ENSURING THAT EXTERNAL AUDIT SERVES THE PUBLIC INTEREST

Submission by Ernest J. Pavlock, PhD, CPA, and Henry E. McCandless, MBA, CA, to the United States Securities and Exchange Commission, in response to the Commission's June 26, 2002 SEC Proposal for a Public Accountability Board, File No. S7-24-0

The State We're In, And A Way Out

In the past six months newspaper headlines about the Enron-Andersen disgrace have been astonishing indictments of the accounting profession - a profession that has suddenly lost its stature in the eyes of the public. The accounting profession is no longer being referred to as a profession, but as an "industry." We have witnessed external auditors being the target of late-night talk show harangues, cartoons and email jokes. Not too long ago we would have never thought that such indictments could occur, let alone for obstruction of justice.

The profession's stature disintegration has had to be acknowledged by its leaders and practitioners.  Recently, the Chairman of the Board of Directors of the American Institute of Certified Public Accountants called for action to restore public confidence in public accounting.  Paul Volcker, former Federal Reserve Chairman who was engaged by the embattled Arthur Andersen LLP to map out a future but resigned without doing so, stressed that "litmus tests" are needed for accounting reform.  In considering current alternatives proposed for a new regulatory approach involving an oversight body for the profession, he urged that one of the tests should be "Does the proposed legislation provide real independence for the oversight board, with the membership representing the public interest rather than industry perspectives?"  Recently, the SEC and related oversight bodies in Congress have each announced proposals to reform the "accounting industry." While these initiatives represent interesting beginnings for change, they lack fundamentals of reform going beyond the regulatory and policing orientation that has typically been the governmental oversight approach.

Specifically, the SEC Proposal 33-8109 of June 26, 2002 calls for the establishment of a Public Accountability Board (PAB) and lays out a framework for the Board.  The proposal describes the Board's work as a system of "private sector" (but not "self") regulation that would be under the control of the accounting profession and would be convergent with SEC's own oversight and enforcement tasks.  While the provisions address needed aspects of control and should provide a beginning for substantive change, the PAB approach does not go far enough.

Although the Board is called an "accountability" board, its mandate as proposed by the SEC is a policing, regulating and sanctioning mandate. The SEC appears not to expect the Board to hold to account, which is to say it would not expect the Board to exact needed public accountability reporting from those with the responsibilities.

Responsibility is the obligation to act, while accountability is the obligation to answer for the discharge of one's responsibilities. These are related obligations, but they are separate obligations. The proposed PAB would therefore not exact the kind of public answering from corporate boards and auditors that can be expected to exert a self-regulating influence on those people. The answering requirement exerts a self-regulating influence, because if answering that must be given publicly and to a standard is misleading or purposefully deceptive to the point of lying, it can be quickly exposed by validation of the fairness and completeness of the answering. With monitoring and policing we must also have public answering and its validation.

The SEC's proposal can be characterized overall as following the traditional oversight and regulatory response to police the conduct of financial statement filers and public accountants' attestations of the filers' assertions. We believe that a new approach is necessary to right the current disarray in the financial community and the critical loss of investor confidence -- especially with WorldCom and Xerox following Enron, and the SEC's response to Enron having being seen by the media as weak.

The Need for Holding to Account

The nature of the Enron-WorldCom-Andersen disgraces is so profound, and the reputation of the accounting profession so reduced, that the SEC's proposal needs to be strengthened.  Congress must apply the public answering obligation not only to the profession but also to any oversight body for the profession, and indeed to the SEC itself for its oversight duty.  This would serve the needs of all those concerned with the issuance of annual financial statements by public companies.  These stakeholders include shareholders, creditors, prospective investors, those managing mutual funds and pension accounts and other investment holders, corporate employees, and suppliers of services and goods. As well, the regulating government agencies are major stakeholders.  Ultimately, and most important, is the investing public at large, whose confidence in corporations and their audit significantly affects the economy.

As members of the accounting profession in North America, we argue that genuine public accountability must be accepted by the profession. For the accounting profession to regain its stature in the eyes of society, it must be seen to respect and serve the public as its primary client.  In the past, the accounting profession saw only existing shareholders and creditors as the stakeholders.  Now the facts -- which suggest that management has become the real client for too many auditors -- demand that the public be installed as the primary stakeholder, and that the profession account to the public. Within that imperative, other constituents can still be satisfied by the quality of the profession's services.

The public, through its elected representatives and the SEC, must now hold to account because:

(1)   The effects of the Enron-WorldCom-Andersen disgrace have been unprecedented, causing general distrust in corporate CEOs and boards as shown by the now seriously-depressed stock market. The needed changes therefore must be seen to alter the fundamental bases and structure of financial reporting and attestation.  The reform must be such that members of the profession, business, government and the public at large see it as drastic, but support its implementation as necessary.

(2)  The underlying causes of financial reporting and auditing shortcomings must be identified and dealt with, not just the symptoms. Congress can ask the General Accounting Office to report on this issue. To be fundamental, changes must encompass the responsibilities and answering obligations of all key authorities, not just employee CEOs asked to vouch for their financial statements. Authorities include corporate boards of directors having the statutory duty to direct and control executive management, and governmental oversight bodies. There must also be changes in the way Congress itself deals with these issues.

(3)    The public is the only neutral and objective stakeholder not having a special interest to protect.   Public awareness about how well the accounting profession is reporting publicly on how it is conducting itself will keep pressure on members of the profession to account adequately for their professional integrity. It is therefore necessary that the profession and bodies such as the proposed Public Accountability Board account to the public.

Two Specific Proposals

The first proposal is formal installation of the public answering obligation. Whether it is SEC's proposed Public Accountability Board or another form of oversight body emerging from Congressional action, that body can be expected to publicly report what it intends as its tasks, and why; what its performance standards are; what its results are; and what it learns and how it applies its learning. If it is a PAB within the accounting profession's ambit, it would report publicly to the SEC, which would confirm the standards for the Board's accountability reporting for its performance. The SEC would in turn report publicly to the Congress on the Board's effectiveness, and on other remedial measures the SEC itself takes. The SEC reporting obligation would be legislated. If it is, the General Accounting Office, as a servant of Congress, can be asked to report on the SEC's oversight diligence -- including any external constraints standing in the way of the SEC doing its job -- and on the quality of the SEC's own accountability reporting.

The second proposal is that Congress and the SEC should oversee the speedy forging of a formal contract between the accounting profession and the public, in part to overcome the "Leave it with us" tendency in all professions. The contract would state clearly that the profession considers the public and the public interest to be the primary client for its professional services. By the terms of the contract, the profession would publicly answer for its performance, initially on an annual basis.

The main components of such a contract are proposed in Appendix A.

The profession's leaders would provide an initial draft of the contract, which would then be challenged by the SEC and by appropriate Congressional committees on behalf of citizens. Both would publish their assessments of what the profession proposes. The draft would set out the specific responsibilities and key performance standards of the accounting profession as its members see them, and how the profession will answer to the public for its performance and external constraints. The requirement to account publicly can be expected to influence the profession in meeting these contractual obligations, and in otherwise conducting itself to regain its stature.
Both of these proposals relate to President Bush's call for a "new ethic of personal responsibility." But the proposals add the important element of public accountability that is needed to renew the critical public trust in corporate boards and management, and in the accounting profession which the President labeled as essential in restoring confidence in the capital marketplace.  Trust emanates from a full and fair accounting of one's performance.  Finally, the proposals recognize the inability of regulation and punishment alone to bring about integrity, and that full personal responsibility cannot be assured without adequate public answering if those accountable are to achieve the standards of conduct that the President has called for.

How Our Recommendation Fits With the SEC Proposal

We see our contract proposal as buttressing whatever is decided in new laws and rules and for compliance with them by boards and management of corporations and by professional practitioners. We think it would help the SEC's oversight to have the leaders of the accounting profession step forward and lay out for the SEC and legislators what they see as their public accountability contract with Americans.  We believe that having such a public contract in place would help compliance with any new regulatory framework. Furthermore, the accounting profession would be perceived as taking credible steps to regain public confidence.

Notes:

1. Basic tenets of the public answering obligation are explained on the website of the Citizens' Circle for Accountability, at www.accountabilitycircle.org  <http://www.accountabilitycircle.org/> and more fully in  A Citizen's Guide to Public Accountability: Changing the Relationship Between Citizens and Authorities, by Henry E. McCandless (ISBN 1-55512-957-8; 2002)

This SEC submission will be posted on the CCA's website.

2. Appendix B sets out twelve principles of accountability and six basic standards for public answering, taken from the CCA's Website. The inaugural February 2002 issue of the Journal of Public Accountability in the CCA website includes the related article, "Response to Enron:  Public Answering" by Dr. Pavlock. The article argues that citizens themselves can hold to account, through citizen committees, if they see that action is inadequate.

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July 9, 2002

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Ernest J. Pavlock, PhD, CPA, is Professor Emeritus of Accounting, Virginia Tech, Blacksburg, Virginia, and resides in Reston, Virginia. He was previously a partner in the international accounting firm of Touche Ross & Co and the Controller of a medium-sized manufacturing company. Author of several books and many professional journal articles, he also develops and instructs seminars in accountability for business and government and publishes The Accountability Network Newsletter. Dr. Pavlock is the financial accountability Convenor for the Citizens' Circle for Accountability.

Henry E. McCandless, MBA, CA, is a writer and consultant in accountability, living in Victoria, BC, Canada.  With a twenty-year background in the Office of the federal Auditor General of Canada, he has advised on accountability in Internet networks and in parliamentary and professional journals.  Mr. McCandless is the author of A Citizen's Guide to Public Accountability and is the initiator and developer of the website of the Citizens' Circle of Accountability, of which he is General Convenor.

APPENDIX A

THE ACCOUNTING PROFESSION'S CONTRACT WITH AMERICANS

PREAMBLE

Whereas professions affect the public in important ways, and receive recognition, status and income ultimately from the public, it is reasonable that the accounting profession declare to the public the performance standards that it sees as reasonable for its members, and report whether it is meeting them. 

Article One
The Responsibility of the Accounting Profession

The accounting profession exists to serve the public interest. In discharging this responsibility, the primary duty of its members engaged in external audit is to credibly attest to the fairness and completeness of significant public assertions made by the governing bodies of organizations in their role as the directing minds of those organizations. The criterion of "fair and complete" means that the reporting can be expected not to mislead stakeholders, who must make important decisions about the reporting organization and its audit. Reporting not being fair and complete would include the governing body failing to assert publicly whether the organization is complying with the law, and whether board-supervised management control within the organization is adequate for the organization's responsibilities in the public interest. For members of the profession engaged in accounting and control responsibilities within organizations, their counterpart task is to apply professional standards that improve the usefulness of what the governing bodies of their organizations intend to report to stakeholders.

Article Two
Statement by the Profession About Its Responsibility

In the contract, the accounting profession will assert that at all times it will serve accountability relationships in the public interest, and that its members will meet standards of competence and independence that the public can reasonably expect them to meet. The profession will publicly report what stands in the way of its members in discharging their responsibilities.  The public includes citizens, organizations, groups and governmental entities that have a legitimate and significant social, financial, property or personal decision-making interest in the intentions, actions and results of entities operating in the United States and of United States entities operating elsewhere.

Article Three
Statement of the Profession's Public Answering Obligation

The public, in its ultimate oversight of professions, can reasonably expect the profession to regularly and publicly assert: (1) its  specific achievement objectives in the public interest; (2) its  key performance standards for its members in both accounting and attestation; (3) whether these standards are being met; and (4) how the profession has applied the learning that significant occurrences in the profession's experience have or should have produced.

APPENDIX B
PRINCIPLES OF PUBLIC ACCOUNTABILITY AND BASIC STANDARDS FOR PUBLIC ANSWERING

Twelve Principles of Public Accountability

The following principles of public accountability serve as a basis for public answering standards for different types of important responsibilities. The adequacy of public answering will be of concern to different groups of people, for example in health, social justice (which includes financial stewardship and reporting issues), education and environment.

1)  The public accountability principle:

Every responsibility that affects the public in important ways carries with it the obligation to answer publicly for the discharge of the responsibility.

Rationale: It makes no sense to assign important responsibilities to authorities and then allow them to act without attaching the self-regulating influence of answering to the public. Regardless of the inadequacy of public answering obligations in existing law, it is reasonable to expect the directing minds of corporations, governments and other authorities to answer simply as an obligation in fairness.  With institutional deception pervasive, we cannot expect people in authority who have no answering obligation to put the public interest before their own needs and wants.

2)  The precautionary principle:

We apply to authorities' intentions in all responsibility areas, the precautionary principle we apply in safety and environmental protection.

Rationale: This principle requires authorities to demonstrate, through validated public answering, that what they intend will not lead to harm or unfairness.  Citizens should not have to prove that the authorities' intentions are harmful or unfair. Authorities must show why an intention significantly affecting the public is really needed; that it satisfies public needs and not just certain people's wants.

3)  The principle of coherence in assigned powers, duties and accountabilities:

Public answering obligations attach to each power and duty of authorities, in sufficient rigor to tell the public whether the powers and duties are being discharged in the public interest.

Rationale: Power, duties and answering must be in balance. Powers and duties should not be legislated for governing bodies without adding the public answering requirement.  Similarly, duty is empty without the authority to carry it out, and it is unfair to hold a governing body responsible for something that is beyond its power to control. In corporations, however, the board of directors has control over what the corporation does or reports, and can report external constraints that it cannot control and what it is doing about them.

4)  The principle of identifying the directing mind:

To make accountability effective, those holding to account identify the directing minds answerable for what a government, corporation or other organization intends to do, actually does, or fails to do.

Rationale: Holding fairly to account will succeed only if citizens hold to account the actual directing minds -- those who have the responsibility to determine the intentions and actions of concern.  If we hold to account only those at a lower level and fail to deal with the persons ultimately responsible for the intentions and needed control, we have no basis for expecting improved safety, fairness and justice in society, or improved integrity in government, business and the professions.

5) The principle of self-informing duty:

People in authority whose responsibilities affect the public in important ways inform themselves for their decision-making to a self-informing standard that citizens have the right to see met.

Rationale: The self-informing principle implies that authorities will know what constitutes reasonable information for due diligence in their duties and obtain it. And to the extent called for, they will validate the information they get.  They will not simply rely on whatever information is tacitly agreed to be given to them and then invoke "plausible denial" -- saying, "I didn't know," or "I wasn't informed."

6)  The principle of answering for precautions taken:

For the responsibilities they control, authorities answer publicly for the extent to which they apply the precautionary principle in their own decision-making.

Rationale: Authorities can be expected to answer for obtaining reasonable assurance that it is safe or fair to proceed before going ahead, and for what precautionary action they took if the assurance of safety or fairness is uncertain.  The principle implies that authorities don't make citizens take risks that are feasible to avoid.

7)  The principle of intentions disclosure:

People in authority who intend action that would affect the public in important ways state publicly the outcomes they wish to bring about, for whom, and why they think the outcomes they intend are desirable and fair. They also state their own performance standards and the standards for those whom they direct, which clarify their outcome intentions.

Rationale: Without full and fair intentions answering before the fact, citizens have no way of knowing whether they should commend, alter or stop authorities' intentions.

8)  The principle of corporate answering for fairness:

The directing minds of corporations answer publicly for the extent to which they serve the public interest as well as the interests of the corporations' management, owners and investors.

Rationale: It is reasonable that boards of directors publicly explain how they are serving the public interest when their intentions for corporate action could reasonably be said to affect the public in important ways, whether in safety, health, social justice (which includes fairness to employees and investors) or in environmental impact.  Also, it is reasonable that those responsible for governing and for regulating corporations report the extent to which their supervision meets the intent of the precautionary principle.

9)  The principle of performance disclosure:

Authorities disclose their achievements or lack of achievement through adequate public answering, which is given by those responsible for the achievement objectives, performance standards and actual performance.

Rationale: It is reasonable to expect people in authority to report publicly the results of their actions, why results were not as intended if that is the case, and the learning they gained and how they applied it. Performance reporting reflects what is fairly within the control of those accountable and includes how external constraints are being coped with.

10)   The principle of answering by those responsible:

Those with responsibilities give the answering, not someone else such as subordinates or external examiners such as auditors, inspectors, inquiry commissioners, ombudsmen or others.

Rationale: It is reasonable to expect the directing minds themselves to account for their responsibilities.  External examiners stand outside the accountability relationship.  It is not acceptable that the statutory and logical directing minds leave the answering obligation to subordinates, such as chief executive officers. It is also reasonable that governing bodies responsible for holding others to account answer for their knowledge and supervision of those others' actions.

11)   The principle of validation of answering:

Important answering for intentions and reasoning, and for results and learning, is validated by knowledgeable public interest organizations or professional practitioners, or both.

Rationale: For corporate financial reporting, external auditors have the duty to attest to the fairness and completeness of the reporting, which is simply applying the precautionary principle to business affairs.  If the business community does not accept corporate financial reporting without independent validation, it follows that citizens should not accept on faith the reporting by directing minds of governments and other institutions for their intended and actual performance that significantly affects the public.

12)  The principle of the wages of abdication:

To the extent that citizens abdicate their responsibility to install public answering standards and hold fairly to account, they give tacit approval to the abuse of power and they reduce their civic competence.

Rationale: The idea of citizen duty is not prominent today, in part because of the erosion of standards in society that has led to mushrooming institutional deception and media conversion of virtually all information for citizens into entertainment.  But as the cartoon character Pogo said, "We have met the enemy, and he is us."

Basic Standards for Public Answering

A standard is something established by authority, custom or consensus as a model or example -- a means of determining what something should be. It is a criterion for assessing conduct. In organizations, standards are reasonable expectations for the level and direction of people's effort and their accomplishment. Standards are judged by their usefulness and reasonableness; they cannot be simply someone's specifications for the behavior of others - what someone would like to see others do as their own preference.  Political correctness is about people's specifications replacing standards.  The test is whether a claimed standard is in the public interest. If it isn't, it isn't a standard.

Decay in standards of conduct leads to harm and fosters deception. It reduces citizen incentive to hold authorities to a reasonable standard of performance, which in turn allows further harm and deception. Those who deny that standards are generally decaying in society would be hard pressed to give the evidence. Today, standards have eroded in a wide range of responsibilities in government, media, churches, business, education, and in society in general.  When we see lowered standards everywhere, we stand out oddly if we maintain our own.  Feeling anxious about this, we then tend to lower our own standards and our expectations that we hold of others.

In public responsibilities, a standard implies conduct reasonably expected that ensures safety, prevents injustice or otherwise produces a public benefit of some kind. That is why citizens who try to maintain standards must ask those with the responsibilities, "Would you kindly tell us your own performance standard?"  Standards crumble when citizens don't halt their erosion, and successive people in authority, in the abdicating language of "choice" and "lifestyle," cease to understand the importance of standards in society.

If standards are important, public answering for responsibilities must meet reasonable answering standards.  If not, the answering (if given at all) can mislead, successfully putting spin on responsibilities that weren't discharged.  Holding to account makes visible the standards not only of those with responsibilities, but also those with the duty of holding to account. To judge the adequacy of answering, citizens and their elected representatives need to agree on a simple set of answering standards that will fit most circumstances.  Then citizens must ask their elected representatives to install the standards as law in their respective jurisdictions.

The following answering standards reflect the twelve principles of accountability.

Six Basic Standards of Public Answering

Before the fact:

1.   Authorities state, for public challenge, what they intend to bring about, for whom, and why they think the outcomes they intend are fair.

Rationale: This standard requires the central "Who benefits? Who bears the cost?" question to be answered publicly, whether by political parties, government departments and agencies, corporations or other institutions. When authorities proposing something are required to answer these two outcome questions, citizens can then learn what is at stake by challenging the fairness and completeness of what the authorities say about their intentions and reasoning.

2.   Before taking a decision to act, or to authorize others to act, authorities report publicly the extent to which they have informed themselves for their decisions.

Rationale: Governing bodies can be expected to know what constitutes reasonable information for good governance, and obtain it. That being the case, they can report the extent to which they think they have met that due diligence obligation. Authorities have not had to answer publicly for the adequacy of their self-informing, except perhaps in a court case.  Yet the self-informing duty is axiomatic whenever a decision by a government or governing board affects the public in important ways.

3.   Authorities state publicly what they specifically plan to achieve, and their intended performance standards for the achievements.

Rationale: When authorities state intended outcomes only in general terms, such as "a healthier population," it doesn't provide a basis for holding to account for achievement.  Since achieving an objective requires accountable authorities to meet performance standards, those with the duty to hold them to account must know the performance standards.  Authorities' statements of their performance standards help to clarify their intentions.

4.   Authorities state who would answer publicly for what, and when, if their proposal or authorization were to go ahead.

Rationale: The requirement to make clear who would answer for what should affect our acceptance of authorities' proposals, because if the answering obligation for this is weak, the "who" intentions may be suspect.  Without this clarification, citizens would be accepting authorities' intentions on blind faith.

Answering after the fact:

5.   Authorities state the results from their efforts, as they see them, and why they were different from their stated intended results, if that is the case.

Rationale: "Results" does not mean simply production or outputs; it means some kind of change in end-state or condition that is in the nature of an outcome.  It means that an intended difference is made to something.  The reporting of results, as the authorities see them, must cover both intended and unintended effects.  The results must be stated in a way that allows them to be compared with specific intended achievement and must include explanation of the cause of significant differences between intended and actual results.  To set our confidence in authorities for the future, we need to know which results are attributable to whom.  We also need to know what stood in the way of planned achievement, and how authorities coped with external constraints.

6.    Authorities state the learning they gained and how they applied it.

Rationale: In the issue of answering expectations for authorities, public answering for learning applied has not even been discussed. Yet the directing minds of every organization affecting the public have a fairness obligation to learn from what they did or authorized, and apply their learning.  What they learned, they can report.  Refusal to answer publicly for learning gained and applied is not a good sign in judging the future ability and motivation of a government or other organization affecting the public. Although general standards for authorities' learning responsibilities may not yet be agreed, each accountable authority can state its existing standards and report against them.