Subcommittee on Securities


Hearing on the SEC's Proposed Auditor Independence Rules


Prepared Testimony of Mr. Phil Livingston
President and CEO
Financial Executives Institute


9:30 a.m., Thursday, September 28, 2000 - Dirksen 538

My name is Phil Livingston, President and CEO of the Financial Executives Institute (FEI). FEI is the leading advocate for the views of corporate financial management, representing 15,000 CFOs, treasurers and controllers from companies throughout the U.S. and Canada

Over the past two years, the FEI has broadly supported the various initiatives of the Securities and Exchange Commission (SEC) for improving audit committee effectiveness and the SEC's efforts to eliminate selective disclosure addressed by the new Reg. FD for "Fair Disclosure". We have hosted and publicized conference calls that advance SEC initiatives and have made SEC information available on our web site. We also interact regularly with the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), the Association for Investment Management and Research (AIMR) and other financial organizations to advocate and promote the highest standards possible for the auditing profession.

I appreciate the opportunity to appear here today to present the views of FEI on the subject of auditor independence. In summary:

· FEI completely agrees with the paramount importance of protecting auditor independence.

· FEI supports the Independence Standards Board (ISB) process, and we would like to see these complex issues resolved within this process, particularly relating to non-audit services.

· FEI also supports the enhanced audit committee process recommended by the Blue Ribbon Committee, and believe that the audit committee must remain the focal point for judgments about auditor independence, taking into account the circumstances of the corporation and the audit firm. And,

· FEI supports the update of rules on financial and employee relationships. We would like to see rules come from the ISB, but we would not object to an SEC rulemaking in those particular areas, because those rules are in urgent need of modernization.

But the SEC also proposes extensive prohibitions regarding many non-audit services, and we do not support those broad prohibitions because of the wide range of interpretations they could be subject to as discussed in our letter.

Those who have spoken in support of these prohibitions cite the importance of fighting fraudulent financial reporting as the rationale for strict new independence rules.

But no one has demonstrated, or even argued with any support beyond simple assertion or isolated examples that all these non-audit services contribute to fraudulent financial reporting. If they did contribute, we would be the first to support a strong rulemaking in this area. There is no place in corporate America for fraudulent financial reporting.

At issue here are things like financial control reviews, financial systems design and implementation, risk-monitoring services that supplement internal processes, and a number of other issues included in our written comments to the SEC dated September 14, 2000 which I have attached (Attachment A) to my written testimony.

Also at issue is the idea of outsourcing the internal audit function to the external audit firm. A number of FEI's members have had success with this sort of outsourcing, and we have difficulty reconciling a ban on outsourcing to the audit firm with the fact that maintaining an internal financial audit function, while prudent, is not a matter of SEC requirements.

All these can be useful services provided by the external auditor. Furthermore, there can be significant advantages to the shareholder, in terms of efficiency and effectiveness of these services when provided by an experienced and knowledgeable expert, and in terms of enhanced audit quality.

Of course no one suggests that consulting services are essential or prerequisite to a quality audit. That would be contrary to the record of quality audits where auditors are not engaged to provide these types of service.

But it does seem well established that these services make a positive contribution to auditor expertise and audit quality, and it also seems clear that the external auditor can often offer a distinct advantage in terms of insight and cost-effectiveness. In our view, these advantages should be given appropriate weighting, evaluated even-handedly through the ISB process, and should be measured up against any real risks that may be demonstrated.

We understand from the SEC's Chief Accountant that at least some of the members of the ISB want the SEC to set the standards for independence in this regard. We have not heard directly form the members of the Board on this, and we can't say that we have understood their reasoning, but we certainly don't think it bodes well for the ISB process to have it relieved of its duties on the critical scope-of-services issues.

These matters on non-audit services need careful study and they need thoughtful evaluation. These matters need a consensus built through the independent process envisioned for the ISB at its founding.

Of course, this is a difficult issue, and we don't think that you can draw such a bright line that all services on one side of the line are benign in all cases, and all services on the other side of the line are tainted in all cases. Determinations about auditor independence require judgment.

In the view of FEI and its membership that the most appropriate judgment to apply to these matters is that of the audit committee based on its own rigorous review. Where caution is needed, it should be the audit committee that exercises that caution and not some regulatory agency.

The audit committee already has the responsibility to reach conclusions about auditor independence, and it should have the authority to make judgments on matters such as this where judgment is needed. After all, corporate financial executives look to and rely on the audit committee to make judgments on other aspects of independence - including the most significant independence question of all, namely the audit fee itself.

FEI believes that audit committees should be given suggested principles that they can use in evaluating independence, such as those proposed by the Panel on Audit Effectiveness. And audit firms must have appropriate controls in place to identify and resolve independence issues. But a blanket prohibition on all these types of non-audit services is neither necessary nor advisable - other than the most obvious, such as bookkeeping services that would place the auditor in the position of auditing his or her own work.

Whatever rules or principles are established, the question of independence ultimately comes down to the audit committee's evaluation of the integrity of the audit firm, and there can be no substitute for that.

On the subject of financial relationships, we urge the ISB and SEC to work together and carefully evaluate the practical impact of requirements under consideration. As drafted by the SEC, broad definitions of audit firm and client "affiliates" would sweep in a host of entities that do not pose a threat to independence, and the SEC's proposed rules would also be onerous to administer.

Finally, FEI disagrees with the intricate detail of disclosure that the SEC proposes to impose on registrants, particularly larger companies. We would support a reasonable amount of disclosure if it would provide information that investors would in fact use in assessing real risks, and if disclosure requirements would be designed to avoid competitive harm.

But the SEC's proposal, in the case of larger companies, would require specific descriptions and dollar amounts for each and every individual service and engagement with fees exceeding $50,000. This just adds up to too much detail, is not focused on real risks, and can bring competitive harm where proprietary matters would be revealed.

In closing, the SEC may want to consider the likelihood that the relevance of any disclosures may be diminishing. With the trend among the large audit firms towards restructuring or spinning off consulting practices, the significance of non-audit services relative to audit fees may become much smaller in coming years.

That completes my prepared statement. I would like to thank the Chairman and the Subcommittee for giving FEI the opportunity to testify. I will be happy to answer any questions that the members of the Subcommittee might have.


(ATTACHMENT A)

 

 

September 14, 2000

 

Mr. Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609

 

Dear Mr. Katz:

Financial Executives Institute (FEI) is the leading advocate for the views of corporate financial management, representing 15,000 CFOs, treasurers and controllers from companies throughout the U.S. and Canada. FEI’s Committee on Corporate Reporting (CCR) appreciates the opportunity to comment on the Release, Revision of the Commission’s Auditor Independence Requirements. CCR agrees that the protection of auditor independence is of great importance to ensuring continued public confidence in financial statements. We take great comfort from recent research findings that showed a high degree of trust in the integrity of financial statements and in the auditing process. While we support the SEC’s broader objective to preserve that trust, we are deeply concerned that the measures proposed in the Release go far beyond what is necessary and, if finalized in its present form, would have significant adverse consequences for corporations and their audit firms. Moreover, CCR would prefer that the Independence Standards Board be allowed to continue with the processes currently underway to develop appropriate solutions in this area.

As financial officers, we benefit directly from robust, high quality financial audits of our companies conducted in accordance with the highest professional standards. It is critically important to us that violations of generally accepted accounting principles, inadequate financial controls, financial fraud and other matters affecting the quality of our financial reports be identified when they occur and are dealt with swiftly. Few, if any, events or disclosures have more catastrophic consequences for shareholder value than a sudden loss of investor confidence in a company’s management. We therefore rely heavily on the independence of our audit firms and, in conjunction with our corporate audit committees, we review judiciously the amount and nature of non-audit services. We reject the oft-stated premise in the Release that non-audit services are used as leverage to force the auditor to "bend to a client’s pressure" – we have as much to lose from impaired independence as our investors do, and we believe that any proposed rules in this area should be founded on that reality.

CCR believes that the development of standards in this area should be the responsibility of the Independence Standards Board (ISB), an independent and objective private sector body that is representative of the constituents that are directly or indirectly affected by the proposed rules. We urge the Commission to work through the rule-making processes of the ISB to produce rules concerning auditor independence, taking into consideration the concerns expressed below in this letter. In particular, we believe the proposed provisions regarding nonaudit services require further study and evaluation, and we urge that this aspect of the proposal be referred to the ISB. On the other hand, we would not object to rulemaking in the area of financial relationships and employee relationships because of the urgent need for updated guidance in those areas.

The General Standard for Auditor Independence

We agree that the concept of auditor independence should be based on the appearance, as well as the fact, of independence. However, we are aware that some individuals may take an extremely strict view of relationships and activities that might be perceived as potentially impairing independence. As a result, we are concerned that the ‘reasonable investor’ criterion proposed in the Release would be misinterpreted to produce unduly restrictive limitations in practice.

While the four principles may be helpful in focusing on sensitivities, they are not useful as dispositive criteria for judging independence matters.

As discussed further in our comments on the SEC’s approach to non-audit services, the assessment of auditor independence is a complex matter that requires thorough and careful consideration of all pertinent facts and circumstances involving auditors and their clients. We believe that the strengthening of corporate audit committees coupled with the discussions between the auditor and the audit committee regarding independence, as required under ISB No. 1, are a more appropriate response to addressing these issues than the aforementioned principles.

Financial relationships

CCR strongly agrees that the investment rules for non-covered persons need to be updated. We note that the ISB was on the verge of issuing an Exposure Draft addressing this matter but withheld it because of the SEC’s decision to issue this proposed rule. As discussed above, we believe that the ISB should be allowed to proceed, with appropriate input from the SEC staff.

Proposed rule 2-01 (f) provides definitions of certain terms used in rule 2-01 that apply only to that rule and nowhere else in Regulation S-X. Proposed rule 2-01 (f) (4) defines an "affiliate of an accounting firm", a completely new term and concept not in any existing rules. This extraordinarily expansive definition attempts to capture those entities that are financially tied to or otherwise associated with the accounting firm enough to warrant being treated as if it is the accounting firm. An affiliate is any entity of which the accounting firm owns 5% or more of the equity and any officer, director, partner, or co-partner of any such entity. Proposed rule 2-01 (f) (5) defines an affiliate of an audit client as any entity (regardless of any materiality considerations as is the case in some respects under existing practice) that has "significant influence" over the audit client, or any entity over which the audit client has significant influence. The combination of these two expansive definitions will sweep in a whole host of new entities into the analysis of audit firm independence that reasonable people would agree do not pose a threat to independence.

CCR also believes that the SEC’s proposed rules could be quite onerous to administer, and will likely cause auditors of large corporations to find themselves perpetually in violation, albeit at immaterial levels. As drafted, the rules would require extensive tracking and monitoring beyond that needed to guard against substantive independence concerns. For example, the proposed proscription of ownership in excess of 5% of any entity in which a client owns any interest – that is, even a single share – would seem to require continuous tracking against all of a client’s worldwide interests, without materiality relief. We see tremendous difficulty in applying such rules as they relate to investments held in or through pension funds, mutual funds, and the like. Additionally, we are concerned by the potential prohibition of arms’ length financial services that create neither economic leverage over the auditor nor an interest by the auditor in the success of the client.

Because of the need for practical rules that accomplish the substantive rulemaking objectives here without being unduly restrictive, we urge the Commission to work closely with the ISB to enable it to formulate rules that are not unnecessarily burdensome to the firms or their clients.

Nonaudit services

We wish to preface our comments in this area by reaffirming the position expressed by Phil Livingston in an FEI press release on auditor independence dated May 1, 2000: "Companies prefer to have all options open to them, to have freedom of choice in selecting consultants. Many times the audit firm has the best knowledge and understanding of the business and can provide certain consulting services more efficiently and economically than competing firms. However, companies time and again emphasized in written comments in the survey that they are very selective about the nature of consulting work they assign to their audit firm and that the company’s audit committee is actively informed and consulted before entering these engagements." CCR believes that the ISB conceptual framework on auditor independence, which is nearing completion, will further enhance the effectiveness of audit committees in this area by providing additional guidance and insight on matters that bear on auditor independence; we believe that audit committees will ask the right questions and will make sure that any concerns they have are satisfied before reaching decisions about the appropriateness of using auditors for non-audit services. For reasons described below, we are concerned that what the Release describes as "prophylactic" measures to protect auditor independence, could have the unintended effect of a "scorched earth" policy on the ability of audit firms to meet the much more demanding requirements of audits in years to come.

There is no doubt that today’s business model and its underlying processes and controls are undergoing a rapid transformation. And yet the nature of the transformation at any given company is intensely personal and individual to its needs and its core competencies, such that no two firms are truly alike. One need look no further than the pervasive effect of the internet and the diverse ways in which e*commerce strategies and business processes have evolved to meet specific business needs and opportunities that this new technology presents. Inherent in each strategy and process are a host of risks that must be identified, understood, and controlled. Audit firms have a unique perspective and expertise regarding their client’s business that enable them to be better than others at providing insightful, cost-effective solutions to the myriad of issues that these risks present. Experience, finely-honed technical skills, and customer specific knowledge not only make audit firms valuable as consultants – they also make them much better auditors. A key issue underlying the proposed prohibitions on certain types of non-audit services is whether the such a ban will have the unintended consequence of stripping out a critical skill-set and knowledge-base, and perhaps even personnel, from the audit process. And if so, will those losses render audits less effective in the future? While the answer to this question is perhaps unknowable at this time, we believe Commission’s actions in this area should be guided by the philosophy of "first, do no harm…"

As discussed above, we urge the Commission to refer the question of non-audit services to the ISB. However, given that non-audit services is the most significant issue addressed in the Release, we offer the following observations on this topic.

We believe that it will be difficult to develop an appropriate list of prohibited services that strikes the desired balance between providing reasonable safeguards of auditor independence and preserving the ability of auditors to perform audits in the most effective manner possible. We also believe that any rules must maintain the role of the Audit Committee as the focal point in determining whether activities and relationships should be judged to impair independence in the particular circumstances of a registrant and auditor.

Alternatives Concerning Scope of Services

The proposal lists a number of alternative approaches that the Commission might adopt regarding the scope of services. These include a blanket prohibition of all nonaudit services, an approach that would identify the services that would be permissible (rather than the primary proposal that identifies the services that would be prohibited), a requirement that audit firms be restructured to separate nonaudit services into autonomous units, an approach that would set a ceiling on nonaudit fees, and an approach that would not specify any particular services as permitted or prohibited but would instead require substantial disclosure. We do not believe that any of these approaches is superior to that taken by the primary proposal, that is, identifying nonaudit services that would be prohibited.

Disclosures About Nonaudit Services

Although we do not support the intricate detail proposed in the Release, CCR would not object to disclosure of non-audit services as an interim step, provided it can be limited to a reasonable amount of detail and to data that will be useful in assessing real risks. Towards that end, we offer the following observations on the disclosure proposal in the Release:

 

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We would be pleased to answer any questions you may have regarding this response. I can be reached at (203)-373-2458.

Sincerely,

 

 

Philip D. Ameen
Chair, Committee on Corporate Reporting



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