Investors of Microsoft (MSFT) and Cisco (CSCO) are being asked to vote on shareholder proposals filed by Citizens Funds on auditor independence. The proposals would require the companies to limit to 25% the non-audit fees currently earned by the auditor. If shareholders approve the proposal, they'll be saying they want auditors to earn the majority of their fees from auditing, not consulting and other non-audit work. The companies say to implement the proposal would cost money. What's more, they say investors should trust the audit committee and board of directors to verify auditor independence. Given the events of the last year, is simple trust enough?

INTRODUCTION

Independent auditors are necessary to ensure the veracity of financial statements of public corporations and to provide investors with confidence that those financial statements are accurate and truthful. Recent market events conclusively illustrate that lack of investor confidence is value destroying, as investors have fled companies that are tainted by scandal and accounting questions. The reverse is equally true - high ethical standards, including attention to conflict of interest as it relates to auditor independence, can be value enhancing for a firm.

The Andersen/Enron debacle catapulted the auditor independence issue to the public's attention. At Enron, we learned the audit, tax strategy, internal audit and advice on corporate-finance issues were integrated, with auditors pressured to approve aggressive accounting tactics. Other post-Enron stories like Worldcom and Adelphia Communications have raised additional concerns about auditor independence, particularly when companies pay their auditor substantial amounts for non-audit services.

Conflict of interest is created when financial rewards create competing loyalties (subconscious or conscious) in the auditor. In a dispute over how to book an acquisition, for example, an auditor who receives $20 million from consulting services and $2 million from the audit may feel pressure to cede a point to the client. The more the auditor has at stake in disputes over non-audit items, potentially the greater the cost to the auditor for displeasing the client. Pressure on auditors can be subtle or direct.

THE RESOLUTIONS AT MICROSOFT AND CISCO

Citizens Funds, one of America's largest families of socially responsible mutual funds, has filed shareholder resolutions at Microsoft and Cisco aimed at removing auditor conflict of interest and ensuring the integrity of the companies' financial results.

The resolutions call on management at Microsoft and Cisco to restrict the non-auditing fees paid to auditors to no more than 25 percent of total fees. Other shareholder resolutions have banned the auditor from any non-auditing services. Citizens' auditor independence resolution allows some flexibility (25% non-auditing fees) but ensures that the auditor's main financial benefit comes directly from the audit.

But doesn't the Sarbanes-Act resolve the conflict of interest issue? Indeed, Congress has acted - that shows the urgency of the need for action and the importance of this issue. However, Congress did not address the basic conflict of interest issue with auditors earning high consulting fees. It is left for investors to carry the ball forward - and that's what these resolutions do.

The legislation helped reduce the chances for conflict of interest by prohibiting auditors from performing certain consulting services, such as financial systems design and implementation, internal audits and management consulting. However, the legislation stopped short of addressing the inherent conflict of interest created when auditors earn high non-audit fees. This is an opportunity for Microsoft and Cisco to be proactive and to implement model corporate governance policies.

BACKGROUND

Former SEC Chairman Arthur Levitt is among the most prominent advocates of auditor independence. The wave of corporate scandals following Enron was partly due to an "almost total failure of our gatekeepers" including accountants, corporate boards, corporate lawyers and regulators, Levitt said. He went on to say that his experience at the Securities and Exchange Commission taught him that accounting firms "supported the demands of corporate clients" and failed to stand up for investors.

The SEC addressed the issue of auditor independence in February 2001 when it issued Final Rule S7-13-00, which noted:

Independent auditors have an important public trust. Investors must be able to rely on issuers' financial statements. It is the auditor's opinion that furnishes investors with critical assurance that the financial statements have been subjected to a rigorous examination by an objective, impartial, and skilled professional, and that investors, therefore, can rely on them. If investors do not believe that an auditor is independent of a company, they will derive little confidence from the auditor's opinion and will be far less likely to invest in that public company's securities.

The SEC developed its rules on auditor independence in response to almost 3,000 comment letters and four days of public hearings. In addition the SEC surveyed academic and professional literature on the subject and heard 35 hours of testimony from almost 100 witnesses. In its rules, the SEC defines audit and non-audit services and requires companies to disclose those fees in the annual proxy statement. The level of detail in the disclosure varies widely from company to company.

WHY THE NEED TO LIMIT NON-AUDIT FEES

As noted earlier, none of the auditor reforms implemented by Congress or the SEC has addressed the issue of large non-audit fees earned by auditors or the inherent conflict of interest this creates. While many of the current reforms are positive, the changes do not go far enough.

Auditors still can earn the vast majority of their fees from non-audit services, with the audit representing a small fraction of the financial connection with the client. Tax work, due diligence in relation to acquisitions and "miscellaneous projects" are among the non-audit services companies continue to ask their auditor to perform. As accounting firms provide additional services to their audit clients, and the complexity of those relationships increases, the independence of those auditors is called into question, and may no longer be in the best interest of investors.

One recent (August 2001) academic study looked at these high non-audit fees and concluded that corporations with the least independent auditors - those who paid the most in non-audit fees - are more likely to just meet or beat earnings benchmarks. "Our results suggest that the provision of non-audit services impairs independence and reduces the quality of earnings," wrote Stanford Graduate School of Business faculty member Karen Nelson and her colleagues.

The debate over what an auditor should be permitted to do, and the demand for disclosure, creates a semantical quagmire. For example, Sarbanes-Oxley prohibits the auditor from doing appraisal or valuation services and fairness opinions, but "due diligence" is apparently allowable. The Act prohibits legal and expert services unrelated to the audit. Hence, companies define multiple services as "audit-related." Tax consulting, for example, can add up to millions of dollars in fees. The result is that the Act is not likely to significantly reduce the high non-audit fees at many companies.

Citizens Funds believes investors are best served by companies that have transparent reporting and policies that promote integrity. Removing conflict of interest in the audit process can be a value-enhancing proposition. Furthermore, the evidence suggests separating the audit function is very manageable. When Arthur Andersen unraveled following its indictment, many companies were forced to change auditors. According to the Wall Street Journal, the transition has gone smoothly. "Indeed, instead of having trouble finding a firm to audit their books, companies are being inundated with offers." (WSJ, 6/17/02)

THE ROLE OF THE AUDIT COMMITTEE

One argument that is used to oppose auditor independence resolutions is that the audit committee provides sufficient auditor oversight. Yet recent events show that board members are often in the dark about important financial issues. Audit committees that meet a few times a year are not adequate to protect investors' interests. In addition, although shareholders vote on audit committee members, election of management's slate is virtually certain.

Neither the public nor audit committee members themselves are entirely clear on the issue of loyalty. According to a recent story in the New York Times, 80 members of audit committees from diverse companies were recently asked to whom they owed primary loyalty: to shareholders, to all stakeholders, or to the chief executive. The audit committee members were divided on the answer.

AT WHAT COST INDEPENDENCE

Both Microsoft and Cisco say the auditor independence resolution will result in increased costs. Cisco's 2002 proxy lists audit fees of $2,344,000 and non-audit fees of $14,981,000 including tax planning, services in connection with acquisitions and miscellaneous management consulting. The non-audit fees were 86% of total fees, down slightly from 90% the previous year. What is investor confidence worth? Would doubling the fees to rectify the situation be material, given Cisco's annual revenue of $18.9 billion? If investors had more confidence, would that be reflected in an increase in the stock price, mitigating the cost of the independent auditor?

It can be difficult to determine the true cost of an independent audit. The practice of using the audit as a "loss leader" has been widely reported. In essence, the audit company low-balls the audit in order to obtain more lucrative non-audit work. Only when companies truly have independent auditors can we access the real cost of the audit.

CONCLUSION

The auditor independence resolutions at Microsoft and Cisco offer investors the opportunity to protect the reliability and integrity of the financial statements. High non-audit fees paid to the auditor represent an inherent conflict of interest. Removing this conflict of interest is essential if investors are to regain confidence in the markets.

Please call (800) 223-7010 for a prospectus that contains complete details of fees and expenses and should be read carefully before investing. As of September 30, 2002, Microsoft Corporation represented 4.88% of the Citizens Core Growth Fund, 2.48% of the Citizens Global Equity Fund, and 2.28% of the Citizens Value Fund; Cisco Systems, Inc. represented 2.10% of the Citizens Core Growth Fund, 3.42% of the Citizens Value Fund, and 0.77% of the Citizens Global Equity Fund. Distributed by Citizens Securities, Inc., Portsmouth, N.H.