Subcommittee on Securities

Hearing on the SEC's Proposed Auditor Independence Rules

Prepared Testimony of Mr. Shaun F. O'Malley
Public Oversight Board, Panel on Audit Effectiveness

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

I am pleased to appear here today and to respond to your request that I describe the work done by the Panel on Audit Effectiveness with regard to the issue of auditor independence and non-audit services, and to report on the Panelís conclusions and recommendations.

By way of background, the Panel was formed at the urging of SEC Chairman, Arthur Levitt, after he had expressed in public speeches concerns about the quality of auditing, particularly in the face of certain highly publicized downward restatements of earnings accompanied by significant loss of market capitalization. The formal request for the establishment of the Panel came in the form of a letter from SEC Chief Accountant, Lynn E. Turner, to the then Chairman of the Public Oversight Board, A. A. Sommer, dated September 28, 1998. That letter detailed the SECís concerns about the current quality of auditing and, in particular, asked for an examination of "whether recent changes in the audit process serve and protect the interests of investors."

The above letter calling for the establishment of our Panel made no mention of the independence issue or the matter of non-audit services as matters for our consideration. We were aware of the establishment a year earlier of the Independence Standards Board, formed through the cooperative action of the AICPA, the major auditing firms and the SEC. As Chairman of the Panel I assumed that the independence issue had been placed in the proper hands and was being fully addressed by a prestigious group formed for the purpose of dealing with independence issues.

At our first meeting, two of our Panel members insisted that this issue be included in our research efforts. Hence, a letter dated January 6, 1999 from myself, on behalf of the Panel, to the Public Oversight Board detailing our work plan for the project added that we would, in addition to our primary focus on audit processes, consider "the relationship between audit and non-audit services."

With respect to our actual field work, the principal element involved detailed reviews of the audit work performed by the eight largest accounting firms on some 130 audit engagements selected to include a representative cross section of publicly-owned companies in a variety of industries and circumstances. These reviews included visits by Panel members and staff to 28 offices of the eight firms throughout the country. Termed "Quasi-Peer Reviews" (or "QPRs"), they also included extensive interviews with personnel assigned to the selected engagements and with focus groups of auditors at various staff levels. The QPRs also included investigations into the independence/non-audit services issue whenever non-audit services were performed for client companies in the 130 selected engagements.

The following quotation from the Panel report outlines our work and findings in that area.

"In the QPR process, 37 engagements were identified in which services other than audit and tax had been provided. (This represented 29% of the QPR population, and is similar to the average of 25% of all the Big 5 firmsí SEC clients for 1999, as indicated above.) Supplemental questionnaires were completed in these instances, and in some cases the reviewers interviewed the firm personnel who performed the non-audit services.

"The QPR reviewers did not identify any instances in which providing non-audit services had a negative effect on audit effectiveness. On about a quarter of the engagements in which non-audit services had been provided, the QPR reviewers concluded that those services had a positive impact on the effectiveness of the audit. On the balance of the reviewed engagements, the reviewers either were neutral regarding the effects of non-audit services on audit effectiveness or concluded that the services had no impact on audit effectiveness.

"Of the 37 engagements, 15 involved (a) systems or processes used by the client to prepare its financial statements (or management reports directly integrated with its financial statements) or (b) financial statement amounts that were involved in, or derived as part of, the non-audit services. In all 15 of these engagements, the reviewers agreed that the engagement teamís audit procedures were sufficient to bring an objective view to the area, provided sufficient competent evidential matter regarding the system, processes or amounts, and were documented adequately. In addition, the reviewers agreed that the engagement team and/or the firm took appropriate steps to ensure that the non-audit services would not impair the firmís independence and that the auditorsí independence was not adversely affected by the non-audit services."

Here are some examples of non-audit services that increased the audit effectiveness of audits in the engagements reviewed by the Panel: assisting in evaluating the clientís Y2K status; reviewing and evaluating the implementation of new systems; due diligence for a potential lender in evaluating the clientís plans, and due diligence regarding a potential acquisition. In addition, the Panel staffís analysis of recent fraud cases and/or alleged audit failures reported by the SEC revealed no audit failure attributable to providing non-audit services.

Beyond the QPR work and fraud case analysis, the Panel staff researched a considerable body of published material on the subject and included the subject in its comprehensive survey and its public hearings.

Upon completion of the QPRs and our other research (outlined in Chapter 5 of our published "Report and Recommendations"), the Panel debated and discussed the issue of an exclusionary ban on non-audit services to audit clients and considered various approaches. In the end, the Panel could not reach agreement on that issue. While all other sections of the Panelís report, which included a considerable number of recommendations, received unanimous support from the Panel members, the non-audit services issue split the Panel with five members opposing a ban and three favoring it. It was agreed to present the full arguments for the opposing views in the Panelís report along with the disclosure that the Panel could not reach agreement on a recommendation.

I should point out that the need for auditor independence in carrying out audit examinations is not in dispute among Panel members. The members were unanimous on its importance.

Finally the Panel, while taking note of the SECís announced rulemaking initiative, recommended that whatever the outcome of that process, the Independence Standards Board take steps to identify important factors to be considered by auditors, audit committees and client company managements in determining the appropriateness of a particular non-audit service. The Panelís recommendation included a list of factors to be considered in making such determinations. It also recommended a system of approval of non-audit services by audit committees.

That is a brief summary of the Panelís work on the subject Ė I would only add that Iím sure I speak for our entire Panel when I say that it is extremely important to investors, to companies, to the accounting firms and to the regulators that the ongoing negotiations concerning independence and the Public Oversight Board Charter be successfully concluded as soon as possible.

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