AMERICAN ACCOUNTING ASSOCIATION 1996 ANNUAL MEETING August 14, 1996 AUDITOR INDEPENDENCE: THE CHALLENGE OF FACT AND APPEARANCE Remarks by Michael H. Sutton Chief Accountant Office of the Chief Accountant United States Securities and Exchange Commission ____________________________________ The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Sutton and do not necessarily reflect the views of the Commission or the other members of the staff of the Commission. I appreciate the opportunity to be here and to participate in your annual meeting. Before I begin, I must remind you that the views I express are my own and do not necessarily represent the views of the Commission or others on the staff. When I came to the Commission a little more than a year ago, I identified a number of issues -- some old ones and some just emerging -- that I believed were of great importance to the future of financial reporting and that likely would come to the fore during my tenure as Chief Accountant. I suspect that if we put together a small group today and compared notes, we probably would find that our lists were remarkably similar. Today, I want to explore one of those issues with you, and that is auditor independence. It's a complex issue and one that has far-reaching implications for both the accounting profession and the public. As I thought about the subject, I found it useful to go back to our roots and to reflect on the auditor's role in the context of the securities laws. The financial reporting and disclosure framework established under those laws more than 60 years ago assigns primary responsibility for the accuracy of financial statements filed with the Commission to the registrant and its management. The role given to the auditor is to attest independently to the reliability of those statements -- that is, to express an independent opinion as to whether the financial statements prepared by management comply with accepted standards and fairly present the financial condition and past performance of the registrant. I recently reread the 1933 Congressional testimony of Colonel Arthur Carter, then President of the New York Society of CPAs, on the proposed legislation that would become the Securities Act of 1933. Colonel Carter testified in support of adding a provision to the proposed legislation that would mandate that financial statements of public companies be audited by independent accountants. Imagine, if you will, the atmosphere of a Senate hearing room and the Senators' reactions as they began to grasp the significance of Colonel Carter's proposal. The transcript of that hearing includes the following exchange between Colonel Carter and Senator Barkley: Sen. Barkley Is there any relationship between your organization ... and the organization of controllers represented here yesterday .... ? Col. Carter None at all. We audit the controllers. Sen. Barkley You audit the controllers? Col. Carter Yes; the public accountant audits the controller's accounts. Sen. Barkley Who audits you? Col. Carter Our conscience. Continuing the dialogue, Senator Barkley probed deeper. Sen. Barkley I am wondering whether after all a controller is not for all practical purposes the same as an auditor, and must he not know something about auditing? Col. Carter He is in the employ of the company. He is subject to the orders of his superiors. Sen. Barkley I understand. But he has got to know something about auditing? Col. Carter Yes. Sen. Barkley He has got to know something about bookkeeping? And to that question, Colonel Carter responded: But he is not independent. At that point the questioning and dialogue turned to issues about how such a proposal could be implemented and the costs involved in doing that. While there surely were a number of factors that were weighed in considering Colonel Carter's proposal, I think the testimony makes clear the critical focus that was placed on independence and the important distinction drawn between the role of the independent auditor and the role of management. The testimony suggests clearly to me that independence -- the absence of a mutuality of interest with management -- was a compelling argument. The premise of the decision by Congress to require an independent audit is that the integrity of financial information provided to investors is critical to the effectiveness and safety of our capital markets. Thus, it is the independent auditor's objective "second look" at the issuers' financial statements that gives confidence to investors that those statements are reliable and provide a credible framework for investor decisions to buy or sell securities of public issuers. Both the fact and the appearance of independence are necessary to maintain the confidence of the investing public. That is the essence of the important public trust that the Congress granted to the profession in 1933, and it is that public trust that must be nurtured and protected today. In a world in which business ethics are increasingly being eroded, the importance of the auditor as an independent overseer of the integrity of information provided to our capital markets is magnified. Much has been written and said about the deterioration of business ethics, and there have been a number of studies and some alarming conclusions. You may have seen an article in The Wall Street Journal1 earlier this year that referred to a study published in the February issue of the Journal of Business Ethics. That study focused on ethics in financial reporting and included as a case one of the most common types of fraud investigated by the Commission -- the failure to report write-offs of overstated assets. The Wall Street Journal reported that the study, based on responses by 400 people, found that 47% of the top executives, 41% of the controllers, and 76% of the graduate-level business students included in the study were willing to commit fraud by understating write-offs that cut into their companies' profits. Those findings are at least troubling, and, if they are indicative of the current state of financial reporting ethics, they are staggering. They provide but one reason why the Congress, the Commission, and the investing public all attach such high value to the independent gatekeeping role of the auditing profession. While many services that professionals provide in the market place can add value to the business success of the companies they serve, on a broader scale of contributions to society, there is no comparison to the value that independent attest services can and must bring to our capital markets. In March 1994, in response to a request from Congressman Edward J. Markey to assess the effectiveness of the Commission's independence requirements, the Office of the Chief Accountant published a report that reaffirmed the importance of auditor independence. While the report indicated that no statutory or regulatory changes were necessary at that time, it also included an undertaking by the staff to continue to be alert to the development of problems of auditor independence. In the twenty-nine months since the staff's report, two private sector studies have reported continuing concerns about the objectivity and independence of auditors. The Public Oversight Board's Advisory Panel on Auditor Independence, known as the Kirk Panel, concluded in its September 1994 report that important steps should be taken to enhance the objectivity and strengthen the professionalism of independent auditors. Similarly, the AICPA Special Committee on Financial Reporting, known as the Jenkins Committee, observed in its 1994 report that users are concerned about current pressures on auditor independence. Both of those studies, I might add, seem destined to become landmark efforts in exploring and charting courses for the future of financial reporting and the governance processes that surround it. We also hear from a broad public audience, and their comments encompass a variety of concerns about auditor-client relationships and professionalism, and whether the profession's self-regulatory processes are working the way they should. As the auditing profession has matured, and the competitive environment has become more intense, that, too, has contributed to concerns about audit quality and auditor independence. Even as we try to keep those issues in our sights, major changes in the professional and business environment continue. For example, the size and structure of the largest accounting firms continue to be affected dramatically as those firms evolve into large multi-service organizations. In recent times, the list of services that firms seek to provide has taken on new dimensions. Examples -- to name a few -- include investment banking and other capital raising activities; various types of strategic planning and operational consulting services; assistance in finding business partners or acquisition candidates; assistance in gaining regulatory approval for major transactions; outsourcing services such as internal audit and tax departments and other traditional management activities -- and I could go on. The growing importance of these services is demonstrated by statistics recently published in Accounting Today2 regarding the 100 largest accounting firms in the United States. Those numbers indicate that, in 1995, revenues from consulting and related services increased by 36 percent over 1994 revenues while, for the same period, revenues from traditional accounting and auditing services increased by only one percent. The numbers for the six largest firms are about the same. If the trend suggested by 1995 results were to continue, in five years -- by the year 2000 -- revenues from consulting services would constitute more than two-thirds of total revenues. This new business and professional environment raises two threshold policy issues. First, what does the declining importance of the auditing function really mean to the future of the profession? And second, what is the impact on auditor objectivity of a relationship that may create, or be perceived to create, a mutuality of interests between the auditor and client management -- or a conflict of interests between the auditor and the true client -- the investors? The broad question raised by the first concern is whether the profession will continue to assign its highest priority to the auditing function and make the necessary investments over time that will assure the public that audit quality will not be compromised and that auditor performance will meet public expectations. The worrisome question raised by the second concern is how best to assure the public, Congress, regulators, the profession and corporate America that the auditor's objectivity and independence with respect to specific auditor-client relationships will not be compromised and that investors can continue to rely on the credibility and integrity of audited financial information. While both are important concerns, and in some respects are interrelated, I want to focus on the second issue in my remaining remarks. Today, we find ourselves in this dilemma: Despite many studies and many initiatives by the profession, over a long period of time, doubt about the objectivity and independence of auditors persists. Fundamental to all of the questions about auditor independence, I believe, is an inherent skepticism about how close the relationship between the auditor and the management of the audit client can be without creating, again in fact or in perception, a mutuality of interest that could impair the auditor's independence. At what point does the auditor become so involved in the success of the company and its management -- as a consultant or an advisor or a provider of a variety of newer services -- that there is a risk that private interests might be placed ahead of those of investors, or that the public will perceive it that way? In the context of Colonel Carter's testimony before Congress in 1933, we might ask ourselves how the dialogue might have gone if, in responding to Senator Barkley's questions about the role of the public accountant, Colonel Carter had said, "Yes, the public accountant audits the controller's accounts -- and also provides a broad array of other services to management," and then had gone on to describe the portfolio of new services being marketed by accounting firms today. Let's look at one specific service that has received a lot of publicity -- internal audit outsourcing -- in the context of public expectations about the independent auditor's role. I choose this issue because it has been highly publicized, many in this audience are familiar with it, and I believe that it illustrates the complexity of the issues we face. Few would question the ability and skills of the auditing profession to perform internal auditing services effectively. The service seems to be highly relevant to the core competencies of independent auditors, and assuming that the appropriate investments are made in people and training, I think most would view those services as credible and relevant to the independent auditor's expertise. In other words, competence is not the issue. The issue is whether those services conflict with the role of the independent auditor and the public's perception of that role. Internal auditing traditionally has been a management responsibility that, in critical ways, has been integral to the system of internal control. In that context, the question becomes, "Can the independent auditor perform the internal auditing function and also provide a truly independent second look at the system of internal control?" The AICPA Professional Ethics Executive Committee, in part at the staff's urging, has been wresting with this issue for many months, and the Committee recently adopted an interpretation under Rule 101 of the Code of Professional Conduct. The interpretation distinguishes between activities that are management functions and those that are not, and then presents a framework and guidance for establishing an understanding between the auditor and the client about which responsibilities management will assume and which responsibilities the auditor will assume. Against that background, the interpretation defines those internal auditing activities that the independent auditor may perform and those that would impair the auditor's independence. The ruling stresses that the independent auditor, when engaged to perform internal auditing services, may not act or appear to act in a capacity equivalent to a member of management or as an employee. And, in an attempt to avoid this conflict, the interpretation requires that a competent member of management remain in charge of the internal auditing function and that the independent auditor perform only "separate evaluations" of the effectiveness of internal controls and not "ongoing monitoring" of those controls. Permissible "separate evaluations" may include, however, "separate evaluations" of management's "ongoing monitoring" activities. While these new guidelines may be an improvement over prior rulings, they illustrate the difficult appearance issues that arise in making distinctions between activities that are reserved for management, on the one hand, and other activities, customarily associated with management responsibilities, that may be assigned to the independent auditor, on the other. Those distinctions may be possible in theory, but they would seem to be inherently difficult to maintain in practice. Thus, the skillful balance sought by the drafters of the guidelines may, in the final analysis, run up against the wall of perception and credibility. And, the difficult appearance issues that were raised with respect to internal audit outsourcing may be even more pronounced with other outsourcing services. It seems to me that both the investing public and the profession would be better off if outsourcing types of services -- services designed to replace traditional management functions -- were provided only to non-audit clients. In response to rejoinders about the economic consequences of that suggestion, I would observe that, if such a framework were adopted, the total market for the outsourcing services in question would seem to be no smaller in the aggregate. Most of the market participants would be affected similarly -- each would lose opportunities to market certain services to audit clients, but each also would gain opportunities to market those services to non-audit clients. And, most importantly, the public perception of the credibility of the independent auditor's role would not be undermined. Reflecting on the auditor independence issues even more broadly, the aspect that concerns me most is that there may be a growing perception that there is a real conflict between the public interest and the broader business interests of the profession. And, that concern, if not addressed, could indeed compromise the reputation for objectivity and independence that is the hallmark of the profession. I say this fully acknowledging that the solutions are not easy; for some, indeed it is difficult to even accept that there is a real problem. But, as I have thought about the underlying issues for a very long time, and from the perspectives of both a practicing auditor and Chief Accountant, it is clear to me that the profession needs to accept that we are facing a perception problem. And make no mistake about it, in a profession that is so dependent on public trust, a perception problem is a real problem. I will not propose specific solutions today, but rather will discuss briefly some approaches that I believe deserve consideration. First, the Kirk Panel report made recommendations aimed at redefining the traditional auditor-client relationship. Those recommendations involve strengthening the independence of boards of directors and their accountability to shareholders. They involve clearly establishing and underscoring the primary auditor-client relationship with the board of directors, not corporate management. And, I believe they may begin to offer an approach to addressing a widespread perception that auditors may have grown too close to management and that management may have too great a stake in, and too much control over, the auditor-client relationship. The Panel's recommendations have merit, and we should consider them. In doing so, we need to recognize that, in some cases, this approach calls for a significant change in the way management views both the auditor -- as an independent representative of the interests of stockholders and the public -- and the public stockholders -- as the absolute owners of the business. Also as suggested by the Kirk Panel report, I think that the profession and individual firms need to consider ways to reduce pressures that could have the effect of compromising a firm's internal consultation processes for resolving client financial reporting issues and for developing positions on standard setting and regulatory proposals. Those suggestions include, for example, assuring that national technical functions are insulated from undue client pressures. With respect to services that may affect the fact or perception of auditor independence, I commented earlier on issues relating to outsourcing. Similar issues are arising with other emerging services that may involve the auditor too directly in management activities or that may align the interests of the auditor too closely with those of management. For example, some services might result in the auditor being too actively involved in the development of strategies for the investment of capital or the deployment of resources to address the client's business risks and opportunities. For those issues, the direct approach may be the most viable approach. That approach would call for a more restrictive interpretation of services that would impair auditor independence with respect to SEC registrants. If such an approach were implemented, it would mean that all firms serving SEC registrants would be similarly restricted. Another approach that has been suggested would be to consider whether the audit and attest function could be "walled off" in ways that would strengthen public confidence that the independent auditing function would not be influenced by other relationships. Whether it is feasible to establish "firewalls" that would be credible, and would be recognized by the public as credible, is not clear. In today's environment of revenue and cost sharing alliances and other direct and indirect financial relationships, it may, in fact, be too problematic and lead to "feel-good" kinds of solutions that may deal with some issues, but not others. Nonetheless, it may be useful to think about and explore such an approach. While the issues are complex and the solutions are not easy, what is clear to me is that the continuing concern about auditor independence is an issue that has serious implications for the image and stature of the profession -- one that the leadership of the profession, including its self regulatory processes, needs to address. And as we do, I think we have to avoid seeking solutions that sound good, but that are "fuzzy" and avoid taking meaningful action and, thus, raise independence to a higher level of concern. If the profession is to continue its special relationship as the exclusive provider of auditing services to registrants, the Commission and the investing public have a right to expect it to find ways to continue to assure that the heavy responsibilities that go with the role of independent auditor are met. I urge the profession to consider thoughtfully the enormous benefit that society has given it, and the privilege through self-regulation of preserving and enhancing that valuable franchise, and to weigh carefully the costs of losing public confidence. Going forward, the staff will continue to interpret and apply the Commission's independence rules in the best interest of investors and the public, as we see it. We will continue to consider the potential impact on independence of non-traditional auditor-client relationships and other potential independence impairing issues as they arise, and we will expect to challenge the independence of auditors when we believe that the facts and circumstances warrant that action. And, we will continue to consider and discuss with the profession and business leaders how the broader issues that I have commented on today might be addressed. That concludes my prepared remarks. I would be happy to respond to your questions. * * * * * * * 1 Blalock, Jane, "For Many Executives, Ethics Appear to Be a Write-off," 2 The Wall Street Journal, March 26, 1996, at C1.2 Accounting Today, March 18 - April 7, 1996, at 13.