WASHINGTON, D.C. -SEC Chairman Arthur Levitt last month said the SEC would produce the "hard" evidence of auditing problems that Phil Gramm (R-Tex.), chairman of the Senate Banking Committee, called for to justify the commission's proposed independent auditor rules.

Levitt, testifying before the Senate Banking Committee's securities subcom-mittee, defended the SEC's rule proposal as necessary, first, because of the rise of "cross selling," - the practice of accounting firms also provide consulting services to their clients. This practice has led to the appearance of conflicts of interest and actual accounting violations, Levitt said. Accounting firms now report that over 50 percent of their revenues come from consulting services, he said.

The rule proposal is also necessary because of the importance of financial reporting in today's volatile market, Levitt said.

"When an analyst speaks of a penny's drop in a company's earnings and the market drops by 30 percent, I worry," Levitt said.

Levitt's comments and the Senate's request for evidence of accounting problems coincided with a Sept. 28, SEC enforcement action for financial reporting fraud at McKesson HBOC, a Fortune 100 company based in San Francisco. The investigation also resulted in criminal charges against three officers of the company. And, on Sept. 27, the SEC announced civil and criminal charges for accounting violations against six different public companies, including Sirena Apparel Group and Craig Consumer Electronics, both of Los Angeles.

The SEC, two weeks ago, was still trying to schedule the closed-door hearing, said Chris Ullman, an SEC spokesperson. Last week, the SEC declined to comment on the status of a hearing. Ullman declined to disclose details of what would be presented at the hearing.

Gramm and other senators on the subcommittee were unconvinced by Levitt's arguments of public perception. Gramm told Levitt that the SEC had a "heavy burden" in convincing the Senate that the proposed rules which would, in his opinion, split up accounting firms into separate auditing and consulting companies, are justified. American accounting firms have a "distinguished record" and are the "envy of the world," Gramm said. Therefore, the commission must show there is a problem and that its proposed rules would solve the problems.

The ranking member of the securities subcommittee, Sen. Christopher Dodd (D-Conn.) called for an end of the "acrimony" that has developed between the commission and the accounting industry. Dodd said he did not want Congress to become involved in regulating the accounting industry because it is "dangerous for politics to affect markets." Therefore, the accounting industry ought to sit down with the SEC and work it out, said Dodd. The dialogue between the industry and the securities regulators slowed considerably over the last few months.

Other senators on the subcommittee requested temporary steps before an SEC rule is adopted. Their suggestions included allowing the Independent Standards Board to come up with some oversight mechanisms, and requiring disclosure when an accounting firm also provides consulting services to a client.

"Why go past disclosure and cut the whole tree down?" said Sen. Enzi (R- Wyoming). Levitt said the rule proposal was in response to consumer protection groups and the industry itself.

Levitt's testimony was followed by a panel that included Barry Melancon, president of the American Institute of Certified Public Accountants, Shaun F. O'Malley, chairman of the Public Oversight Board Panel on Audit Effectiveness, John H. Biggs, chairman of TIAA-CREF, and Philip B. Livingston, president and CEO of the Financial Executives Institute.

Melancon criticized the rule proposal, calling it "regulation by hunch" unsupported by studies or empirical evidence establishing that non-audit services are causally connected to audit failure. He also said the public does not perceive that there is a problem. Livingston took a similar position against the proposal.

Biggs, on the other hand, supported the rule proposal and called for a "simple rule" whereby accounting firms that provide auditing services cannot provide other services for these clients. Biggs said that TIAA-CREF manages $300 billion for its participants and relies heavily on audited financial statements that must be independent. The ICI has said previously that the mutual fund industry is most concerned about the "consumer protection" angle and the perception that financial statements are independent is critical.

The rule proposal would identify certain non-audit services that, if provided to an audit client, would impair an auditor's independence. The proposals would not extend to services provided to non-audit clients. In addition, the rule proposal would have a limited exception provided to accounting firms for inadvertent independence violations if the firm has quality controls in place and the violation is corrected promptly. Finally, it provides that companies would have to disclose in their annual proxy statements certain information about non-audit services provided by their auditors during the last fiscal year.

Levitt said he did not have a timetable for final rulemaking.

Neil Hare is a freelance writer and the content director of USLaw.com of Silver Spring, Md.

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