Accountant Independence: A Needed Change
I appreciate having an opportunity to participate in this hearing, and to express in person my support of the Securities and Exchange Commission's proposed revision of its Auditor Independence Requirements. My comments refer primarily to the Commissioner's proposals concerning non-audit services.
My company, TIAA-CREF, manages $300 billion for its participants, investing $30 to $40 billion in new investments every year. Essential to these investments is our reliance on the audited financial statements of the borrower, stock issuer, or entrepreneur. Our analysts necessarily assume that those statements have been audited by an independent, disinterested, and highly professional auditor from the outside. And most of the time that assumption is correct. But recent exceptions -- including fraudulent and deliberately misleading financial statements -- have caused serious concern among investors. Could the auditors have been so totally deceived without some explanatory reason for what seems gross negligence?
Most of our largest losses due to fraudulent financial reporting have come in the public stock markets, where the totals come to several hundred million dollars - but let me note that our overall investment results have absorbed these losses and produced excellent returns. One of our most painful losses occurred however in a private fixed income investment in a company that went bankrupt within weeks of our making a $12 million loan. Our "after the horse left the barn" investigation uncovered a grossly fraudulent financial statement, on which we relied because a Big 5 (then Big 8) accounting firm had audited the statement. A major asset, a building valued on a percentage of completion basis at 90%, turned out to be a hole in the ground. The independent auditor had not bothered to look at the site!
We sued and lost additionally a lot of lawyers' fees since the jury found that the auditor had truly been negligent but did not have an intent to defraud us. Was the auditor just incompetent or was he currying the favor of management? This is simply one more example of financial loss to investors due to auditor error - - but like all the others it raises in the most direct way the suspicion that the auditor was not sufficiently independent of management.
It seems the old concept of "independence" no longer fits the practices and culture of today's accounting firms. Prior to the buildup of non-audit professional services in accounting firms, the focus was on one primary question: Did the audit professional have any direct financial interest in the company? To answer this question satisfactorily, the accounting profession developed far-reaching (and, I believe, excessively refined) rules on what members of the firm could or could not invest in. The proposed ruling of the SEC wisely corrects these excesses.
I certainly endorse the relaxation and narrowing of the rules proposed by the Commission.
Meanwhile, a genuine threat to independence emerged from the growth of non-audit management services. Today these consulting services are extremely profitable, growing faster than any other part of the accounting profession, as is dramatically shown in the SEC proposed regulation. Such services, in effect, have been "owned" by the audit professionals, but it is clear that such a relationship -- with its inherent conflict -- cannot endure. Those who are "owned," i.e. management consultants, are reluctant to see their profits shared with their audit partners, - and this is an important point - unless those audit partners can justify a return due to their ability - to "cross-sell" consulting services to their audit clients.
Sales of these consulting businesses by Arthur Andersen and Ernst and Young and the most recent sale of PricewaterhouseCoopers to Hewlett Packard are recent examples of this industry transformation. As was documented in the SEC proposal, the other two Big Five firms are exploring ways to separate their management consulting and audit capabilities and capture the capital value of this fast-growing consulting component.
This frenzy of activity is not confined to the larger firms. Small accounting operations are also players as they sell out to major non-auditing firms that wish to benefit from the "cross-selling" of other financial services by their controlled auditing firms. American Express and H.& R. Block are leading examples of companies that follow this acquisition strategy. Simply apply the term "cross-selling" to the vital and independent role of the auditor, and it's easy to see how professionalism has been compromised.
Assuring independence within firms that offer consulting services is a Gordian knot that can easily be cut. My own suggestion is to allow the firms to do what they want. Let them pursue their self-interest, as long as they abide by one simple rule: independent public audit firms should not be the auditors of any company for which they simultaneously provide other services. It's that simple. I understand that this is a broader rule than what is proposed by the Commission; it would totally ban such activities rather than narrow the kinds of services to those that impose obvious and clear conflicts.
In my role as Chairman of TIAA-CREF, I live in two of the classic roles for the accounting profession - one, TIAA-CREF is a user of financial statements as an investor and, two, we are a preparer of financial statements to report our results to our 2.2 million participants. I want to comment on my experiences in the latter role as a preparer.
For the past four years TIAA-CREF has maintained a strict view of professional independence for our own audit firm. This is our rule: When we need professional services in management consulting, we hire someone other than our auditors to do the job. For example, we bring in the consulting arm of a different accounting firm, or perhaps someone totally unrelated to the accounting profession. Our Board Audit Committee does not need to question our accountants' independence. Committee members never wonder whether our auditors are receiving so much in consulting revenue that they dare not challenge management.
We know the arguments against our rule (they have been vigorously articulated by our auditing firm!), but the drawbacks include distinct advantages of their own. First, our accounting firm has not developed, say, a general ledger software system for the company. If they had, our financial executives might have been relieved since the audit firm could hardly challenge the quality of that work. More to the point, however, the CEO, the Audit Committee, and the users of the financial statements would have lost an independent appraisal of that important system. And the same analysis can apply to a host of other difficult financial management systems for which consulting help might be sought. The narrow limitations proposed by the SEC identify the types of management consulting that would conflict with the independent auditor's role and exclude only such services.
A major advantage to our rule is the simple certainty that our auditors are expressing a clear-eyed, independent view of our financial situation. When a contentious issue on financial reporting arises and the auditing firm refuses to back down before management, company executives may regret not having a "deeper economic relationship" with the auditing firm. On the other hand, when such a relationship does not exist, CEOs, Audit Committees, and the users of financial statements enjoy the confidence of an independent and unblemished view.
There's another benefit to our rule. If adopted by most companies, this rule would bring the accounting profession to a considerably stronger position than it currently holds. Accountants would continue their consulting practices as they wish while enjoying substantial financial benefits. Or they could spin off the related entity and maintain an interest in its stock. Let the audit and consulting partners resolve how to split up the extra returns of lucrative businesses without injecting the public interest.
It seems to me that a powerful argument does exist for maintaining management consulting practices within the audit firm. It has to do with the extraordinary complexity of financial information systems in most companies. The auditors -- including their colleagues -- need firsthand experience in developing such systems in order to audit effectively modern high-tech accounting systems. But I would encourage them to get that experience while serving non-audit clients.
Our total exclusion at TIAA-CREF of any services by the independent auditor addresses the "deeper economic interest" conflict. Many have noted the inherent and obvious conflict in the outside auditor's role: the firm is selected by the company and is paid by them for the audit. This conflict has been mitigated by several broad public policies, such as the federal requirement that financial statements of issuers of public securities must be audited and that the dismissal of the auditor must be disclosed to the SEC staff with opportunity to comment by the company and dismissed audit firm.
The real conflict arises when the auditor has succeeded in cross-selling a lot of other services to the company such as systems work, internal auditing, bookkeeping, relocation services, tax planning, actuarial services, or even corporate travel management and credit cards. Is that successful auditor-marketer really likely to stand up to management on a financial accounting issue when so much is at stake? Are skeptical investors like our TIAA-CREF analysts expected to be so gullible that they would not question such a relationship? Of course today, we don't even have full disclosure of the relationships.
If CEOs and Audit Committees take their functions seriously, and if they operate under a few simple rules of independence, the rewards are subtle but significant. In those quiet meetings with their audit firms they are likely to get reliable answers to questions such as these: "How are we doing?" and "Has that new system really worked as planned?" Both the CEO and the Audit Committees, as well as their investors, can rest assured that external influences or self-interest have not compromised the critical information upon which they base their financial decisions.
Our practice has been useful and is strongly endorsed by our Audit Committees, which are made up of eight independent and experienced directors. It is a harsh rule for our accountants, since few companies follow our practice. If it were a uniform requirement, all the firms would have the opportunity to provide services to all the clients of the other firms. And the incentive to general financial services firms to acquire audit firms for their cross-selling potential would be eliminated.
The concern about auditor independence in the presence of substantial management consulting fees has been with us for years, and has caused much questioning and study in the profession. Investor uneasiness and suspicion of the quality of audited financial statements is growing rapidly along with the dramatic rise in the percentage of audit firm revenues that come from cross-sold services. This is a good time to send a strong signal that the SEC wants the system changed.
I would urge the adoption this year of the Commission's proposed rule.
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