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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Shifting Paradigms in Self-Regulation

Remarks by

Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

27th Anniversary Securities Regulation Institute

January 27, 2000

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. Turner and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

I am thrilled to be here today. But I must tell you, I was talking before lunch with former SEC Chairman Ruder who reminded me that I was invited not only this year, but last year as well to this prestigious conference. Unfortunately, on both occasions, the weather resulted in either my delay in arriving or in the case of last year, outright cancellation. He said as a result, he doubted I would be invited back next year. I responded that it was kind of him to tell me about that before lunch because most of the people who have to listen to my remarks wait until after I have spoken to tell me not to come back.

In fact, even the people I work with at the SEC like the Commissioners, the staff, and especially my staff, want to make sure I let you know that the views I express today are not necessarily their views. To the extent you may or may not agree with them, they may or may not be my views as well!

Lastly, my family asks that I add them to the list of disclaimers. They tend to be a little more forthright. Thank goodness I have a dog!!!!

Today, America's capital markets stand as the most liquid, deep and efficient markets in the world – markets that have propelled our economy onto a plane where we have no equal. Why have our markets been so successful? In large part, because of high quality, transparent financial reporting. And, nothing has guaranteed that transparency more than the independent audit.

This afternoon, I want to focus on two concepts key to public confidence in financial reporting: (1) the importance of independence as an integral and immutable part of the audit process; (2) and the importance of an effective self-regulatory structure for the auditing profession.

Over the past quarter century, since the accounting profession's self-regulatory structure was put in place, there has been a sea-change in our markets. Just look at the sheer growth and velocity. Look at the dramatic revolution in the structure and product mix of accounting firms. Amidst this backdrop, how can we ensure that the independence framework and the self-regulatory structure be modernized for the times?

The Times, They Are A-Changing

The number of public companies that file financial statements with the SEC has grown from 9,000 in the 1970's to nearly 15,000 today. The total amount of public equity offerings in 1990 was $24 billion, and ballooned to $152 billion by 1998. In fact, the amount of IPO's alone in 1998 was $44 billion, almost twice the total equity offerings of a decade ago. And 1999 looks like another record year.

Today, it has been reported that the Nasdaq stock basket, after gaining 86 percent last year, trades at 125 times its companies' earnings of the last twelve months. That's approximately eight times the historical average.

In the post-war era of 1948, there were 6 million public shareholders in this country; in 1973 there were almost 32 million; and today there are approximately 79 million. In 1947, the average daily turnover on the New York Stock Exchange was less than 1 million shares; in 1971, it was well over 15 million. And as we enter the new millennium, just thirty years later, we have seen daily trading volumes of 1 billion shares, an increase of 66 times!

The total US market capitalization has also increased from $651 billion in 1970 to $13.3 trillion in 1998. During that same period, our country's Gross Domestic Product has increased eight-fold from $1+ trillion in 1970 to over $8 trillion in 1997. And keep in mind that the total market capitalization has increased from 62% of GDP in 1970 to 169% in late 1999. The last time we saw a number that high was in 1989 - in Japan.

Our markets have been successful in attracting capital because of the confidence and trust investors put in the numbers they receive. Unlike in Asia, Russia and Latin America, which have experienced flights of capital in recent years, the lack of smoke and mirrors in the U.S. has largely shaped the integrity of our markets, fueling investor confidence and encouraging expanded capital investment, making our economy and quality of life the envy of the world.

The reporting of comparable, timely, credible financial information – that is, high quality, transparent financial reporting – also forms the basis on which investors can assess whether management has achieved its stated objectives, and enables investors to make rational decisions regarding the allocation of capital in our capitalist society. The efficiency of this process results in lower costs of capital for companies as well as greater access to the capital they need to grow, and in turn fuels strong economic times like we are in today.

So we must be ever vigilant in protecting and continuously improving the elements of a high quality financial reporting structure. The five elements that would make up that structure include:

  • Effective, independent, high quality accounting and auditing standard setters;

  • High quality accounting and auditing standards;

  • Audit firms with effective quality controls worldwide;

  • Profession-wide quality assurance; and

  • Active regulatory oversight
What is the overriding context we need to place these elements in?

  • First, we need to recognize that independence is an integral and immutable part of the audit process and the public's reliance on that process.

  • Second, if we are to continue to rely on a self-regulatory structure for the accounting profession, that self-regulatory structure must have the power and authority to truly investigate, regulate, and effect corrective change.

  • Third, there has been a paradigm shift in the pace, breadth and depth of the markets, in the U.S. and worldwide, in the workforce and certain family relationships within that workforce and particularly within the accounting profession, and a concurrent shift in the macro and micro structure and product mix of the accounting profession. However, despite this paradigm shift, there have not been comparable changes in the rules relating to auditor independence and in the self-regulatory structure. The importance of continuous quality improvement requires us to update our rules and self-regulatory structure, to "sharpen the saw" if you will, in order to maintain the high quality financial reporting that has become the hallmark of the US capital markets.

The Changing Face of the Accounting Profession

Let me set the stage by giving you a perspective on the changes the profession has gone through in America in the past twenty-five years or so. I use that time period as a benchmark as it was in the mid 70's, that the profession put in place the self-regulatory scheme that largely remains unchanged today.

Interestingly enough, these changes were made in response to numerous financial frauds reported after the longest sustained period of economic expansion in the history of America – until now that is – during the 1960's. For those of you in the audience with a few gray hairs, you probably remember names like Penn Central, Equity Funding, and Continental Vending. In addition, scandals surfaced in 1974 when congressional investigations brought to light unrecorded slush funds, secret bank accounts, and other devices to hide bribes and kickbacks by over 200 major companies. And the cry went out, "Where were the auditors"?

As a result, fundamental changes in the self-regulatory structure were enacted in 1977, resulting in the current "alphabet soup" of organizations such as the SECPS, PEEC, QCIC, and POB.

But the self-regulatory structure has not kept up with changes in the accounting profession.

Let me illustrate with some numbers. In the past 25 years, we have gone from the Big Eight Accounting Firms in an era of Eight Track Tapes, to the Big Five accounting firms in an era of CD's, DVD's, 4x4s and SUV's!

The audit and accounting fees of the largest accounting firms as a percentage of their revenue has decreased significantly from 70% of total revenue in 1976 for the Big Eight to 34% of total revenue for the same firms (merged into the Big Five) in 1998. And just as the macro-structure of the accounting profession has changed, so has the micro-structure of the product mix within the firms. In 1981, management advisory services ("MAS") for traditional audit firms represented approximately 15% of accounting firms' total revenue; today MAS accounts for 40% of revenue.

In the 1970's, the largest firms were national practices; now they are internationally branded names you see worldwide in every major airport concourse (I know, I've seen them as I've run, and I do mean run, to catch a flight!) There has been an explosion of services ranging from broker/dealer services, to outsourcing of most corporate office functions, to transactional structuring advice, to strategic business planning, to business process restructuring, to asset management, and on and on. These firms no longer advertise themselves as auditing firms, but rather as one-stop financial service firms that offer a full range of services.

And engagement partners, who were accounting and auditing services experts in the 70's, have now been handed the role of ensuring that clients are aware of, and buying, as many of the multitude of services offered as possible. This marketing function is imposed while also asking the same engagement partners to "Just Say No" to the buyers of these services if the quality of their financial reporting is not within the boundaries specified by generally accepted accounting principles. I'm not sure even Sampson had the strength to carry the water for these two masters! (No, not our friend Clarence!)

Another dramatic change affecting the profession is the desire on the part of the auditors to be able to invest in dot.com companies and to enter into strategic business alliances with audit clients. As a result, the interests of the investing public for an examination of the numbers by an independent third party, who is free of conflicts of interest, financially and otherwise, are being supplanted by those in the profession who see auditing as the dog's tail, and nothing more.

Today, these professional services firms assert that they must expand their scope of services. They cite the need for in-house expertise for auditing that, in their view, can best be developed through MAS activities. And they say that their clients demand these services. They also note that MAS opportunities enhance their ability to attract and retain high-quality professionals. Of course, these services have been very profitable too.

While these arguments have merit, we must not lose sight of the core attributes of high-quality audits – capable professionals who serve the public good through their independent scrutiny of a company's financial statements. And today, as in the 1970s, auditors are well compensated for their work. The audit practices of the large firms generate billions in revenues and are very profitable. Earnings of audit partners are typically in the upper echelons of their respective communities. In addition, when there has been a downturn in the economy, it is the auditing practice that has subsidized the operations of the consulting practice. These economics, along with the on-the-job learning experience, make auditing an attractive career choice.

Vacuum Tubes or Cutting Edge

The need of investors for a quality audit has not changed. And if you doubt the value of an audit in today's pressure-packed, fast-moving, volatile environment, just ask the investors - who reportedly have lost tens of billions of dollars in the high profile financial fraud cases reported all too frequently in today's newspaper headlines - what they think about the need for quality audits.

The changes in the profession since the 1970's are significant, and have fundamentally changed the way accounting firms operate their businesses internationally, the way they perform audits, the structure and governance of the firms, as well as their cultures and perhaps even the "tone and focus at the top". Yet, notwithstanding these changes, when we at the SEC suggest that continuous improvement would benefit the profession, just as I found as a business executive that it benefited our company and investors, I hear accountants say "Why fix it if it ain't broke?" "Why throw out the baby with the bath water?"

I think it would be amazing to see how well off our economy and investors would be today if the leaders in the semiconductor, software and biotech industries had merely said "Don't fix it if it ain't broke". Vacuum tubes, IBM selectric typewriters and small pox shots would no doubt still represent the cutting edge. Perhaps we'd even still have the Edsel.

And it is for this very reason - to ensure we maintain our competitive edge - that we must look at the way we do things in the accounting profession. We must institute now, rather than later, the necessary changes that will improve how we serve our client, the investing public. We need to make the changes that are required to update the existing quarter-century-old self-regulatory structure to reflect the dramatic changes that have occurred in the profession. Just as we do in business, we need to "map" out how self-regulation and audits are actually performed today and then compare this to a design that yields the most effective and efficient audits and self-regulation. By going through such a process, we will be able to identify ways we can add value to our customers - the investing public.

Critical Success Factors for High Quality Audits

A starting point is to look at what it is that makes for a great audit.

In going through such a process, I have spent considerable time with members of the profession. In one of these discussions, we identified some of the critical factors for a successful audit. The factors we identified include:

1. "Spine," or the ability to stand your ground, and do what's right on the tough issues;
2. An objective, independent perspective based on integrity and ethics beyond reproach;
3. Quality professional staff committed to serving the investing public - after all, investors are the most important client;
4. Continuous training focused on providing the auditor with the skills necessary to complete a successful audit - training that begins when a professional joins a firm, and continues throughout a professional's career;
5. Availability of and capability to use up-to-date technologies;
6. Current knowledge of the client's business and the risks associated with that business;
7. An effective quality assurance program;
8. Auditing standards with sufficiently detailed audit procedures and guidance necessary to produce audits that will assure the public's confidence in the numbers;
9. A process that provides input to clients on how they can improve the quality of their financial reporting processes, procedures and product;
10. A sufficiently robust audit methodology and process;
11. The appropriate compensation program that rewards or penalizes an audit professional based on the critical success factors for a successful audit; and last, but absolutely not least,
12. Effective oversight and regulation by an independent body representing the public's interest.

Toward Continuous Improvement in Self-Regulation

Yet, in spite of it's importance, the oversight and self-regulatory mechanism we have today in the profession has not kept pace with the changes occurring in the accounting firms I described earlier. And so, I would like to share with you some thoughts on what a possible self-regulatory structure should encompass for it to effectively and efficiently regulate the profession.

Highly Respected Independent Oversight Board

Our experience in the United States has shown that oversight is best performed when done by a highly qualified body of independent representatives. For example, we were unable to successfully restructure the military bases after the end of the cold war until Congress established an independent commission that was willing to make decisions based on what was right. And in our financial circles, just look at the internationally acclaimed success of the Financial Accounting Standards Board ("FASB"), which has been comprised of independent board members who are some of the most highly qualified individuals from their respective fields. And, to their credit, the International Accounting Standards Board has voted to approve a new structure based on independence and technical competence.

Likewise, we need to ensure that we have independent oversight of the auditing profession by an independent body of capable, highly respected individuals whose principal mission is to serve the investing public. The Public Oversight Board ("POB"), which is now chaired by the highly respected former comptroller general of the United States, Chuck Bowsher, certainly could fill this role. In order for the POB to effectively accomplish its mission, however, it will need to have the necessary authority and responsibility to ensure that investor confidence and trust in the numbers are not eroded. This undoubtedly would necessitate those who establish the respective standards and rules coming directly under the auspices of the POB.

Establishment of Professional Practice Rules and Standards
for Peer Reviews

Today, most, but not all, CPA firms that audit public companies belong to the SEC Practice Section ("SECPS") of the AICPA. The Executive Committee of the section establishes membership rules that set certain requirements, such as the need for peer reviews and for a review of significant parts of the audit by a second partner. In addition, the peer review committee of the section is actively involved with development of the guidelines for peer reviews, as well as the performance of the reviews.

The membership of these committees is comprised of practitioners, including some from the national offices of the firms. However, it used to be the most senior members of the firm served on the executive committee. We need to consider if we wouldn't be better served if we went back to that practice.

In addition, I have personally reviewed some peer reviews. In a recent letter to the POB, I also noted that the peer review of Coopers & Lybrand, one of the two firms that now comprise PricewaterhouseCoopers, received a comment from its peer reviewer that stated it had an effective set of internal controls monitoring independence. It is somewhat disappointing that such a letter was issued to the public in light of the recent independent consultant's report on PwC.

As a result, we are concerned about the approach to, and quality of, peer reviews. This has led to the belief that perhaps peer reviews should be done under the direct supervision of the POB.

In addition, these reviews, which are conducted once every three years, should perhaps be done more often, much like the CPA firms do their own internal inspections. And finally, as an engagement partner, I was always told in advance which of my audits were going to be peer reviewed. I think it would be beneficial if the staff of the POB could review some audits on an unannounced basis.

High Quality Auditing Standards

I believe that we have the highest quality auditing standards in the world today. The recently adopted standard requiring auditors, audit committees, and managers to have a discussion about not just the acceptability, but also the quality of a registrant's financial reporting, is an excellent example of where the Auditing Standards Board has kept the investing public in mind.

But we can do better. The discussion of quality was first recommended by a special report of an advisory committee of the POB in 1994. Yet this latest standard adopted in January 2000 was undertaken in response to the 1999 report of the Blue Ribbon Panel on Audit Committees. We need an auditing standards setter that is proactive in identifying issues such as the quality issue and developing standards that adequately address the issues raised. While I firmly believe this board needs to have members comprised of practicing auditors, perhaps we should consider including independent board members, such as retired audit partners and CFO's who were formerly employed in the audit practice of an accounting firm.

A Declaration of Independence

Let me shift for a moment to the concept of auditors' independence. No one has stated this role more clearly than the United States Supreme Court, which said:

"The independent public accountant performing this special function owes allegiance to the corporation's creditors and stockholders, as well as the investing public. This public watchdog' function demands that the accountant maintain total independence from the client at all times and requires complete fidelity to the public trust." (emphasis added) [United States v. Arthur Young, 465 U.S. 805, 817-818 (1984)]

And John L. Carey, the AICPA's former chief staff officer, wrote the following definition of independence:

"Independence is an abstract concept, and it is difficult to define either generally or in its peculiar application to the certified public accountant. Essentially, it is a state of mind. It is partly synonymous with honesty, integrity, courage, character. It means, in simplest terms, that the certified public accountant will tell the truth as he sees it, and will permit no influence, financial or sentimental, to turn him from that course...It is not enough for the member to do what he thinks is right. He must also avoid behavior which could lead to ... [or] subject [him] to, improper influences. The accounting profession must be like Caesar's wife. To be suspected is almost as bad as to be convicted."

The question of independence was asked of a representative of the accounting profession at Senate Hearings when the Securities Laws were first enacted in 1933. When asked by a Senator if there was any relationship between corporate controllers and their auditors, Col. A.H. Carter, President of the New York State Society of CPA's at the time, replied, "None at all. We audit the controllers." The Senator then asked, "Who audits you?" to which Col. Carter replied, "Our conscience."

Yet recent events, news stories, and the business desires of public accounting firms to be able to invest in certain companies, have their clients invest in their own public offerings, and practice law, in addition to serious concerns over the culture and controls within the firms, raise significant public policy issues that require serious consideration. I strongly believe we must not condone conflicts of interest that the public would perceive as raising questions about the credibility of financial statements.

As a result, we need to develop a framework for independence, in fact as well as in appearance, that adequately addresses the need to give markets confidence in the objectivity and reliability of an auditor's opinion. The framework must also address the ever-expanding business practices of the accounting profession. In doing so, we are going to have to come to grips with the issue of how to ensure the independence of the auditor and the state of mind required to ensure that the tough questions get answered right.

And so, in light of today's business imperatives, I believe the accounting profession has to rededicate itself to a profoundly simple proposition: the judgment and work of the auditor must be free from any bias or outside pressure and clear from any conflicts of interest. The judgment and work of the auditor must be dedicated to the public interest. We dare not lose sight of that - ever. We should not allow the audit process - long rooted in independence and forged through professionalism - to be diminished in the name of other commercial opportunities.

It is instructive to note that a 1979 POB report included the following statement:

"The Board believes that there is possibility of damage to the profession and the users of the profession's services in an uncontrolled expansion of MAS to audit clients. Investors and others need a public accounting profession that performs its primary function of auditing financial statements with both the fact and appearance of competence and independence. Developments which detract from this will surely damage the professional status of CPA firms will lead to suspicions and doubts that will be detrimental to the continued reliance of the public upon the profession . . ."

It seems that the current environment is exactly what the POB warned us about twenty years ago.

The core principle of independence is immutable. But, the rules which weave the fabric around independence must continually be scrutinized. Recently, some have said certain aspects of the independence rules are unfair, too cumbersome and just unrealistic. I don't dismiss those concerns. And, I can tell you neither does Chairman Levitt.

Earlier this week, Chairman Levitt asked my office to identify independence rules governing certain investments and employment relationships by auditors and their families in firm clients that need to be modernized, given the significant demographic changes of the last two decades. Given our experience that every good idea drags on for far too long, he asked that within 45 days, we come back to him with recommendations for changes to those rules. Such an examination will only help to ensure that the audit process remains independent and robust - eliminating rules that provide marginal benefits and unjustified sacrifice for all participants in the audit process, including the families of auditors.

In addition to developing these proposals, I also believe we need to take a closer look at the structure of the Independence Standards Board. The Commission noted that the staff would undertake a review of the ISB within two to five years of its formation – we are planning to do that as part of an overall review of the present self-regulatory structure. The chairman of the O'Malley Panel has also indicated the Panel is reviewing this topic. Ultimately, I believe questions such as those regarding the ISB's structure, whether there are sufficient independent members of the ISB, the role an independent oversight board should take, and the viability of the Independence Issues Committee – whose members are all from the profession – will need to be answered as part of an overall improvement of the present self-regulatory structure.

There are some basic concepts I have always believed were important as it relates to independence. First, auditors should not provide services that might affect the numbers in the financial statements, such as valuations used for financial statement purposes, and internal auditing. Second, auditors cannot provide services requiring them to be an advocate for the client. Third, audit firms should not be part of a web of business relationships that gives them a mutuality of financial interest with an audit client. Finally, there should not be financial interests or employment with clients. I fully understand some services provided by auditors may enhance an audit. But all too often the auditors do not avail themselves of this knowledge resident with the consultants.

In light of the explosion of financial services offered by CPA firms to their clients, I also believe consideration must once again be given to the need for disclosure of non-audit services. One of the former Commissioners who voted to withdraw the previous Commission rule requiring disclosure of non-attest services has said it was the worst decision he made while at the Commission.

Timely Diagnosis and Effective Discipline

I believe strongly that the true mark of any group of professions is the ability of the profession to investigate concerns expressed by the public, including alleged improper professional conduct. The investigation and diagnosis of what, if anything, went wrong should not have to be performed by state or federal investigators all of the time. While we at the SEC stand ready, willing, and able to fight fraud, I question if it is a good use of our resources to try to identify lower quality, "C grade" audits.

Instead, we need a mechanism that can:

1. Perform in-depth studies of CPA firms and the profession, much like the study we have requested the POB to undertake on independence issues, so as to identify clearly the issues and recommendations. These findings and recommendations should result in the appropriate standard setter, professional body, or regulator taking timely and appropriate action so as to improve the quality of audits, and to maintain the trust of investors.
2. Perform timely investigations of alleged audit failures to determine if changes in standards or further guidance are needed, and to take disciplinary action when warranted.
3. Determine appropriate disciplinary policies to assure that the disciplinary action fits the level of improper professional conduct. When an auditor fails to conduct an audit in accordance with generally accepted auditing standards and investors lose billions of dollars, actions pursuant to the Commission's cease and desist authority or Rule 102(e) may well be appropriate. But if the improper professional conduct was but merely a simple oversight, then such action may be inappropriate.

Have the protection to carry out its investigations and studies, while maintaining the confidentiality of its files and where appropriate, its work product.

5. Be composed of independent, qualified public members.

Such a disciplinary and diagnostic structure does not exist today. The AICPA's disciplinary body, the Professional Ethics Executive Committee, currently lacks independent public members. Further, it has been unable to take timely action due to an inability to protect its files from subpoena, and in numerous financial reporting cases where the Commission has taken a 102(e) action, it has failed to take any action.


You know, 1999 was coined "The Year of the Accountant" by our Enforcement Director, Dick Walker. And people have asked me, what will the Year 2000 bring? Well, perhaps we will not only celebrate Independence Day on July 4th , but this may really be the Independence Year. And for those of you interested in our Y2K readiness, I can assure you that the only 00's we will recognize will be Zero Tolerance for Accounting Gamesmanship.

But for now, in the coming weeks, I wish you all a Happy Ground-Hog Day and remind you not to bury your heads too far in the sand looking for that ever-elusive shadow! And remember, on Leap Year Day, to look before you leap!

Thank you very much!