Contact: Jeff Peck (202)481-7311

Testimony of Joseph F. Berardino on Behalf of Arthur Andersen

Good afternoon. My name is Joe Berardino, Arthur Andersen's Managing Partner for Assurance and Business Advisory Services for North America.

Let me begin by expressing Arthur Andersen's support for modernizing the financial interest and family relationship rules. We have not had time to study the details, but it is clear that this modernization is long overdue, and we hope the Commission will reconsider its approach of combining consideration of these rules, around which there is wide consensus, with those pertaining to scope of practice, which, of course, are highly controversial. We also suggest reconciling these proposals with those developed by the ISB.

With respect to scope of practice, we fear that the Commission's proposal has dramatic and far-reaching implications, with great likelihood for negative and unintended consequences. We believe that the accounting profession should be allowed to evolve to meet investor and client needs in the New Economy (with audit committee oversight), and we do not believe that this regulatory intervention will enable us to adequately serve the information needs of investors and help companies address their business risks.

Rather than focusing attention on a real investor need - the development of a new measurement and reporting framework to address the growing inadequacy of a centuries-old model - and working cooperatively with Congress as it exercises its central policymaking role in this area, the scope of practice proposal diverts key resources and constitutes a solution in search of problem.

The Comment Period Should be Extended

With respect, we object to the 75-day comment period. It is clearly inadequate for us to respond fully to a proposal of this magnitude and we urge the Commission to extend it.

The proposed practice restriction is complex and far-reaching. It asks the public to comment on more than 400 questions. It presents multiple alternatives that the Commission, presumably, wants the public to consider and evaluate. It is devoid of any empirical evidence, and provides no data whatsoever on costs and benefits. A fact-based, substantive analysis of the proposed rule, the alternatives and the more than 400 questions will take months. The ISB, for example, has given thoughtful consideration to many of these issues over the past two years, and we believe, is making meaningful progress.

We understand that the Commission took 45 days, including an extension that it sought, to respond to 15 questions from Members of the Senate Banking Committee. Why not give the public the same fair process that the Commission sought - and received - for itself!

Apart from the inadequate time period, the breadth of this proposal represents an unprecedented assertion of regulatory oversight over firms and the profession, a role properly reserved to Congress.

The Proposal Rule Is Based On An Unfounded Premise

The underlying premise of the proposal is that investors are harmed when accounting firms provide non-audit services to their audit clients. The factual findings of the Panel on Audit Effectiveness contradict that premise. After extensive study, this independent Panel concluded that it was "not aware of any instances of non-audit services having caused or contributed to an audit failure or the actual loss of auditor independence." Indeed, the Panel "did not identify any instances in which providing non-audit services had a negative effect on audit effectiveness."

The Commission's release admits that such evidence is lacking, but claims it must create a "prophylactic" rule. Evidence of a problem is unlikely to ever be found, the proposal explains, because objectivity is a "state of mind" and "involves assumptions about human behavior that cannot easily be verified." Government policy, however, should be based on evidence, not on hunches or on what some individuals assert to be "common sense," particularly when that "common sense" is contradicted by the existing data. It disserves investors to rely on speculation to justify a rule of such magnitude - but that is all the more true when speculation is contradicted by the facts.

A Broad Scope of Practice Enhances Audit Quality

Let me turn now to the one reason, perhaps more than any other, that our Firm so passionately and so staunchly opposes the scope of practice proposal. Decades of experience tell us that the more you know, the better the audit. Because we believe this proposal will ensure we know less, it will, in our view, seriously harm audit quality and undermine investor protection.

The day of the audit generalist is dead. By necessity, audit engagement teams today consist of diverse and complementary competencies. These specialists hone their skills to world class levels by working on both attest and non-attest engagements. Any policies that discourage or impair the assembly of an engagement team consisting of specialists with the necessary skills threaten audit quality. Today, 20% of our ABA personnel posses deep technical skills in process auditing, technology auditing, derivatives and other areas. These numbers need to grow for us to keep pace with the significant changes brought about by new technologies.

The proposed limits on scope of practice will make it more difficult to attract, retain and motivate such professionals with specialized skills needed for quality auditing. They will also reduce our ability to understand client business risks, systems and controls, which are at the heart of effective auditing.

Specialists obtain and sharpen their skills by working on cutting-edge issues. You do not learn simply by diagnosing problems; you learn by fixing problems. Without the ability to fix the problems they find on audit engagements, our specialists' skills will decline and become outdated - and the attractiveness of our firms as career choices will decline with it.

At the same time, audit teams gain valuable insights about risks and controls from non-attest work performed by non-attest specialists. Their insights flow directly into audit planning and execution. If our specialists are limited to a diagnostic role with audit clients, their incentive to identify weaknesses or problems will be reduced. Again, audit quality will suffer.

Non-attest competencies make a material difference to the quality of audits. They result in more adjustments to financial statements and better recommendations for control improvements for the simple reason that the more we know about a client, the better the audit. In times of rapid change and complex systems, it makes no sense to abandon these contributions.

The Panel on Audit Effectiveness confirmed this view when it found non-attest services had "a positive impact on the effectiveness of the audit" in about a quarter of the audits it studied. We think the percentage is even higher - and that contributions of non-attest services to audit quality will only increase in the New Economy.

Some will say that some finns are already moving against our point of view - separating audit and consulting services. But these firms have many motivations. Over the long run, different firms are likely to choose different models for delivering assurance services. This is good. It gives the marketplace choices and the strongest firms will prosper.

The Proposal Will Stymie the Development of Audit and Assurance in the New Economy

Our economy is thriving on the shoulders of change that is both real and of extraordinary speed and depth. New business models are emerging, and new business processes are being created at an astonishing rate. At the same time, business risks are increasing. Audit firms need new tools, skills and competencies to understand, analyze, and interpret these changes and meet the needs of the changing market.

We're not far off from the day when companies can close their books on an hour's notice. They'll be able to file registration statements any day of the year because of electronic infrastructures that share all financial data almost instantly. Everything will be visible in real time. Will investors want our audit and assurance skills to reflect this new reality? Surely. Will we be able to do so? Not if this proposal is adopted. The Commission's proposed rule would lock the accounting profession into an Old Economy model at exactly the moment when, in our view, policymakers ought to be examining how to develop a New Economy model that "ensures" the relevance of auditing and assurance for investors in the 21st Century.

The Proposal Denigrates Audit Committees by Taking Away Freedom of Choice

The problem that the Commission wants to "solve" has already been addressed. In the past year or so, with the Commission's blessing and our strong support, significant new measures have been instituted to bring greater audit committee scrutiny over scope of practice. With audit committees just beginning to exercise this new authority, we see no reason to conclude that they will not discharge their oversight duties responsibly.

Audit committees, unlike a bright line regulatory ban, have the judgment and oversight responsibility to make informed decisions about services provided to an audit client. Before we radically alter the audit landscape with new rules, we should give audit committees a chance to do their job. We share the conclusion of the majority of the Panel on Audit Effectiveness, which viewed "any notions that audit committees have not made or cannot make reasoned judgments about independence matters as unfairly impugning the abilities and integrity of these committees."

Audit committees that don't want to use their auditor for non-audit services can choose not to, and some do. They don't need a rule to allow them to adopt such a policy. It is a choice they can and are entitled to make. Why not let others, who decide their auditor is the best provider of certain services, have the same right - within the existing rules and disclosures, of course. As Phil Livingston of the Financial Executives Institute recently said: "Companies prefer to have all options open to them, to have freedom of choice in selecting consultants." Further, as the market demands deeper and newer competencies, the audit committee can determine whether the audit firm should be involved.

The Proposal Will Have Unintended Harmful Consequences

The well-known law of unintended consequences will produce many other harmful and costly effects. One is further consolidation of the auditing profession, with the obvious reduction of competition that will result. As James Emerson wrote in a recent article in Emerson's Professional Services Review (July/August 2000), "Does [the Commission] really want to reduce competition among the Big Five by forcing a merger?" Even if mergers do not take place, creation of artificial barriers will limit competition in providing both audit and non-audit services.

The proposed rule will impose also tremendous costs. Public companies will go through the cost and distraction of choosing new vendors for services. Surely there will be instances where several of the most knowledgeable providers will be eliminated because one is providing external audit services, another might have installed the systems and a third may have advised on transactions around the world. The proposal is incorrect in assuming that there will simply be a reshuffling of consulting service providers. More careful study will almost certainly reveal that there will be substantial dislocations and inequities.

Conclusion

Despite the profession's critical need for a broad range of capabilities to serve the modern technological era; despite the fact that audit quality is acknowledged to be high; despite the fact that audit committees are alive and well and exercising increasing scrutiny on scope of practice; and despite the fact that there is no factual evidence that non-audit services have ever caused an audit failure or lack of independence - despite all these things, the Commission proposes to fundamentally transform the profession and override market demand.

This proposal is not simply a minor or narrow matter of defining accounting or independence terms or a mere implementation of existing requirements. On the contrary, it is a sweeping regulation that will have significant negative consequences. The Commission, we believe, should allow audit committees to do their job, allow the ISB to continue to develop a conceptual framework and invite, not preempt, the policy participation of Congress. It should not, in our view, proceed with its proposed ban.

The future of the profession is bright and will remain bright -- as long as the Commission does not force us into an outdated role trapped in the old economy. Unfortunately, the proposed rule threatens to do exactly that. A broad scope of practice is critical to enable us to keep up with the new business environment, attract, motivate and keep top talent, and thereby provide high quality audits in the future.