• Recent market events demonstrate that lack of investor confidence can destroy value as investors flee companies tainted by accounting scandals.
• The Andersen/Enron debacle catapulted auditor independence to the forefront of public attention. Post-Enron stories involving WorldCom, Adelphia Communications and others raised additional concerns about auditor independence.
• In spite of positive reforms implemented by the 2002 Sarbanes-Oxley Act and the SEC, the changes do not go far enough. Auditors can still 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.
• In 2001 Microsoft paid its accountant $4.7 million for audit services and $14.7 million for non-audit services (Figure 1). Thus, 75.6% of total auditor fees to Deloitte & Touche LLP were for non-audit services (as defined by the sec). This level of interconnectivity between audit and non-audit services creates a conflict of interest on the part of the auditor. As a result, investor confidence in the company’s financial statements could be severely harmed.

Figure 1: Non-Audit Fees and Audit Fees paid by Microsoft

Auditor Independence

• Scandals this past year have heightened the dialogue on whether auditors are truly the “gatekeepers” for the securities markets. Congress, government regulators, the Exchanges and investors have all voiced concerns about auditor independence.
• Corporate scandals following Enron were partly due to an “almost total failure of our gatekeepers,” maintains former SEC Chairman Arthur Levitt, among the most prominent advocates of auditor independence. He says his experience at the SEC taught him that accounting firms “supported the demands of corporate clients” and failed to stand up for investors.
• 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 concluded in issuing its final rule on auditor independence in February 2001 (Rule S7-13-00).

This resolution asks the company Board of Directors to adopt a policy that would cap non-audit fees at 25% of aggregate fees for the firm retained as the company’s independent auditor.

This Resolution Will Protect Shareholder Value

• Independent auditors are necessary to ensure the veracity of financial statements, avoid conflicts of interest, and secure investor confidence.
• A Stanford Graduate School of Business study, completed in August 2001, evaluated 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. Stanford faculty member Karen Nelson and her colleagues wrote, "Our results suggest that the provision of non-audit services impairs independence and reduces the quality of earnings."

• Conflict of interest is created when financial rewards create competing loyalties 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 an auditor has at stake in non-audit items, potentially the greater the cost to the auditor for displeasing the client over an audit item. Pressure on auditors can be subtle or direct.

• A wave of accounting scandals in 2001 and 2002 severely damaged investor confidence. Among the companies in the news for accounting practices in 2002 was Microsoft. On June 3, 2002, the Associated Press reported that Microsoft agreed to refrain from accounting violations to settle federal regulators' allegations that it misrepresented its financial performance. The SEC alleged that Microsoft's accounting practices from July 1994 through June 1998 caused its income to be substantially misstated. The SEC alleged that: "Microsoft maintained undisclosed reserves, accruals, allowances and liability accounts (collectively 'reserves' or 'reserve accounts') that (a) were not in conformity with generally accepted accounting principles (GAAP) to a material extent, and/or (b) lacked properly documented support and substantiation, as required by the federal securities laws." (Under the settlement, Microsoft neither admitted nor denied wrongdoing, and no fine was imposed.)

• Citizens Funds uses the definition of non-audit fees provided by the SEC. The level of detail in company disclosure varies widely. These discrepancies clearly undermine the integrity of legislation designed to improve auditor independence and investor confidence.
• The debate over the definition of non-audit services creates a semantic quagmire. For example, although the Sarbanes-Oxley Act prohibits the auditor from conducting "appraisals and valuation services" it apparently allows "due diligence." The Act prohibits "legal and expert services" unrelated to the audit. Hence, companies define multiple services as "audit-related." Tax consulting, for instance, 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.
• The Sarbanes-Oxley Act prohibits 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.

• Citizens Funds is not asking for a total separation of audit and non-audit services as some resolutions have done. Setting the limit at 25% of aggregate fees allows the company flexibility to have its auditor perform some non-audit functions it deems crucial or complementary to its audit function.
• Resolutions earlier this year calling for total separation of audit and non-audit services garnered 46% support at Pacific Gas & Electric and 41% at Walt Disney Co. These voting results emphasize the importance investors place on auditor independence and the integrity of financial statements.
• After consulting with accountants and proponents of similar proposals on the appropriate level of fees for non-audit services, Citizen Funds concluded that more than 50% of fees from non-audit services would severely hurt independence, while complete separation was not reasonable. It is noteworthy that the Sarbanes-Oxley Act requires an audit committee to approve non-audit services representing more than 5% of a company's aggregate fees to the auditor, thus recognizing the need to monitor and limit the relationship with the auditor.
• The 25% limit ensures that the auditor's primary loyalty is to the audit. At this level, the auditor is permitted to provide meaningful non-audit services in limited circumstances while significantly reducing the potential psychological and financial impact of competing loyalties.

Vote FOR Proposal No. 2 * Support Auditor Independence * Improve Investor Confidence

Citizens Funds filed this resolution. For more information, please contact: Andrea Avolio at As You Sow Foundation (415) 391-3212, or Diane South at Citizens Funds (603) 436-1513 x3659,