the Big 5, who perform over 2,200 public company audits and 45,000 other firms as well as sole practitioners and members in industry and elsewhere who are CPAs.
We also support the right of each firm to follow its own business model, but are strongly opposed to a system in which one model is fit into one answer. The market will ultimately judge in the future which business model works, but it should not be the role of the SEC or the AICPA to impose its idea of what business model should be on the entire profession.
Let me turn to our specific concerns with the rule proposal. First, the process for consideration of this complicated, comprehensive and far-reaching proposal is, in our opinion, just to short.
Second, there is no basis for the radical surgery that the rule would perform on the profession.
Third, the definition of "affiliate" would stop audit firms from effective participation in the dynamic new economy.
Fourth, the rule relies too heavily on an inadequately informed and potentially legally inappropriate appearance standard.
Fifth, the rule is overly restrictive in terms of prohibited non-audit services.
Sixth, unintended adverse consequences are likely from these rules.
Seventh, the rule will not produce the desired degree of certainty or even predictability. Let me go in a little bit more detail on each one of these.
We have serious concerns, as I mentioned, about the process that you've adopted for consideration of this rule. These concerns are well known and have been fully discussed in the past and will be in our written comment, which we will submit later this week.
There is no need for me to go into that here, except to note that to close the comment period only four days after the last hearing before transcripts of the hearings are even available prevents meaningful comment by anyone on the voluminous materials covered in these hearings. Once again I urge you to extend that comment period.
Secondly, our overall concern is simply this: There is no basis for the radical surgery the proposed rule would perform on the accounting profession. We are sincerely concerned, if this rule takes effect, about the profession's ability to meet the public interest in the long term.
Given the severity of the treatment one would expect to find a substantial record of empirical studies establishing the link between audit failure and non-audit services, findings to that effect in litigated cases,enforcement actions at least alleging such a connection, or other evidences of harm. We do not find such a record.
We recognize and share your concern about recent large audit failures. We need to do all we can to reduce the risk of breakdowns. Fortunately, the frequency of these instances is no greater today than it has been historically, but we do not agree with your assumption that this risk is connected with auditor independence and specifically non-audit services.
And there is support for our view from objective observers. The U.S. General Accounting Office in a 1996 report reviewing the studies relating to auditor independence concluded:
"None of these studies reported any conclusive evidence of diminished audit quality or harm to the public interest as a consequence of public accounting firms providing advisory or consulting services to their audit client."
The insurance industry, which arguably has the most to lose from an audit failure and whose very business is that of risk management, does not consider non-audit services to be an audit risk.
And in not one of the 37 engagements involving the provision of non-audit services to audit clients studied this past year by the O'Malley Panel did the panel "identify anyinstances in which providing non-audit services had a negative effect on audit effectiveness."
In fact, on the contrary, the panel's reviews concluded that those services had a positive impact on the effectiveness of the audit in about a quarter of the engagements studied.
Lacking any empirical support, the proposing release relies instead on common sense and the impossibility of observing an auditor's state of mind. But someone's assertion of what is common sense is not a substitute for reasoned decides-making, particularly where it is at least equally likely as a matter of common sense that if non-audit services were tied to audit failure, someone -- the SEC, our profession, private securities counsel, the insurance industry, investors, audit clients or even the academic community -- would now be able to demonstrate a significant relationship. But no one has done so.
Even if there was some isolated cases in which non-audit services were found to be linked to audit failures that would not establish a proper basis for the drastic action proposed by this rule.
Even without a body of litigated cases involving findings of such linkage the issue can be subjected to disciplined analysis as it was by the O'Malley panel, the committee of sponsoring organizations of the TreadwayCommission, known as COSO, studied ten years' worth of SEC enforcement actions involving financial fraud using the SEC's own public records and identified a number of risk factors or red flags.
Surely, a follow-up review of these records, supplemented by data showing the nature and extent of non-audit services provided by the auditor in those cases, could be carried out to determine whether any causal nexus exists between the provision of non-audit services and the instances of financial fraud.
Or even a broader study could be done applying widely used social science methodology to determine whether a statistically significant correlation exist between non-audit services and with audit failure. I have no doubt the Commission could obtain the necessary data on the non-audit services provided to these clients.
The fact that the rule-making had reached this advanced stage without the benefit of such studies is, quite frankly, one of our concerns.
Thirdly, the proposed rule definitions would cripple the accounting firm's ability to participate in the new economy. Your proposed rule makes accounting firms what is the equivalent of economic pariahs in the new economy.
Because of the broad definition of "affiliate of an accounting firm," no one will want to engage in any businessventure with an accounting firm due to the imputation of independence obligations and compliance.
Let's say a software firm, a large one or a small one, let's say Oracle, were to want to be a venture partner or look for a venture partner to assist in develop a new accounting software application, a natural fit and good opportunity for an accounting firm.
If Oracle were to join in such a venture with an accounting firm regardless of the materiality of the investment, the accounting firm would have to ensure that Oracle, as an affiliate of that accounting firm, complied with all the intended independence obligations.
Oracle could not invest in any audit client of the accounting firm. Oracle could not provide any non-audit services, such as installing software, to any audit client of its accounting firm partner.
Any other entity in which Oracle had a 5 percent investment would be subject to the same restrictions as Oracle, and that entity would also be considered an affiliate of the accounting firm. Given such serious consequences, Oracle would never participate in any venture with any accounting firm.
The proposal's restrictions with respect to material indirect investments seek to prohibit situations where an accounting firm or its affiliates own more than 5percent of the equity of an entity that either has an equity interest in an audit client or in which the audit client owns any equity interest.
There is no qualification based on materiality. How would this work? Let's assume the audit client of a firm is General Motors. General Motors invests in businesses across America in due course.
Any entity in which an accounting firm or its affiliate has a 5 percent equity interest, regardless of how small the total value of that interest, could not hold even one share of General Motor's stock without violating the proposed rule.
The 5 percent threshold in the definition of an "affiliate of an accounting firm" and "substantial shareholder" in the business relationship rule depart from long-standing and well-established financial concepts of control and significant influence.
There is simply no basis to argue that ownership of a percent of a company's equity establishes control or even significant influence, and therefore should have such draconian consequences. The 5 percent tests are unworkable.
Fourth, your reliance on appearance with no adequate foundation is a considerable concern. This is not to say that appearance is unimportant. It is a concern for us and for you, but we don't agree with the approach you havetaken to appearance in this rule.
From the standpoint of appearance, the greatest threat arises from the fact auditors are paid by their clients. As the Commission knows, Congress was well aware of this in the 1930s when it established our current regulatory system, considered alternatives such as a government cadre of auditors, and concluded that the risk of auditors being paid by the client was acceptable, given the greater benefit attached to having the audit performed by a robust, private profession.
It follows that perfect independence is not the holy grail, and rather than continue to pursue it the regulatory process should focus on identifying threats and considering safeguards, precisely the task the ISB has undertaken in connection with the conceptual framework project.
Fifth, many of the restrictions the rule would impose are excessive. For example, in the area of external audit services, the ban on extended audit services will restrict the ability of a client to use the expertise of its auditing firm to fill in gaps in its internal audit competence and will degrade overall internal control quality.
We seem in this area to have a problem that I would describe as a problem with terminology. We do not view it as internal audit out-sourcing. Rather, we see many of theseservices as extended audit services, as part of the scope of the audit.
Extended audit services are permitted under AICPA rules within express limits. Management cannot shirk its responsibility and totally transfer the internal control function to the external auditor. This was a concern of the bank regulators who previously testified, and we agree with their concern.
However, one must understand the definition of "extended audit services." If the client's internal auditor is unable to review some aspect of their function, such as the books and records of a remote location, it is perfectly appropriate, cost efficient and responsible for the external auditor to extend their audit scope and do so. This is permitted now under our rules.
Your rule proposal seeks to prohibit it. Extended audit services should not be prohibited but left to the judgment of the client and their audit committee, subject to restrictions designed to ensure that the auditor does not take on management functions as in the current AICPA requirements.
Subject to that constraint the extended audit, which is essentially a broadened audit scope, should help to ensure audit quality and investor protection. Let me give and you couple of more examples.
IT auditors, from an internal audit perspective, are very scarce today in the marketplace. Let's assume that a client wants to out-source the internal IT systems function.
Let's say specifically that the service that they would like to be tested is a billing system, a billing system that management has acquired, made all implementation decisions on, and has required the use of within their enterprise.
If the external auditor were to perform services to test that billing system, in all likelihood they would exceed the requirements that are currently required by GAAS. More work would be done than would be required in an audit today.
But by doing so the auditor now has access to additional information that is the result of the extended audit engagement, and that information is required by the auditor to be used in determining their final conclusions on the year-end audit. In this case, investor protection is enhanced.
Another example. Let's assume that a client believes that there is possible employee theft occurring at a plant in a remote or foreign location. One might conclude that the appropriate place to turn is to the internal audit team.
But maybe the internal audit team does not have theresources or does not have the ability to perform the fraud audit in maybe such a remote location, or even the expertise to detect a fraud in that environment.
And so the client asks the auditor to conduct an internal audit procedure to determine whether or not the fraud had occurred. That process again would produce greater investor protection, and the results of that work would be required by the auditor to be considered in the culmination of their activities as it relates to the audit at year-end.
Another example is appraisal services. Limits on actuarial services, appraisals and valuation services and broker investment advisory services all go well beyond current restrictions and impose great cost, particularly on smaller firms, without any showing of current harm.
For example, the proposed rule would prohibit purchase price allocations in the valuation of non-material assets, neither of which is currently prohibited. Clearly, the use of the accounting firm's own appraisal and valuation specialist, particularly on immaterial assets, can improve both of quality and efficiency of the audit.
Let's turn to financial information systems. There's an outright prohibition in this area in the rule. Designing or implementing hardware or software systems used to generate information that is significant to the financial statements taken as a whole are prohibited. So let me giveyou an example.
Let's assume that the client's MIS department buys an off-the-shelf PeopleSoft program for payroll processing. Four months into the system's implementation the client determines that the project is too complex, and it will not be able to meet its future implementation deadlines.
The client asks for auditor assistance in completing the project by training its employees to effectively utilize the program within the desired time frame. The client has made all of the decisions regarding the selection of the software and the implementation of the system, has an internal team that is overseeing the system's implementation.
The auditor is not writing code but is simply formatting the database on management's desired design and training employees to use the software.
At year-end, the auditor will be auditing compliance with the processes to determine human user breakdown. The auditor can perform the service faster, better and cheaper because it knows the client staff and processes.
And one of the benefits that could come out of this is by having greater exposure to all aspects of client personnel and systems the auditor is actually learning more about the client and is more likely to be able to perform abetter audit and, therefore, to protect investors further.
In the area of human resources, recruiting, hiring and designing compensation packages and advising about the clients management or organizational structure are all prohibited in the proposed rule.
Let's assume for a second that a client merges with another company. One of the main issues in a merger is to integrate the benefit packages for employees between those two companies.
It would not be unusual that the client would ask for help of understanding the differences to be able to have an effective integration of those benefit packages between the two merged companies. That is prohibited under the current rule but does not reduce audit quality in any fashion.
Even expert services. Rendering or supporting expert opinions in legal administrative or regulatory filings or proceedings as an expert are prohibited in this proposed rule. Let's assume that the SEC is challenging a client's position in a Form S-1, and possibly is considering requiring a client to restate its financial statements.
SEC rules, as we all know, are complex, and the client needs assistance with articulating its position, a position that it has determined and that the auditor independently has reached a conclusion that the position isappropriate.
The auditor is asked to assist the client in explaining and defending its position to the SEC. We do not see any problem with this particular issue. The CPA has made an independent determination that the position that the client has taken, the decisions that the clients have made are, in fact, appropriate.
Contingent fees. Beyond barring contingent fees from audit clients, which the AICPA already prohibits, which is in your rule, the proposing release calls into question the violate of value-added billing; i.e., where the fee is based on the value of complexity of the services rendered.
This we believe could result in anti-competitive limits on billing arrangements.
To move into our next point, it is likely if not inevitable that complex and highly interventionist regulation will have unintended consequences when drafted and considered in a compressed mode.
I cannot tell you that in the short time available to study the proposal that the AICPA has not been able to identify all of the consequences which the rule is likely to engage, but we have identified some which are clearly foreseeable and I hope unintended.
Bob Elliott has already spoken of one of the most important unintended consequences, the adverse impact of theability of accounting firms to function effectively in the new economy. A proper cost/benefit analysis would uncover others.
The absence of a meaningful cost/benefit analysis of the proposed rule reflects the time frame in which the Commission is proceeding. We would also call your attention to some of the following points:
Although it appears that the Commission intends its proposed rules would apply only to SEC auditors, there is substantial reason to believe that the rules will cascade down to all auditors, small firms, and small businesses.
As a direct result of the current SEC rule-making on auditor independence, federal and state regulators have become engaged in the auditor independence issue. Several have already made it known, both in testimony before the SEC and in public forums, that they will consider the SEC's rule-making in establishing similar regulations for their constituencies.
State boards have testified that they would be significantly influenced by what the SEC does. And, in fact, the chairman of NASBA has said, and I quote, "The state boards are willing to let the SEC's public hearing and rule-making process run their course, then adopt similar rules for all auditors."
Clearly, there will be some impact on small firmsand auditors. Other unintended consequence include the following. Despite the suggestion that the rule proposal would improve auditor independence the pressure on accounting firms to maintain positive relationships with their audit clients might grow as revenue sources from other services to client.
The restrictions on cooperative arrangements with other accounting firms through the affiliate rule could lead to the dismantling of regional alliances of small and mid-size firms. That would damage effective client services, audit quality and competition.
As firms try to compensate for the cost of non-audit service severance, pressure could grow for a new round of industry consolidation. Absent consolidation, dependence on an individual audit client would grow as revenues from other business lines are lost.
Although the rule proposal purports not to restrict accounting firms from performing services for non-audit clients, pressure on these clients to take their business to non-accounting firms would be great.
But you've asked, couldn't an accounting firm simply trade clients so that one accounting firm provides non-audit services to the audit client of another firm and vice-versa. This is a fallacy.
First of all, firms are not fungible. Particularfirms have expertise in particular areas. Indeed, consulting services today are much more highly differentiated than audit service offerings.
Second, accounting firms are competing for non-audit business not just with each other but with non-accounting providers.
Third, if accounting firms have to bear the additional cost in restrictions imposed by the rule, they would be competitively disadvantaged with the loss of business to their non-accounting firm competitors.
Finally, the affiliation rule would further restrict the number of firms eligible to provide these services.
Our final point, our final major area of concern is that despite the highly detailed provisions of this proposed rule, the proposed rule provides no greater assurance of predictable decision-making that do rules now in effect.
This is particularly unfortunate because both the profession and the Commission share the objective of greater certainty in the application of the independence rules to specific circumstances.
For example, how are accountants to predict whether the staff will consider a particular service as aligning the auditor with a client in a sense of "a mutual interest"? After all, the client and the auditor have a mutual interest,one would hope, in the reporting of high quality reliable financial information.
Similarly, don't tax services, otherwise permitted by the rule, involve a mutuality of interest in that the client wishes lawfully to reduce its tax obligations, and the auditor is assisting in achieving that objective?
And don't a variety of tax services involve advocacy of the client? What is wrong with an accountant advocating a client's position on an issue which, in his professional opinion, is well founded?
And how is the staff, which makes the calls ultimately in this, to know how any of this appears to a reasonable investor? Or more to the point how is the auditor to predict how the SEC staff would perceive this perception?
The auditor would have to guess how the SEC staff would guess that the investor would guess on that point; in essence, a triple guess, rendering the rule impossible for predictability.
Realistically, the catch-all provision that's contained in the proposed rule and the four principles, the four vague principles, we would assert, would have a devastating effect on the willingness of a client to obtain any service other than traditional audit and tax from the audit firm, and that consequence would disable them from doing the things that Bob Elliott has stressed as being ofcritical importance in meeting the needs of clients and serving the public interest in the 21st Century.
Some would argue that because several of the major firms are divesting themselves of portions of their consulting business the non-audit services rules would not cause harm that we have outlined.
However, if anything, these market driven business changes taking place at major firms should cause the Commission to pause and consider. Let's see how all of this shakes out before adding new rules which the affect the work of hundreds of thousands of professionals, disrupt thousands of clients and could potentially ruin a crown jewel of the American economy, the public accounting profession.
Clearly, different models might produce different results, and those different results, some of which neither of us could anticipate today, might, in fact, be the best model to produce the accountability and the public interest that we both desire.
In this debate, the Commission and the profession are committed to a common goal, protecting the public interest in high quality audited financial information. In assessing whether the current proposal meets the goal, we simply ask two questions.
Does it threaten audit quality? We believe the answer is yes. Will it hurt companies and their shareholderswho seek to meet the challenges of the new economy? We believe the answer is also yes. As long as the answer to either of these questions is yes, then the public interest will not be served.
Mr. Chairman and members of the Commission, we look forward to continuing our dialogue to meet our mutual public interest goal. And with this, Harold Monk, who represents many of our small firms, would like to add some comments as well.
MR. MONK: Chairman Levitt, Commissioners Hunt, Carey and Unger, thank you very much for the opportunity to testify before you.
I am the chair of the Executive Committee of PCPS, now known as Partnering for CPA Practice Success, of the AICPA. The PCPS has more than 6,800 local and regional CPA firms as members, provides a forum for these firms to work together on ways of improving the quality of our service and the performance of our firms.
One means of improving the ability of the many small and mid-size firms which participate in the work of PCPS is the formation of alliances and networks of firms. The typical structure for such an arrangement does not involve cross-ownership or control by one alliance member over the other members or over the alliance itself.
In fact, no one member could be said to exertsignificant influence as that concept is understood in accounting literature. However, we are concerned that the breadth of the definition of an affiliate of an accounting firm, coupled with the collaborative business activities of the typical alliances, such as cross-referrals, shared marketing, and the like, would lead to alliance or network members being considered affiliates for independence purposes under the rule proposal.
These alliances or network arrangements are critically important to these firms in serving clients operating in many domestic and foreign locations and thereby competing with larger firms.
Our PCPS members, by definition, do not have very much in the way of SEC audit practices. Still, we believe your proposed rule will adversely affect us. If the proposed rule is adopted, we would expect the other regulators --state boards of accountancy, U.S. Department of Labor, federal and state bank regulators, for example -- will follow your lead.
Hence, we must assume that your rule would become our rule. And that causes us great concern. In particular, the definition of an "affiliate" of an accounting firm would force our members who participate in an alliance of accounting firms to treat each member of the alliance, including any foreign affiliates, as an affiliate forindependence purposes.
As a result, any work of any audit client of any member of the alliance would be attributed to every other member of that alliance, notwithstanding the fact that no member of the alliance exercises control or even significant influence over any other members. This is simply unworkable.
None of the members of the alliance would have the information about the other members required to comply, and the risk of disqualifying members from serving a client because of the attribution of the activities of other alliance members would be so great that alliances would have to be scrapped.
By creating an insurmountable hurdle to those of us in smaller firms seeking to compete against the larger firms by coming together in various alliances, the rule proposal would make it very difficult for smaller firms to compete effectively and encourage further consolidation, whether we wish it or not, and audit quality would suffer.
In addition to my role at the AICPA, I am the managing partner of Davis, Monk & Company, a local firm in Florida with 35 people in two offices. Our firm is also a member of CPA America, an alliance, a group of 60 firms similar in size to my own who have banded together to enable us to provide our clients with extended services outside of the geographic area of our firm. And to enrich the expertiseavailable to our clients.
Restrictions your rule proposal place on particular non-audit services such as human resource consulting, financial information systems consulting, internal audit out-sourcing and valuation services and the uncertainties it creates with respect to any and all consulting services provided to audit clients are of great concern.
These are traditional services that have grown in recent years. For example, human resource consulting is frequently a client-requested service and one area where small firms can add tremendous value for clients.
Small firms like mine will also be impacted adversely if the rule barring contingent fees is expanded to include value billing. We do not see any connection between fee arrangements that are contingent upon the results of our services and those where firms bill based upon the value added to the client.
I urge you to slow down and hold additional hearings, including regional hearings, so that accounting practices in other areas of the country have the opportunity to address you directly.
For a small firm to comment on the 400-plus questions in the SEC rule proposal is difficult. To do so in 75 days is impossible. There are many voices in the profession all across America who want to be heard but arenot able to come to Washington or New York City.
Consider carefully the consequences you may not intend. There is no reason to rush to regulate on this very complex issue. Thank you very much.
CHAIRMAN LEVITT: Thank you very much for a very informative and comprehensive testimony. Mr. Melancon, do you believe that these hearings have been constructive for the industry, and do you believe that the Commission should schedule, as Mr. Monk has suggested, three or four or half a dozen more hearings around the country?
MR. MELANCON: Well, I certainly commend the SEC for the hearings. I think you've gotten a lot of input. We certainly support the notion of inputting. We have no problems from that perspective.
I guess we certainly would have no problem with regional hearings, as Mr. Monk has suggested. We would encourage whatever input mechanisms as possible because we do think that there are far-reaching impacts of the rule, as we've testified.
CHAIRMAN LEVITT: So you think that the results of this dialogue in this public environment, if you were concerned about the well-being of the profession and the image of the profession with the public, you would urge the Commission to schedule more hearings, which I think we can certainly do.
COMMISSIONER UNGER: I object.
MR. MELANCON: Mr. Chairman, I think your wife may object based on your opening comment.
CHAIRMAN LEVITT: Yeah. Well, I'm not sure that this is necessarily the best way to build the image of the profession in the public's mind, but I guess we each have a different perspective about that.
MR. MELANCON: We would certainly be willing to dialogue with you on the best way to accomplish that,
Mr. Chairman.
CHAIRMAN LEVITT: If you had a choice between embracing a formula for change similar to, say, the ones put forward by Ernst & Young and Price Waterhouse or carrying on this dialogue or this debate or these hearings for another year, where do you think you'd come down?
MR. MELANCON: I guess the easy answer is to say to carry on the dialogue for another year because we have concerns about the impact of the rule. But we also respect the issues. We are willing to dialogue on those issues. We certainly will consider and look at any of the proposals.
I have not, obviously, done any detailed analysis of the proposal you referenced. We certainly will. And so it's very difficult for me to comment precisely as to whether one or the other is the better approach.
CHAIRMAN LEVITT: Well, again, it seems to me thatthis issue will never satisfactorily be put to bed. It has been raised for -- and you can put that responsibility on any number of shoulders -- but it has been raised to a higher level than it ever has in 25 years, and it has always been around.
We've had the Metcalf-Waxman hearings. We've had the studies you talked about. We've had countless stories in the media but never at the decibel level that it is today. And it would seem to me that if I were -- and I am concerned about the interests of the profession. It's a great profession. In many ways, he's a noble profession with a wonderful history. And I care passionately about the interests of the small individual accountants.
I would think that trying to reach a consensus solution would be a preferable alternative to more public hearings, more debate, more dialogue. We're never going to have total agreement on both sides. That's just an observation.
MR. MELANCON: Mr. Chairman, just a comment, I think that -- I think what you heard us testify here today was two things; one, that we are very concerned that any rule that be adopted be considerate of the fact of our profession's ability to meet its public interests in the long term, and a solution that allows that to happen is certainly a solution that is in the best interests of the public aswell as in the best interests of the profession and the SEC.
So I think that ought to be a test of however or whatever happens. I think also you've heard us testify that we would not want to see a solution passed by the SEC in the short run that would gut the ISB from the perspective of being a place where ongoing dialogue is appropriate for, as you described, maybe the next 25 years, because obviously these issues are very critical. They're dynamic, and, from that standpoint, we hope that in the construction of -- if the SEC does adopt something, in the construction of that rule that it does not take away the ability for the ISB to be a body that can constructively address these issues in the long term.
So I think that those are two important issues that we need to consider however decisions are made on going forward.
CHAIRMAN LEVITT: Well, again, as I mentioned yesterday, in the July hearing, Chairman Allen said that, "The scope of services issues is different in kind than a lot of these other issues," I'm quoting now, "and so it's not well-suited for a board of our character.
It's really a public policy choice that the government needs to make, and that's, I think, the view of us all." And it was the unanimous view of all of the independent members of the ISB. It's hard for us to turn itback to the ISB when they've rejected embracing it.
CHAIRMAN LEVITT: Chairman Allen is a person I have an ultimate amount of respect for. He also pointed out in his testimony that he thought disclosure was something that the Commission had to take action on if it desired to have a result in that area because it was not something that was within the purview of the ISB to address.
And I would also point out that regardless of today and regardless of what happens, if the ISB were to adopt a conceptual framework, that conceptual framework -- and it's certainly my hope, and it's my intention that the ISB will --that conceptual framework to move to a principles-based approach would require the SEC to support that particular decision in order for it to be successful.
So in many ways, I think Chairman Allen's comments could be construed, regardless of the timing, to indicate that the SEC has to weigh in on any conceptual direction from that standpoint.
We don't disagree with that, but we do believe that the ISB has done a tremendous amount of work, more to be done, in a very difficult area of addressing the conceptual framework and that that should be supported.
CHAIRMAN LEVITT: The other day I asked the question of several of the witnesses about whether they felt that the work of the ISB and the perception of the ISB mightbe enhanced if we increased the number of public representatives, and three of the firms yesterday -- Arthur Andersen, Ernst & Young and Price Waterhouse -- said that they did feel that was worthwhile.
Are you, perhaps, open on considering that?
MR. MELANCON: You had a vision for the ISB in 1997, Mr. Chairman, and you convinced me of that vision. And since that time I have been an ardent supporter of the ISB, and I've spent a tremendous amount of time being involved in it, probably as much or more than anybody other than maybe the staff of the ISB.
And I would tell you that I would welcome a dialogue with you in which we identify those things that are necessary to have the ISB meet that vision that you laid out and that I think if we jointly showed our support for the ISB to the public members and the profession members that the ISB with that support from both of our organizations could be a very effective body.
And so I welcome the dialogue, and I think that anything that makes the ISB effective and meets that obligation certainly is something that we would want to address, and there are probably several things that we would need to address.
CHAIRMAN LEVITT: I appreciate that. Mr. Elliott, you said some things which troubled me, but that's nothingnew. In your comments about the SEC, you said, and I quote, "The SEC is not friendly toward innovation."
Well, I don't think you're right. I think you're very, very wrong, and I would appreciate your comments on a number of areas of SEC involvement that I think are innovative -- our three internet releases telling companies how to use the internet for disclosure, our Reg ATS dealing with the most dramatic changes in our markets in the history of the country, the appointment of the Garten Panel to address the value of intangibles, our concept release on international accounting standards, our whole initiative with respect to plain English, an undertaking that three prior commissions have looked at and were not able to address.
It was the Commission, not the profession, that pushed for the creation of the ISB and the O'Malley Panel, the Garten Panel and the Blue Ribbon Committee on audit committees, the whole use of Edgar, our internet fraud unit, our use of exemptive authority that was given to us in recent congressional action. Where are we lacking?
MR. ELLIOTT: Mr. Chairman, if I had that list of accomplishments to my name, I'd be very proud. I think they are outstanding achievements of the Commission under your leadership. There's no question about that.
I was not referring to innovation in every sphere. I was referring to the GAAP model, and what we have there isa model which fundamentally is the same model as the one when the Commission was established in 1934.
If I misled you into thinking it was a broader statement than it was, I apologize. I'm speaking about accounting and the GAAP model.
CHAIRMAN LEVITT: I'm totally disarmed.
MR. MELANCON: Mr. Chairman, that is something new.
CHAIRMAN LEVITT: Is the FASB, in your judgment, sufficiently tuned to the new economy?
MR. ELLIOTT: The FASB is working on the area. The recommendations of the Jenkins Committee, which was established by the AICPA, were handed over to the FASB, and they've been working on them.
And it's my understanding that they're trying to work in the sense of best practices that could be voluntarily adopted by companies, rather than rule-making or required standards.
And I think that is all to be much applauded. But I don't think the pace is what it needs to be. The Jenkins Committee reported, I believe in 1994, and we still don't have substantial results. So it's a question not of the direction but of the pace, Chairman.
CHAIRMAN LEVITT: I share your feeling. The pace sometimes frustrates me. Were you supportive of the efforts of an FASB under prior direction to expense the cost of stockoptions?
MR. ELLIOTT: Are you asking me as the chairman of the institute or as an individual?
CHAIRMAN LEVITT: Give me both.
MR. ELLIOTT: As the chairman of the AICPA, my answer to the question is that those choices are appropriately made by the FASB; it's their area of domain. We have an Accounting Standards Executive Committee which is our standard-setter which interfaces with them, and they select their policy positions.
Speaking as an individual, I will say that I think that stock options are not free. They are not valueless and need some form of accountability. While the form of accountability selected by the FASB is somewhere in the middle of the scale, it does, in fact, inform investors of important information. So I think that the FASB made excellent progress.
CHAIRMAN LEVITT: At the last hearing, we talked about the fact that the AICPA's own rules prohibit, among other things, appraisal and broker dealer investment services as impairing independence, and the Practice Section's rules currently prohibit certain valuation, actuarial and human resource services.
Barry, I think you said then that even if our rules parallel the AICPA's or the SECPS's rules, you would not becomfortable with them. Is there any way of reconciling this?
MR. MELANCON: Certainly, Mr. Chairman, as a matter of definition of independence, let's say, or a matter of policy, one could not argue that if your rule were identical to the rule that's currently in place within the profession that that would necessarily be, in today's world, a bad result.
I will point out that in the proposed rule, even though those broad topic areas are covered, they are not identical to the current rules, and I think you've acknowledged that.
I think the point as to whether they are in a self-regulatory environment or they are embedded into a government process of regulation is one that reasonable people can debate as to the role of regulations and the role of how easy those can be changed.
I think, as an example, your own rules for decades have pointed to the AICPA's ethics rules where they do not conflict with SEC rules.
Obviously, if you had a feeling towards one of those from a substantive standpoint and we sought to change one of those, you would, obviously, make that known, and you could potentially adopt something that would then be in conflict, and your rule would supercede from that standpoint.
Our concern in trying to answer your question --which was a very artful question, because we don't disagree from the standpoint that those ruse should be in place today and should be enforced.
Our concern is that the process that's used to adopt rules -- there are different levels of complexity of fixing those things as the world changes. We live in a very dynamic society today.
For instance, we have the ISB talking about a different approach to a principles-based look at independence in general, which, again, I think if both of us support that and give that charge to the ISB, I think they can succeed from that standpoint.
I think that, however, putting them in SEC rules makes them more difficult to change. Just look at the process we're going through today to adopt. And that's our fear.
I mean, reasonable people can disagree as to how much of a problem that will be, but it's a legitimate concern, we believe, from the standpoint of evaluating where rules that get to that much specificity should reside.
CHAIRMAN LEVITT: I really believe that the '33 and '34 and '45 Acts have been remarkably flexible in terms of the ability to conform to changes in the business community. And I disagree with you in terms of where these rules belong, but I hear you saying that you're open to a discussion onsome aspects of this.
Now, the O'Malley Panel found that leaders of the largest firms, largest accounting firms, "treat the audit negatively like a commodity." And based on this finding the O'Malley Panel recommended that the firms and the AICPA take steps to emphasize and promote the importance of audits.
Do you think the attitudes of the O'Malley Panel that they found have contributed at all to the problems that you say firms may have in recruiting new auditors?
MR. MELANCON: Well, first, I have had interactions over the years with the chairmen of each of the five firms, as I know other people in this room have, and I would respectfully disagree with the assertion at the beginning as to how they treat audits. I don't think that they do that.
I think auditing is a very significant part of their firms and their businesses, and I think they view it that way, as you would expect the heads of those types of organizations to do so.
As to the issue of attractiveness to students, we do a tremendous amount of research with high school students and accounting students in college, high school students who might be contemplating, et cetera.
We've spent a lot of resources and have grave concerns in this particular area, as to the attractiveness of the profession. We go focus groups. We do research, etcetera.
One of the interesting things about 18-year-olds, and I think you'll find this result pretty interesting, what we have found is that high school students who attend a high school that has an accounting program are less likely to major in accounting at college than those who come from a school with an accounting program.
And through the digging into that research one of the conclusions we reach is that the first exposure to what this profession is about is very influential to young minds, as first exposure to anything is very influential to young minds.
And what is taught in those early programs depicts the auditor as very narrowly focused. We've had focus groups are students have said, "I don't want to be an auditor because all I'm going to do is work in some cubicle someplace and never interact with humans," or whatever.
We all know that the audit environment in today's complex business enterprises is very much interactive; otherwise, we would have very poor audits.
So I think what the research shows is that the number one hurdle that we have to overcome from an attractiveness of students standpoint is an ignorance of what the profession is really about.
So I don't believe that how the Big 5, however theO'Malley panel referred to that, how their conclusions reached are the driving factor in that. I think there are much more subtle impacts at an 18-year-old level, and I think it's major concern we have as a profession.
CHAIRMAN LEVITT: However, in your 15-page letter to your members asking them to write to the SEC and to Congress opposing the rule-making, you state that the proposal will affect recruiting because, "the best and the brightest students will not be drawn to firms with a limit on upward opportunities."
MR. MELANCON: I definitely believe it will have an impact, and I didn't mean to imply I don't think it will have an impact. I was responding to what I heard your question to be was that was the attitude of -- the alleged attitude of the firms towards auditing a driving force or a significant force in that. And I was trying to comment as to there are many factors.
But clearly, if a profession -- if ignorance of the profession is one of the driving factors in turning people off or not having them proactively come into the profession, the more narrowly focused that the profession is, the more difficult of a communications process that we have to teach them something else. And I think that's the point that we were trying to make there.
CHAIRMAN LEVITT: But doesn't that say that thereare no upward opportunities for auditors in accounting firms, only consultants? And isn't that an example of what the O'Malley Committee was talking about?
MR. MELANCON: Well, there is certainly upward mobility opportunities for auditors in firms. I think young students today, Mr. Chairman, they have a very different look. Their reward systems are very different. What their expectations are are very different.
We described, for instance, the accounting profession and majoring in accounting of, let's say, in the '70s. When someone made a decision in a college campus to go into accounting, we believe that at that time they were making a decision that said, "If I get an accounting degree, I'm going to have this world of knowledge about a broad base of information that allows me to have many opportunities.
"I mean, I can go into auditing, or I could go into management, or I could go into government service, but I'll have a wide base."
Today, in accounting programs in universities, students have the exact opposite view. They say, "When I major in accounting, it's very narrow, and therefore my opportunities will be limited." They tell us that all the time.
So if the profession moves in the direction of limiting, that will reenforce that. We have to fight to tryto change that perception because, like you just said, we don't agree that those are the only options that are available.
But the more the public persona is that it is narrow, it is statutory audit firms, if you will, the harder it will be to rebuff that in the minds eye of students.
MR. ELLIOTT: Mr. Chairman, may I comment on that? The students, I think, are aware of the fact that accounting records, accounting statements no longer very well portray companies.
We never, as accountants, said that the net worth on the balance sheet was supposed to equal the value of the company. We never said that. In fact, we said the opposite. But 20 or 30 years ago the average market capitalization was about twice the net book value of companies, on average.
Today it's about six times the net book value on average. What that's telling us is that the accounting reports are not capturing as large a fraction of the information as they used to capture, and I think part of that then reflects down to the students.
They come into a curriculum where they know that what they're learning is less and less depicting of the real world. It's not an exciting and challenging curriculum ,as it might be if we had an accounting model that was more descriptive of reality that let these students feel thattheir work was of higher relevance.
CHAIRMAN LEVITT: In three of the hearings that we've had thus far, Mr. Elliott, we've heard from a broad number of witnesses, practicing lawyers, expert witnesses, accountants, and others, who have assured us that they've seen instances where non-audit services and lack of independence contributed to audit failures.
What do you think of that testimony?
MR. ELLIOTT: Well, in the first place,
Mr. Chairman, I did not hear most of that testimony, and I haven't read it. So it makes it very difficult for me to comment on somebody else's testimony. I'm really here to comment on the proposed rule.
But the information that we have, the best information is that there is no correlation between non-audit services and failed audits. If somebody makes those types of allegations, we could certainly consider them, but the point is not that we should base public policy on an anecdote or even a bunch of anecdotes.
The point is that there is a system in place here which would yield to a disciplined study of the net effects of non-audit services.
Mr. Melancon indicated the way some of the studies could be further worked out, larger samples, and so forth. But there are ways of doing this, of, in effect, looking atthe good effects of these non-audit services of which we believe there are substantial good effects -- and the O'Malley Panel identified that in a quarter of the cases, there were good effects -- and the bad effects, and put them all on a scale.
I think to just look and search out a few bad effects, find a few anecdotes, is not a balanced study of the system. It would be almost like if a drug company took a drug to the FDA and said it fixed the -- it helped 90 percent of heart attack victims recover faster and the FDA said, "Well, that aside, we're going to look for any cases of side effects and base our decision on that," it wouldn't be a balanced study. And we believe it needs to be a balanced study.
COMMISSIONER CAREY: But it would be a study that considered the public interest, correct?
MR. ELLIOTT: I think that would be the criterion. Absolutely, Commissioner Carey.
COMMISSIONER CAREY: But you'd have to consider the effects on the remaining 10 percent before making a decision.
MR. ELLIOTT: You have to consider all the effects. That's the problem. Just looking for negative effects of which we're not aware of any, but just looking for them and not looking for positive effects is not an unbiased study.
CHAIRMAN LEVITT: Well, what possible motives couldthe custodians of the largest pension funds in the nation, CALPERS and TIAA-CREF and people such Paul Volcker and the Controller of the Currency, what motives could they have in calling for resolution of these issues, other than they are concerned about the public interest?
MR. ELLIOTT: I certainty can't comment on the motives of the other witnesses.
CHAIRMAN LEVITT: All right. Commissioner Hunt.
COMMISSIONER HUNT: First of all, again thank you for taking the time to testify before us again. Nice to see you again. I'm intrigued by a couple of things that you said, Mr. Monk, and others have made this comment as well, that we do have now or soon will have at least two models of what an accounting firm should look like and how it should operate.
And I don't think either of us have a perfect forward-looking glass ball to see what's going to be the best model. So I am intrigued by the idea that looking at the two models for some time is not an illegitimate idea, because you'll have two very distinct models, at least at the large firms.
I'm also concerned about what some witnesses I guess yesterday mentioned, which the unintended consequences of our rule, and some of you mentioned that too.
Particularly, I personally am somewhat concernedabout the unintended global consequences of the rule because we are going to have influence, and the unintended consequences of the other standard-setters, the state boards of accountants, the people who regulate accounting for banks and others.
And also, I don't know how to get at, but I will think about what you mentioned, Mr. Monk, about your size firms and how the affiliate prohibition might affect the way they do business and the way they manage to enter into arrangements so that they can more effectively compete with the larger firms.
And, along that line, I'm particularly concerned about -- I think we all have been on this Commission -- of not having unnecessary negative effects on small business entities of any kind, small firms or smaller business entities, so we have to look out for that.
Mr. Melancon, you mentioned that value-added billing will lead to competitive restrictions, or words to that effect?
MR. MELANCON: We're concerned about that. Certainly, our own profession has been challenged back in our history by the FTC on certain restrictions on how billing occurs.
If you go back in many professions, there were restrictions on how things happen, we were challenged as aprofessional organization -- I guess it was in the '80s or maybe late '70s, early '80s -- along those lines.
So restrictions that get into how financial arrangements exist between two parties not by your agency but by other agencies of the federal government bring certain inquiries, and we were in the middle of several of those inquiries, and that's why we wanted to point that out.
I would also tell you that value billing, the ability to look at a service that's provided -- and no one would agree, for instance, that that would be on the basis of the outcome of an audit. No one would assert that.
But there are certainly instances where other work is being done, that certain solutions and certain value that's being created actually creates a significant value for the economy, the company, the shareholders, et cetera. And different financial arrangements exist out there in the marketplace.
They are probably more numerous than either of us could identify in the next two hours if we just tried to brainstorm them all. So that's our concern from that standpoint.
COMMISSIONER HUNT: And, Mr. Elliott, I am intrigued by your statement. I never talked to any 18-year-old accounting students. I don't know a lot of people who were born to be accountants or lawyers, but I could be wrong.
MR. MELANCON: There are some, Commissioner.
COMMISSIONER HUNT: There are some? Okay. But I have known graduate business students who were accounting majors when I was in education and I was shocked by their limited view of what an accounting degree would do for them and what they could do with it and what the opportunities were. So I'm sure it's even more of a problem at the undergraduate level.
I don't have to go into any more the very different world views or professional views of those of you who oppose the rule and those others of the profession who think the rule or maybe the rule as modified is a good idea. But I was interested in a remark made by one of the witnesses yesterday to the extent that we do have some, as the Chairman said, anecdotal -- anecdotal in the sense of non-statistical, non-quantitative -- evidence of perhaps non-audit services having marred the judgment of audit participants on a few occasions.
I don't want to say it's endemic, but on a few occasions, at least we have evidence to that effect or have had evidence to that effect.
I am intrigued about what you think about the idea of either using the appearance model and you said we rely too much on that standard, or relying on the relatively small series of anecdotal evidence that there have been audits marred in the past because of the other services provided.
What do you think about -- now, that's looking sort of at the present time or looking backwards. What do you think about the idea that as you look forward in the profession, that perhaps the audit side of a particular accounting firm and the consulting side are going to develop different world views and necessarily have different relationships with the clients and that maybe those are incompatible?
MR. MELANCON: Commissioner Hunt, you mentioned a couple of models. I think that scenario might well occur. I think that there are many scenarios that will occur. I think that it is very difficult for either of us to predict what is the right model.
Just to comment, there's more than two models out there right now. There are many, many, many different models. We could certainly look at some in the past, though. We've certainly all read about, you know, Andersen and Andersen Consulting. Arthur Andersen sort of recreated some of its consulting capabilities because they felt like they had a need to have those competencies in those firms.
There are small firms that strategically align because they don't have the capital resources to be able to deliver or build the competencies that they need and they do that through strategic alliances. Some have sold out. Some smaller firms have sold out to larger enterprises to be ableto access technology.
I would say to you, Commissioner, I wish I was smart enough to predict exactly which one was the right model, but I do know that if we sort of arbitrarily make a decision that one model is the right or that the model that has served us well for, you know, however many years is right, that there are some risks associated with that.
CHAIRMAN LEVITT: I think that this is a little bit aside the point. The Commission doesn't have the luxury of just putting things out and letting things develop as they will.
This issue is not a new issue. It's been with us for years and years and years. All four of my predecessor chairmen have dealt with this issue. All four of them have felt that the issue cries for resolution.
MR. MELANCON: I said before that public attention, which is very much more our concern, perhaps than yours, although I think if I were running an accounting firm I'd be very concerned about it, calls for some sort of closure, some sort of resolution.
MR. MELANCON: I understand that point, Mr. Chairman. I was just responding from the standpoint that how a rule is crafted could cut off maybe unnecessarily some other options to develop and I think you want to be considerate of that and based on my knowledge of yourthoughts along those lines, I think that you would be considerate of that.
CHAIRMAN LEVITT: That's true.
COMMISSIONER HUNT: Well, again, thank you. We look forward to trying to work with you to see if we can fashion a rule that is satisfactory to the profession and to the investing public, for all of us. I am heartened by your expressions of a willingness to work along those lines, as you expressed both today and in the hearing in New York last week. So thank you.
MR. MELANCON: Thank you, Commissioner.
COMMISSIONER HUNT: Thank you, Mr. Chairman.
CHAIRMAN LEVITT: Commissioner Carey.
COMMISSIONER CAREY: Thank you, Mr. Chairman.
And thank you for your extensive and informative testimony this morning.
I am slightly concerned that when we throw around the results of surveys and statistics and panels that we sometimes do it selectively and so I wanted to use what I thought were a couple of examples to perhaps further elucidate the conclusions of some of the panels that have been discussed.
I'll address this to you, Mr. Melancon because I think that most of these examples were from your testimony, correct me if I'm wrong.
From the O'Malley Panel, you testified that the panel was not aware of any instances of non-audit services having caused or contributed to an audit failure. Is that the quote that you used? Something sort of indicative of the fact that --
MR. MELANCON: It was based on the 37 that it reviewed, it reached a conclusion along those lines.
COMMISSIONER CAREY: The panel, I would point out, also noted that the firms' management consulting practices have expanded far beyond those skills required for audit support and the traditional areas related to financial planning and controls, certain investment banking and legal services, outsourcing a variety of corporate functions, strategic business planning and business process reengineering advice. Independence questions arise when these services are marketed to audit clients. Chapter 5, Section 11.
Also, the Penn and Schoen poll that was commissioned by the AICPA, one of the results it that 89 percent of investors thought it would be important for shareholders to know if a company's auditor also provides consulting services to that company.
Doesn't this overwhelming interest in increased disclosure indicate that investors see a connection between the provision of non-audit services and auditor independence?
Would you agree that in light of this finding that at least the appearance of the auditor's independence will be strongly influenced by what consulting services the auditor is providing?
Why else would 89 percent of the respondents want that information?
MR. MELANCON: As a representative of a profession that certainly agrees with disclosure in a lot of different areas, I can certainly understand that information would be useful and I think we first off support vigorously the Commission's position that information such as that needs to be disclosed to the audit committee, and the audit committee has a reporting responsibility related to the matters that it considered in making an independence determination. And that certainly is a form of communication and information that comes out in the sampling.
COMMISSIONER CAREY: Also, would you say that you share the results in large part of the Earnscliffe, share the views supported by the Earnscliffe study?
MR. MELANCON: I didn't specifically in today's testimony reference Earnscliffe.
COMMISSIONER CAREY: I'm sorry. I'll be fair and not use Earnscliffe as an example. But you did quote the GAO and refer to their findings.
In their 1996 report on the accounting profession,page 8, the second paragraph, final sentence, "The accounting profession needs to be attentive to the concerns over independence in considering the appropriateness of new services to ensure that independence is not impaired and the auditor's traditional values of being objective and skeptical are not diminished."
MR. MELANCON: We agree and, as an example of that, that's why we supported the Chairman's initiative along the lines of the ISB. So we agree with that dialogue. We agree that those are important issues. We have agreed with that for over 100 years.
COMMISSIONER CAREY: And, also, I want to make sure because some of the paperwork flies fast around here, but the talking points titled "The E&Y and PWC Proposed Rule Demonstrates that the SEC's Rulemaking is Fatally Flawed," is that an AICPA document?
MR. MELANCON: I don't know the document that you are referring to.
COMMISSIONER CAREY: No? Okay.
MR. MELANCON: It's not our document.
COMMISSIONER CAREY: Would you like to see it?
MR. MELANCON: I don't think it's our document. I don't know what he's talking about.
This is not our document, Commissioner.
COMMISSIONER CAREY: Well, good for you.
All right. Thank you.
I have no further questions.
CHAIRMAN LEVITT: Commission Unger?
COMMISSIONER UNGER: Thank you very much.
Thank you. I appreciate your coming back. I thought your testimony was very helpful. I appreciate the slide show and I was very impressed by that stool. I thought that was good graphics.
I do think I sense a change --
MR. ELLIOTT: Your opinion was not universal, I'm sure.
MR. ELLIOTT: I use that in my Social Security presentations.
COMMISSIONER UNGER: The stool?
MR. ELLIOTT: Yes. The three-legged stool.
COMMISSIONER UNGER: Not just the three legs, but then the little prongs underneath. I couldn't have done it.
I do think I sense a change in the tenor of our discussion today, too, as opposed to last week and that pleases me enormously. I think you're a much more powerful ally or effective ally, although you are a powerful adversary, and that the dialogue is really essential to getting not just something done, but the right thing done.
Because we've had the benefit of a number of other witnesses in the interim since last week, I thought it wouldbe helpful if you could sort of help me put in perspective some of the differing views that I've heard as opposed to maybe some of the things that you all were talking about today.
You talked about -- and a lot of what you said really resonated with me, especially what you were saying, Mr. Elliott, about sort of modernizing GAAP and really trying to take advantage of the technology available today.
I would love to sit down with you and talk about that some more, because I think that's very, very interesting and I agree with you.
MR. ELLIOTT: We can make an appointment to do that.
COMMISSIONER UNGER: Okay. I would really like that.
But one thing I don't understand is despite all of what you've said in terms of attracting talent and having the right people and being sort of business minded in the audits, all of which I think is true, why do you need to perform the auditing and the consulting services under the same roof, as it were?
MR. ELLIOTT: If they're not under the same roof, you don't have the same interchange of information. In order to move in the direction that I was speaking about, Commissioner Unger, what you're really talking about is avery different model that involves different skills, leading edge skills.
I tried to indicate some of them: strategy, information technology, mathematical modeling and capabilities, actuarial skills and so forth. And if these are just outsourced, let's say, you go to another firm and try to learn what they know, you don't have synergies the way you do when these people are working together on engagements, whether it's audit engagements on this day of the week and different engagements on that day of the week.
If there is too much of a restriction put on what services can be performed for audit clients, then the most economical thing for the firm to do will be to divest those. And if you look at the proposals, the proposal that's outstanding, the one that we're commenting on today, although it does not in any place say that you can't do non-audit services for clients and it does not in any place say that firms must divest themselves of non-audit services, if you put all the provisions together, the affiliate rules, the open-ended catch-all provision, the list of services, if you put everything together, it makes it really uneconomical to have those services under the same roof, as you put it. It makes it uneconomical.
It's not worth as much to have a firm that can only focus on 60 or 70 percent of the market, instead of 100percent. That's a more valuable firm. And I think you are seeing firms undertaking transactions in the marketplace and when they're selling off these consulting divisions, what you have to see that as is a market signal that these consulting operations are worth more outside than inside. That tells you something about the loss of economic value that comes from having a restricted range of clients.
So what we're talking about here is setting up a set of conditions under which these skills can be under one roof because only if that's the case are we going to be able to move into the future that I was talking about.
COMMISSIONER UNGER: Well, today, how do you use the crossover in terms of the experts from the consulting service to assist you with the audit or vice versa?
MR. ELLIOTT: It comes about in several ways, Commissioner. One way is that on a given audit where the audit team needs these services, they can call on them directly and they can call on them from consultants who are in the firm that are subject to the same independence rules, the same culture and so forth, and they know that these people are going to be ethical and upstanding and so forth.
If they have to go outside to get those services, they are not under the independence rules and who knows what would be accomplished. So that's one way, you actually bring the consultants onto the engagement.
A second way, though, is that when firms are developing their technologies for auditing, and developing their benchmarking for clients and so forth, the availability of these capabilities within the firm helps to design a better process or product or database or something like that, which can then generally be used on all audits.
And some of it is strictly informal. It's the give and take in a collegial environment in which people facing issues from different perspectives educate each other.
The auditor, isolated in an only audit firm, talking to everybody in the firm who is talking about the debits on the left and the credits on the right, is not going to have as rich an experience as somebody who is in a firm that has a broad variety of perspectives and begins to understand these different perspectives -- strategic, competitive perspectives, technology perspectives.
So there are a lot of reasons. There are a lot of ways that that transfer takes place, Commissioner.
COMMISSIONER UNGER: But there is nothing in the rule proposal that prohibits you from using your management experts or -- I forget the exact term -- to accomplish that same objective, even if the proposal was enacted as it stands.
MR. ELLIOTT: Well, that was the point of my first comment, which I probably wasn't very sufficiently clearabout.
I agree with you that the proposal in no place says you have to divest consulting operations. It's the joint operation of all the conditions together that create a framework in which it's just not, we believe, it's not going to be economical for firms to have robust consulting practices under the same roof. And we think that that is not in the interests of the shareholders.
COMMISSIONER UNGER: But today, do you use the same management experts from the consulting side to work on the audit and then to later perform other duties or services for that client?
MR. ELLIOTT: That happens, yes.
COMMISSIONER UNGER: So is that the synergy that you are afraid of losing?
MR. ELLIOTT: That's part of it. As I indicated, there are other aspects of it, too, including the use of this expertise to develop services and technologies to support the audit process, so it can happen at the individual audit level, it can happen at the firm-wide level, and it can happen informally.
COMMISSIONER UNGER: So you had mentioned in that three-legged stool that I complimented you on that one of the main three legs was objectivity, right?
MR. ELLIOTT: Yes, that's correct.
COMMISSIONER UNGER: And two of the components under that leg was independence --
MR. ELLIOTT: Integrity and independence.
COMMISSIONER UNGER: Right. So if that's a concern you have today, then I am assuming you have in place some kind of mechanism to ensure the independence of the relationship that we just talked about.
MR. ELLIOTT: Yes.
COMMISSIONER UNGER: Can you describe that for me?
MR. ELLIOTT: We've had, as you know, independence requirements in our profession even predating the SEC. And we have rules and we have the requirement for quality controls and we have peer review that comes in to test the application of these quality controls and so forth.
What happens then is as the AICPA or the SEC or, more lately, the ISB comes up with new rules, they become embedded, they become absorbed into the rule base in each firm and it has to educate its people and change its systems and so forth. But it's like any of the other quality controls.
We actually have a long list of quality controls. They go not just to independence, but competence and supervision and review and the way we do hiring. All those things are elements of quality control and we -- we, when I say we, all the firms in the profession -- are required tohave quality control systems to make sure that those things function. And one of those areas and one of the most important is the independence area.
COMMISSIONER UNGER: And how does that function? Can you give me a practical example?
MR. ELLIOTT: Well, I might get too much in depth, but, for example, there are rules that prohibit ownership of securities by people in the firm. So people in the firm therefore report --
COMMISSIONER UNGER: No, in the specific instance where you have what we've been talking about, an individual who works on an audit and then who provides consulting services for that same client.
MR. ELLIOTT: The rules right now are not engagement based, they cross the whole firm. So it wouldn't make any difference whether individual A was working on an audit or not an audit. All partners in the firm, for example, are subject to the same set of rules.
Now, your proposing release would change that if it were adopted, but right now, all the partners in the firm are subject to the same rules.
COMMISSIONER UNGER: Mr. Melancon?
MR. MELANCON: That's the case. I mean, they are subject to, being member firms of the SECPS, a whole set of quality control rules that they must comply with that aretested to and even non-CPAs, non-auditors, must comply with those rules as part of the system of quality control for the firm to remain a member of the SECPS.
COMMISSIONER UNGER: We talked a little bit yesterday with some of the witnesses -- actually, in probably all the days of the testimony -- about loss leader engagements.
Do either or all three of the witnesses, is that a prevalent practice in the industry? Could you describe it a little bit for me?
MR. ELLIOTT: Well, I believe one of the witnesses, I wasn't here, but I believe Professor Antle testified that auditing is a very profitable practice for the firms; in fact, at the gross profit level, it's the most profitable practice in the firms. So, on average, audits are profitable.
So you're asking a specific question, would a specific audit be not profitable. And the answer to that question is that, when audits change firms and they're put out for bids, new firms may price the audits low and they may do that in order to get the engagement because in the future it will be profitable.
There is no rule against that. In fact, if we had such a rule against that, the FTC, as Mr. Melancon indicated earlier, would challenge that rule.
These firms are free to compete as long as they meet the standards. And that's what makes them, by the way, loss leaders, because they are actually doing all the work necessary to conform to the standards, which may not cover the revenue in the first year or something like that.
Then it gets to the question why would they do that? And given that a small fraction of audit clients use non-audit services, I believe the release points to 25 percent, the reason they're doing it is not to get this other work because that's not a sure bet at all. The reason they're doing it is because in the future they expect it to become a profitable audit and an audit has a different characteristic than consulting work.
An audit continues year after year. As you know, the number of firms that change auditors in a given year is quite small. So while it's not an annuity, it's more like an annuity than a consulting engagement which, when it's over, it's over.
So, in order to get this profitable stream of future engagements, some firms may bid less in year one.
MR. MELANCON: Again, just I'll reference the comment that I made, I think it was to Commissioner Hunt. The FTC has certainly had influence on many of the professions as relates to how they bill, how they advertise, et cetera.
I think the most important part is that we do not interface between the client and the CPA firm as to what they negotiate on a price for a service to be developed or delivered. However, what is not debatable is that the CPA, in deciding on whatever it's going to charge for that service, cannot do a substandard audit. They are required by auditing standards, their ethical commitments, et cetera, to do the work. This cuts across all lines, whether it's public company audits or non-public company audits. And so, you know, that's the rule.
So if you choose to do it for less than that, that's fine, but you can't do less work.
COMMISSIONER UNGER: Well, I guess you didn't hear the testimony of Rod Hills because
