auditors with greater freedom from influence by management because their limited tenure would minimize fear of losing a client.

At first blush, a rotation requirement might seem beneficial in bolstering the independence of auditors. However, a considerable price would be paid for such a requirement. The most effective audits are generally performed by auditors who have acquired a thorough knowledge of the business entity under review. It is generally recognized that such knowledge is best gained through actual audit experience over a considerable period of years. This level of expertise would be substantially dissipated by a system of periodic rotation.

Furthermore, the costs of audits would increase because of frequent duplications of start-up learning time and development of a background data base that underlies every audit. Also, the intense competition by CPA firms to attract clients up for rotation would tend to create such severe pressures on auditor independence that the net result of rotation would be a decrease rather than an increase of independence.

CPA firms have for many years rotated their personnel on audit engagements to bring fresh viewpoints to bear on the audit process. This is accomplished on a gradual basis which permits the retention of continuity, thereby avoiding many of the disadvantages that would result from the rotation of firms. To the extent that there are advantages to be gained by rotation, they are largely achieved by these alternative procedures of systematically bringing new personnel into audit engagements.

It should also be recognized that rotation of firms could have an adverse effect on the ability of auditors to obain information from their clients. The effectiveness of audits depends to a substantial degree on the maintenance of an attitude of candor and goodwill by a client toward his auditor. This attitude would not be as readily developed if there were frequent changes in auditors and clients would tend to be less open in discussing their affairs.

When all of these factors are considered it seems likely that on balance a requirement to rotate audit firms would weaken rather than strengthen the independence and effectiveness of auditors and the costs of audits would be increased. Accordingly the proposal should not be adopted because it would be counterproductive.

A second proposal that is often advanced by the profession's critics is that the scope of services of auditors be restricted to preclude those services which are perceived to create adverse pressures on the objectivity and integrity of auditors. There are varying opinions among the critics as to what specific services should be prohibited and whether the restriction should extend only to audit clients or to all clients regardless of whether audits are performed for such clients.

Among the services which have been cited as posing a threat to auditor independence are the following broad categories:

1. Advice leading to management decisions and assistance with systems and their implementation.

2. Preparation of accounting records or financial statements which are subsequently audited by the preparing firm.

The concern underlying both of these categories is that an auditor may be biased in reporting on the reliability of financial statements based upon the results of decisions or systems in which he played an advisory role or assisted in their implementation. It is alleged that under such circumstances an auditor would be reluctant to concede that his advice or assistance to the client has been faulty. This reluctance would be evidenced by expressing a favorable opinion on financial statements that failed to reflect any adverse results of the auditor's services to the client.

No doubt the providing of non-audit services to audit clients could create some potential for conflicts that might affect the objectivity or integrity of auditors. Indeed, even judgments made as a part of conducting an audit could cause an auditor to be defensive about such judgments in a succeeding audit when events may have proved him wrong. But the risks of impairment of objectivity or integrity are so minimal in relation to the benefits that accrue from providing nonaudit services that prohibition of such services would be unwarranted and undesirable. Consulting services help management to achieve efficient business operations and auditors are uniquely qualified to provide them because of their knowledge gained through observation and analysis of the activities of a wide range of clients. In addition, the insights gained by auditors in providing consulting services are highly beneficial to the effectiveness of their audits. The quality

of audit judgments frequently depends on the application of expert knowledge about business operations and practices.

There are many reasons to conclude that the risks of providing consulting services to audit clients are not significant. The most important of these are:

1. No evidence has been produced that providing services involving an advisory role or assistance with implementation has in fact impaired the objectivity or integrity of auditors.

2. Auditors providing such services are likely to be constrained by the strong countervailing pressures of threat of lawsuits, loss of reputation and disciplinary action leading to loss of rights to practice.

3. Auditors are by training, background and experience inclined to resist the various pressures on their independence.

4. Management is not likely to conspire with auditors to issue financial statements that hide the results of poor advice or assistance by the auditors.

5. Auditors do not express opinions on the quality of management or management decisions. Their opinions relate only to financial statements. Thus auditors do not express direct opinions about their own advice or assistance and are not under strong pressure to agree to the issuance of financial statements that distort operating results.

6. Providing non-audit services provides an auditor with a more intimate knowledge of a client's affairs and enhances his ability to perform an effective audit because of his understanding of the business. Thus the more an auditor is professionally involved in the preparation of financial statements and the underlying accounting records the greater will be his knowledge of them and his ability to form an opinion about the fairness of the statements.

The argument by critics that auditors cannot audit their own work, consisiting of non-audit services, misses the main purpose of an audit which is to obtain a degree of confidence from someone outside the control of management. An auditor does not fall under the control of management simply by rendering non-audit services. Thus his ability to lend credibility to financial statements should not be diminished. To the contrary, he will know more about the client and its affairs and is likely to be a more effective auditor. The main objective of an audit is achieved because an outside party, the auditor, is passing judgment on the fairness of management's representations in the financial statements.

All of the foregoing factors, coupled with the fact that auditors serve many clients and provide all their services from the posture of an outside contractor, tend to keep pressures on their objectivity and integrity within acceptable limits. On balance, then, the disadvantages would far outweigh the benefits if auditors were precluded from providing non-audit services to their credit clients.

Most of the other suggestions of criticis are directed at changing the fact that auditors are appointed and paid for their services by their audit clients. Some have proposed that auditors be paid out of a pool of funds created by assessments against companies subject to audit. This misses the principal issue since it is the appointment of the auditor which counts rather than how he is paid.

Others have suggested that a government agency have the power to appoint and dismiss auditors or that all audits be conducted by government employees rather than by members of a private profession.

These proposals are so drastic that if they were adopted they would virtually destroy any vestiges of a private profession. Such an invasion of the private sector by government would not seem warranted in the light of the many achievements of the public accounting profession and the advantages of its retention. Indeed, there is no assurance that a government bureaucracy would perform the audit function nearly as well as the private profession. It has been alleged, for example, that government regulatory agencies tend to become protective of the industries they regulate and are less independent in their relationships than are private auditors. Furthermore, transfer of the audit function to a government agency runs the risk that it may be used for partisan political purposes.

Short of covering the private profession to a government function there would seem to be no practical alternative to the present system under which auditors are appointed and paid by their clients. In any event, the pressures that stem from a fear of dismissal and loss of fees are probably not nearly as great as might be contended by critics of the profession. Also, the countervailing pressures which have been previously cited are of such magnitude that any drastic changes in the present system would seem to be unwarranted.

CONCLUSIONS

To sum up, auditors cannot practice their calling without being exposed to pressures on their integrity and objectivity. To define and proscribe all such situations would be impracticable.

The pressures that accompany normal relationships with clients are offset by powerful countervailing restraints. These include the possibility of legal liability, professional discipline involving revocation of the right to practice, loss of reputation and the inculcated resistance of a professional to any infringement upon his basic objectivity and integrity.

In deciding which types of relationships should be prohibited, both the magnitude of the threat posed by a relationship and the force of countervailing pressures have to be weighed. Such judgments should be based on whether reasonable men, having knowledge of all the facts and taking into consideration normal strength of character and normal behavior under the circumstances, would conclude that a particular relationship would pose an unacceptable threat to an auditor's objectivity or integrity.

The profession has applied these criteria in establishing its prohibitions of relationships between auditors and their clients. It believes that those prohibitions are being scrupulously observed and are adequate to assure the independence of auditors.

The profession has also taken steps to minimize the pressures on auditors by urging the establishment of corporate audit committees and assisting in the development of reporting requirements on changes in auditors. Safeguards to assure a high level of performance have also been imposed by adopting and carrying on extensive quality control review programs and requiring continuing professional education by practitioners.

In short, the profession is doing all that can reasonably be expected to assure that a high level of independence is maintained by auditors. However, no procedures or system of constraints, whether self-imposed or invoked by government, can provide a guarantee of zero defects.

Even though there have been failures in the performance of auditors they have been minuscule in number in relation to the overall volume of audits performed. When failures have occurred they have rarely involved impairment of objectivity or integrity. In almost all instances, audit judgments were found to be faulty in the light of hindsight, audit procedures were not effectively applied or generally accepted accounting principles had not been sufficiently narrowed to deal appropriately with new forms of business transactions. None of these shortcomings would have been cured by the rotation of auditors, restrictions on the scope of services of auditors, different methods of appointment or remuneration of auditors or transfer of the audit function to a governmental body.

The problems that have been encountered are to a large extent inherent in the difficulties in accounting for and reporting in a highly condensed format on the operations of large complex corporate structures. Impairment of the independence of auditors is not a principal or fundamental cause of the few shortcomings that have been encountered in audited financial statements. Auditors have, overall, displayed a remarkable degree of objectivity and integrity in fulfilling their role and are likely to do so in the future without changes in the present system of constraints.

Mr. CUNNINGHAM. We will recess until the chairman returns and then continue with two witnesses until the Sergeant at Arms appears to close down the hearing.

Thank you.

[Recess.]

Senator HARTKE. The committee will come to order.

The next witness will be Mr. Richard Cyert, the president of Carnegie-Mellon University, Pittsburgh, Pa.

STATEMENT OF RICHARD M. CYERT, PRESIDENT, CARNEGIEMELLON UNIVERSITY, PITTSBURGH, PA.

Dr. CYERT. Good morning, Senator.

What I would like to do is just briefly indicate the points in my statement which has been submitted and a little of my background.

Then I would like to answer any questions you have.

My background has been economics. I have concentrated on microeconomics and I have been particularly concerned with decisionmaking within the business firm.

Since I have been president of the Carnegie-Mellon University, which has been for the last 4 years-and prior to that I was dean of the business school-I have accepted several directorships so that I feel I know the corporation from the outside and from the inside.

In my statement what I have done is talk about the whole question of governance, which deals with the relationship of a board of directors to the chief executive officer and to the stockholders of the corporation in general, and, secondly, I have discussed the problem of antitrust.

I would be prepared to answer questions from you on either of these areas or any of the other areas that are of interest to you.

Senator HARTKE. Do you consider that there are, at the present time, what you call corporate violations of the law?

Mr. CYERT. Well, I would say this: What is happening within corporations is that a number of incidents are surfacing because of the general sensitivity and concern.

These are incidents generally which top management would have great difficulty in ever discovering. There are relationships where the company may be selling through an agent in a South American country and it turns out that that agent, who is not even an employee of the company, has been taking some of the funds which the company has been paying him, which are completely reasonable in terms of an agent's fee, and it turns out they discover he has been bribing some people in that South American government.

He is a native of that country. That is a violation in the way that the corporation views it.

At the top management level, I think the violation question has to be answered "no," that there is no known kind of violating going on, and there is a great sensitivity to this whole area.

Senator HARTKE. Let me give you a specific.

What about the Gulf Oil thing?

You said "no known".

Mr. CYERT. Well, the Gulf Oil situation, I just do not believe there are other situations like that Gulf Oil situation going on at this time. Senator HARTKE. I don't want to go into specifics. I think generally speaking I would feel there is. You say that on critical subjects such as the supplying of energy that we should have neither more competition or more government involvement.

Is that right?

You say we should increasingly rely on the ability of businessmen to behave like statesmen.

Mr. CYERT. That is right.

Senator HARTKE. What are the incentives for them to behave like statesmen?

Mr. CYERT. Well, I think, first, the board itself is a factor in this in that they are-most boards, and particularly those with a fair number of outside directors-are critical of behavior of chief executives, who seem to be self-seeking or exhibiting behavior that would smack of illegality.

I think the chief executives themselves are professionals in the same sense-I am talking about most of them now-in the same sense that most physicians are.

Just as physicians and other professionals have self-regulating and self-auditing bodies, I think that is the kind of development that has to be increased in the whole business area.

Now, I don't think at the moment, however, that we need just to rely on that, because I do believe for critical things like pricing of products, like investment in new areas, that competition does exist in a very strong fashion in our economy despite the fact that we may have markets where there are only three or four firms which economists refer to as oligopolies.

There is a lot of evidence that has been developing in the economic sector to indicate that oligopolies are extremely competitive, and that it is not a question of these companies somehow getting together and setting prices and making huge profits. They are competing.

So, I think my long-run hope is that we can develop among top executives-and I think educational institutions play a role in thismuch more of an attitude that stimulates ethical standards among this group so they will be behaving in the way that I describe as statemanlike, which means taking the best aspects of society.

Senator HARTKE. Is the sum and substance of what you are saying, then, that there really is no problem?

Mr. CYERT. No. I don't mean to be Pollyannaish about it.

I do think we have a number of things we have to be concerned about. I think business firms are concerned about them and are in the process of doing something about them.

We have heard some of them today. The audit committee, a concept which has been developing among boards of directors, is a very healthy thing.

These committees are made up of outside directors, and are very tough. I am on several of them.

We have given instructions to the auditors that they are to come directly to us with anything that smacks of any illegal activity.

We question them hard on the possibilities of their having uncovered such things, and we go over their audit program before they audit, so that there is, I would say, a growing control through the outside directors and through sensitivity of directors because of some of the events that have happened, and in particular the Gulf Oil situation.

Senator HARTKE. Would you feel that in any case there would be a justification for a public board of directors to be appointed to these corporations?

Mr. CYERT. I personally do not.

The reason I think not is that I think the board of directors has a particular kind of relationship with the management.

It has to be involved in the decisionmaking process at particular levels of the corporation. It is an important part of that decisionmaking process.

The directors do not sit there only as auditors. They are also decisionmakers. Therefore, there has to be effort to understand the operation.

There has to be a basis of working with the management at the same time that it is recognized that ultimately the board holds the authority to hire or fire that chief executive officer.