Bampton, Near Tiverton
Devon EX16 9HU
Telephone/fax 01398 331 418
Mr. Jonathan G. Katz, Secretary,
Securities and Exchange Commission
450 Fifth Street N.W.,
Washington, D.C. 20549-0609
24 September 2000
Dear Mr. Katz:
File No. S7-13-00 Submission by Brian Currie
Iím sorry to be on the last day with this submission, but your rather short consultation period has coincided with a busy period.
I am a chartered accountant in the UK. I retired from the practising profession ten years ago. In recent years my contacts with the profession have been as client rather than colleague. I have no longer any working involvement in the profession.
My first reason for writing to you is that I value greatly the part that the accounting profession plays in our communities (yours and mine). I describe in Annex 5 why I continue to give time to helping the profession improve its structures.
My second reason for writing to the SEC is that I have been much involved in work on professional independence. After retiring I conducted a personal study of the issues of independence for the accounting profession. In reporting my conclusions I set out the first elements of a new more structured approach to professional independence.
This became widely known as the Framework for Independence (in this paper I call it the Analytical Framework, purely as a title to distinguish it from the framework posited by the SECís proposals). It has progressively been adopted as the core of the ethical independence requirements for the bodies of Chartered Accountants in the British Isles, by FEE for Europe, and by IFAC. I was closely involved in the development of the framework and its application to a variety of different countries.
(My background and qualifications for opining on regulatory matters are set out in Annex 4)
Although the Commission speaks of its proposals as forming a framework, the document appears to take little note of this existing Analytical Framework already adopted elsewhere.
I fear that the framework suggested by the Commissionís proposal lacks in important areas the logical integrity and consistency which it might have secured by using the concepts in the Analytical Framework. It would have benefited if it had made greater use of work done elsewhere.
The Analytical Framework includes a number of elements:
I attach (at Annex 1) an extract from a speech I made to an international conference many years ago during the early development of the Analytical Framework. It will serve to set out for the Commission some of the central features of the Analytical Framework. There are of course plenty of examples of the developed framework in use as a regulatory instrument. The Commission could inspect these to see how the framework is actually used.
I commend to the Commission the thought that it should approach its rule-making by incorporating more explicitly the terminology and structure of the Analytical Framework. It would enable the Commission to make clearer the thought processes by which it arrives at whatever prohibitions and exclusions it finally concludes are right. As a regulator at the time, this was part of my purpose when I launched the first drafts of the Analytical Framework. I set out in Annex 2 some of the considerations I recorded at the time of designing it.
This would also serve a number of useful purposes on the international scene by strengthening yet further the authority of the existing Analytical Framework (whereas the SEC purporting to reinvent yet another framework will scarcely help it). That purpose may strictly lie outside the statutory duties of the SEC. But the Commission will recognise that in dealing with global businesses and firms it will be helped in its domestic duties by adopting common ground with other regulators outside the USA, and by taking advantage of principles and standards which have already gained respect and acceptance elsewhere.
I do not comment much on the detailed rules emerging from the SECís proposals (regulation differs with culture and we have learned, in using the Analytical Framework, that its central structure may give rise to different rules in different countries because of underlying differences in culture, law and commercial structures Ė see annex 5). I comment rather on the foundations on which the proposals are based. Two of them are based on intuitive assertions rather than analysis and they are expressed in language which is too general and imprecise for use as the universal premise for an extensive set of rules. I know the Commission will now have a lot of reading to do and I have not sought to write in too much detail, but I provide brief illustrations in Annex 3 of the main and rather serious problems I see.
Annex 3 may thus be the most important part of this submission for the reader, though the other annexes will provide a better understanding of the background and my reasons for the criticisms and suggestions I offer.
I strongly believe that the Commissionís proposed rules would be more logical (and probably different in their specific prohibitions) if they were based on the kind of analysis that the Analytical Framework provides. I believe they would also command more support from the key constituency Ė the profession to be regulated.
If I can help by expanding on any of the points made in this paper and its annexes, please let me know.
Extract from speech introducing the Analytical Framework
Considerations in designing the Analytical Framework
Suggestions for improving the foundations on which the SEC Proposal is built
Authorís background qualifications
Why bother to seek a universal framework?
Extract from early speech introducing the Analytical Framework
Ö At ICAEW's request, I studied the profession's ethical rules on independence. I reached many conclusions. Some of the earliest were these:Ö
6)ÖThe connection in the existing guidance between rules and their purpose, objectivity, was intuitive rather than reasoned and was not always easy for practitioners to understand. I concluded that there had to be a better structure for regulating a profession.
7)Our previous guidance, though clearly requiring the auditor to address the issues of independence, said relatively little about how and when issues should be addressed, or who was responsible for addressing them.
I developed a procedural framework built round the following introduction (following the preliminary sections on our fundamental principles of integrity and objectivity):
In order to safeguard their objectivity, members contemplating audit or any other role or engagement requiring objectivity of judgement should consider certain matters before deciding whether to accept or continue the appointment. The matters to be considered fall under the following headings:
The expectations of those directly affected by the work.
The public interest and its bearing on the work.
The threats to objectivity which may arise actually or potentially because of the expectations.
The safeguards which are or can be put in place, overt or otherwise, to offset the threats."
This process should normally be documented in writing.
8)Practitioners, and probably observers, will be helped in their thinking about independence issues if we adopt uniform and generally accepted terminology for analysing the nature of threats to objectivity. I proposed some headings for this analysis:
1.The Self-Interest Threat -A threat to the auditor's objectivity stemming from a financial or other self-interest conflict.
2.The Self-Review Threat -The apparent difficulty of maintaining objectivity and conducting what is effectively a self-review, if any product or judgment of a previous audit assignment or a non-audit assignment needs to be challenged or re-evaluated in reaching audit conclusions.
3.The Advocacy Threat -A risk to the auditor's objectivity, if he becomes an advocate for (or against) his client's position, particularly in any adversarial proceedings or situations.
4The Familiarity Threat -A risk that the auditor may become too trusting of the client's representations so as to be inadequately rigorous in his testing of them - because he knows the client too well or the issue too well or for some similar reason.
5The Intimidation Threat -The possibility that the auditor may become intimidated by threat, by dominating personality, or by other pressures, actual or feared, by the client or an associate of the client or by some other party.
We have found that this analysis makes it easier to discuss and understand activities or dependencies which might threaten the objectivity of the auditor. Each of these threats may be serious (sometimes so severe that the auditor must recognise that they raise insuperable obstacles to objectivity Ė and the codes and guidance developed around the framework make these situations clear). More often the threat may be relatively modest and capable of being overcome by additional procedures or safeguards.
9)Safeguards. It was apparent that there were many procedures and control within firms, within their clients, and within the structures of the profession which helped practitioners to resist or remove threats to their objectivity. There were also specific steps that could be taken in response to certain types of threat which achieved the same. While some of these safeguards were referred to in our existing guidance, the framework set out to present it in a more organised way. This helps practitioners to place adequate but not excessive weight on them.
The external perception of Independence
All the ethical codes and sets of rules which have evolved around this central framework set heavy emphasis on the need to take into account not only the auditorís own view of his objectivity but also the perception by others.
Regulation of Independence
From a regulatorís point of view, one of the strengths of the Analytical Framework lies in its procedural requirements. Most regulators have laid down that the analysis procedure described in paragraph (7) above requires to be evidenced. In practice that usually means recorded in writing. Such a record provides valuable evidence as to how any specific problem was addressed. More valuably it also provides (through audit monitoring or peer review etc) good evidence as to how firms, offices and individual auditors approach the requirement to assess their independence. It enables a reviewer to judge the thoroughness of their review and the integrity of their conclusions. This is the tool that a regulator needsÖ..
Considerations in designing the Analytical Framework
The easiest form of regulation is to prohibit activities in response to real, imagined or suspected abuses. Unnecessarily prohibiting activities narrows the choices of clients and restricts markets. From all of history we should have learned that to prohibit something is the poorest way of regulating it.
If we can't persuade people of the merits of appropriate behaviour, they will find a way, legal or illegal around our regulations. People may think that if we prohibit temptation we will remove the risk of sin. It never works like that. Many professional prohibitions work well - but only because the practitioners were already persuaded of the need for the requirement. Prohibitions only work well if they codify or elaborate the codification of accepted good practice.
The connection in the guidance between rules and their purpose, objectivity, has been [before the Analytical Framework] intuitive rather than reasoned. Often the prohibitions were arbitrarily expressed and gave rise to unfairness in particular circumstances Ė as arbitrary rules do. Rules are only easy for practitioners to understand and comply with if they are derived from principles which the practitioners accept as right.
My vision of the professionís ethical code is one that provides a common core of principles, which everybody understands and knows and which are quite brief.
And then everything else, although it may be written down and interpreted, flows from it so logically that members of the profession almost donít need to read it to know what it says.
"Independence" risks becoming a "blur-word". It is a word used by different people to mean different things. Yet they speak to each other as though it means the same thing to them all. I dislike terminological arguments. But we have to be precise if we want to avoid confusion from the outset.
Independence is a shorthand expression for: "Freedom from dependencies which are likely to impair the objectivity of judgment required by the auditor".
What sort of dependencies are we to include?
It is not logically possible to exclude an auditor from all relationships between himself and the entity to be audited. Yet every relationship entails some dependency. In other words there can never be anything absolute about independence. It is a relational word. In practical terms it is much more meaningful if we talk about the need to protect the auditor's objectivity. (Though I fully recognise that at the end of the analytical thinking we have to revert to the use of the word "Independence" because thatís the word we use in public debate and regulation. We must avoid letting the word confuse us).
For these and other reasons it will not be feasible to eliminate every relationship which might, from an external observer's viewpoint, impair objectivity. I donít illustrate this in the space of this paper. But if one examines scenarios about arrangements which professional regulators or external legislators might impose on the profession in an effort to eliminate any perception of possible dependency, they ultimately don't work. There will always remain residual traces of dependent relationships which could (and therefore doubtless would) be taken as a threat to independence.
This leads me to conclude that arguments based solely on the appearance of independence required careful examination. The structure of the Analytical Framework is designed to provide terminology and analysis to strengthen this careful examination.
Once we begin to depart from what has been generally accepted by practitioners, intuition is not enough. We need to be powerfully analytic and persuasive. We need [an Analytical Framework] as a powerful tool in explaining to practitioners quite specifically what the threats are to their objectivity, how far safeguards will work and why, if necessary, any new areas of prohibition or restraint are needed.
Equally, and just as important, the profession will be right to ask that any parties who would urge new rules upon it should also leave intuition behind. They should use these more analytic approaches to explain in detail what types of threats to auditors' objectivity they are addressing, how far safeguards will work and their logical justification for proposing any new areas of prohibition or restraint.
Prohibitions are no less likely under the Analytical Framework. But they will be supported by it and developed from the fundamental principles on which the framework is based.
Suggestions for improving the foundations on which the SEC Proposal is built - by use of the premises in the Analytical Framework
I have considered the foundations on which the SEC says that its proposals are to be based, the premises from which the proposed rules are to be derived.
The Commissionís proposed rule identifies four governing principles for determining when an auditor is not independent. They are when the auditor:
"We believe these four basic principles provide a framework for analysing auditor independence issues, in that actions inconsistent with one or more of these principles would result in a lack of auditor independence. We apply these principles in the remainder of the rules."
The second and the fourth are based on intuitive assertions rather than analysis. I also find that they are expressed in language which is too general and imprecise for use as the universal premise for an extensive set of rules. Like many intuitive ethical statements they will tend to command assent from the uninformed who will not be conscious of the many exceptions which make them unacceptable as universal principles. The principles which govern a set of rules must be capable of universal application.
To illustrate the point (and in an effort to keep things as short as possible) I will in this submission concentrate on the second of these headings (the auditor is not independent when auditing the accountant's own work).
First, to any experienced auditor it lacks conviction as a principle. The terms it uses are too broad. It is a principle that would exclude much work that is an essential part of the audit process. Let me illustrate.
The audit process is a complex one embracing many phases in which professional auditors are rescrutinising their own work and conclusions and those of other members of the audit team. During the work a large volume of the working papers will comprise the "point sheets" or "review queries" (there are many names) created by members of the team as they review each othersí work. An auditor must rescrutinise his own previous findings and the findings of the rest of his team at many points in the audit. For example:
These activities clearly all fall within the definition "auditing the accountant's own work". The principle ought to prohibit them if it means what it says. But they cannot be prohibited.
These activities of rescrutiny are no different in their essential nature from the examination an auditor would make if another member of the firmís staff had:
It is beside the point whether any of these activities is permissible or otherwise. The principle as stated appears to debar them. Yet it is clear that the SEC proposal does not seek to prohibit all these activities which fall outside the strict parameters of the audit process Ė nor should it.
[One comment I offer en passant from long observation of many different firms in action is that an auditorís self review scrutiny of a colleagueís work will be even more thorough than his scrutiny of the work of a third party Ė simply because of the increased risk to the auditorís reputation if something is missed.]
In dealing with self-audit or self review, there is always a spectrum of circumstances along which the threat varies from mild and acceptable (with safeguards) to severe and unacceptable. It is this spectrum which makes essential the approach adopted in the Analytical Framework. Self review is one of the defined areas that give rise to threat or risk Ė and the analysis proceeds from there to determine how serious the threat is, and where it lies on the spectrum. There is certainly ample scope for prohibitions at the end of the spectrum where the extent of self review is so great that the threat appears insuperable.
The difficulty about the SEC proposalís premise (the auditor is not independent when auditing the accountant's own work) is that it intuitively seems right, yet a little exploration of its significance shows that it is over-simplified as a premise. There are going to be so many exceptions that it cannot be the right universal premise on which to build a regulatory system.
The premise of the Analytical Framework, on the other hand, is that self review always gives rise to a threat, which must then be analysed to ascertain its extent and severity. The guidelines and regulatory codes set out approaches to measuring the degree of threat, possible safeguards, and conclusions. The conclusions certainly include prohibitions where it is evident that the threat is severe. But the approach is more logically reasoned than that set out in the SECís proposal.
The Commission may see this problem as purely a linguistic problem. It may be tempted to address the contradiction by refining and redefining some of the words in its basic premise (the auditor is not independent when auditing the accountant's own work). I would prefer to see it adopt the premise from the Analytical Framework: "Self review always gives rise to a threat, which must then be analysed to ascertain its extent and severity".
There are some other points to be made briefly. The SEC proposal omits, but ought to include, reference to a number of criteria which are essential to an assessment of the extent and severity of a self review threat. Such criteria are illustrated by the following questions:
Further consideration of criteria such as these, combined with better premises, would enable the SEC to refine the rather blunt prohibitions it proposes, for example on financial information systems design and implementation.
In a small business the auditor is the natural person to advise on the selection of accounting software packages and will inevitably assist with the development of coding and closing routines. This work is not likely to jeopardise the auditorís objectivity, not would outside observers generally suppose that it would. Granting the differences in scale, it is not necessarily the case that the auditor jeopardises independence by assisting a large business in a similar way. The SEC proposal appears to recognise this by the exception discussed for work on internal control ("Our proposed rule would not, however, cover services in connection with the assessment, design, and implementation of internal accounting and risk management controls.").
The criteria for this distinction are not clear. It is a distinction made intuitively Ė it ought to have an analytic rationale behind it. I believe the section would be clarified if more use were made of the threat analysis provided by the Analytical Framework.
There clearly are serious issues of independence and objectivity which arise when auditors perform extensive systems work for clients. But I doubt whether the SEC is right to identify the self review (auditor auditing own work) threat as the main threat.
I suggest that the threats arising under other aspects of the Analytical Framework probably identify risks which it is more important to address:
[The risk of getting into managementís shoes is not identified as a separate threat to independence under the Analytical Framework though it has been considered from time to time. Guidance/regulatory codes typically say that all of the threats to objectivity (categorised in the Analytical Framework) would affect the auditor who took management decisions, and their combined weight would make it impossible for an auditor to claim to have retained objectivity in audit reporting.]
I strongly believe that the Commissionís proposed rules would be more logical (and probably different in their specific prohibitions) if they were based on the kind of analysis that the Analytical Framework provides. I believe they would command more support.
I also believe that some of the questions that the Commission is obliged to ask in its detailed consultation would not arise if the proposed rules were derived from the premises available in the Analytical Framework. Some are questions which arise from apparent inconsistencies in the proposed rules. These inconsistencies stem in their turn from their foundation on a false premise.
Background - Brian M Currie MA, FCA, FIMC
Retired from the practising profession in 1990.
Current activities: small amount of informal advisory work for the UK government, farming and work as trustee for several charities.
MA at Oxford (Greats - moral philosophy and classical studies).
After service as an army officer, qualified as a chartered accountant.
Considerable experience working at different times as an auditor and as a management consultant and periods in charge of practising firms in both fields.
For some years a big five managing partner in London
Finance director in a major organisation.
Judge in the UK Restrictive Practices Court (for 21 years).
Member of the London Take-over Panel.
Chairman of several regulatory bodies, member of others outside accounting profession.
Chairman of several major disciplinary investigations and enquiries (for the profession, for the government and for other bodies)
Arbitrator appointed by the government.
Past President of the Institute of Chartered Accountants in England and Wales
Deputy Chairman of the UK Financial Reporting Council (responsible for Accounting Standards and Financial Reporting in the UK)
A leading member from the outset of the Regulation Review working party which devised the new UK regulatory arrangements for the accounting/auditing profession and chairman of sub-committee designing new investigation and disciplinary structures.
In short, extensive experience of regulation from both ends and in the course of developing better regulation have done much thinking about it.
I proposed in 1992 the first elements of what is now widely known as the Framework for Independence. It has progressively been adopted as the core of the ethical independence requirements for the bodies of Chartered Accountants in the British Isles, by Fee for Europe, and by IFAC. It is also central to the recommendations being prepared for consultation by the EU Committee on Auditing.
Why bother to seek a universal framework?
I believe the work that independent accountants do in their communities is a considerable force for good. I have in mind particularly the small firms whose advice and service to the small businesses they audit is an immense force for honest and fair behaviour. The large firms equally have an important effect on the morality of larger businesses.
This good work is largely done unseen. For every fraud committed or irregularity undetected, there are thousands of occasions when impropriety dies at birth because someone round the table says "The auditors would never accept it". Scores of schemes are envisaged and abandoned because the auditor, when consulted in confidence, advises that the actions contemplated would be in breach of law or inconsistent with duties of the directors or the management. The force and extent of this moral influence is unrecognised but huge.
Practitioners take it for granted in their daily lives, but seldom pause to consider what an enormous power it represents for the public good, when spread across a large and dispersed profession. Much of this happens because auditors are generally advisors and counsellors to their clients. Diminishing their role to audit alone risks sacrificing this great benefit.
We have an advantage that our commercial scene is pervaded with people who have been taught to observe the spirit of the rules Ė not only accountants and auditors but many other professions as well. But we need to consider the world the next generation may inherit! If we have a community that is (on the whole) committed to ethical principles and can find adequate ways of detecting and interdicting the occasional miscreants, we have a blessing. If we donít, we risk a slide towards the commercial morality which brings capitalism the bad name it has and deserves in so many other countries.
Regulators have an important role to play in this. Good regulation proceeds on the basis of general principles which are supported by the population they are to regulate. Good regulators place the highest priority on the need to capture the hearts and minds of the regulated and their commitment to the principles. The detailed rules by which they will police the wicked and the incompetent are important but subsidiary. . Good regulators recognise that positive precepts are better than prohibitions. Good regulators know that they help the regulated to stay within the rules if they provide the format that most practitioners find helpful:
There a number of ways in which bad regulation could seriously diminish the vale of the profession to our communities. I will not enlarge on them Ė but I mainly fear two possible outcomes:
Commerce is becoming more global. In the course of this, our businesses face the choice of exporting their principles or importing those of other countries. We can bring global standards of behaviour up to ours, or we can let ours sink to what is found elsewhere. The profession cannot export detailed rule books. It can only export frameworks and principles.
Many of the differences in professional ethical codes between countries are no accident. They spring from deep underlying differences in culture, in commercial law and practice, in economic and commercial structures. They reflect the differing needs of the societies where they were developed. The corollary is that we must be patient and ready to take a long-term approach to the harmonisation of detailed ethical rules. It would be careless indeed to suppose that the specific detail of professional ethical rules could meaningfully be harmonised until the harmonisation of culture, law and structure between countries has proceeded a long way from where things are today. But what we can do in the meantime is adopt, in our own countries, central principles and frameworks for regulation which can be readily understood by cultures different from our own. This will provide them with a model which they can copy and harness to their own specific needs.