SEC Speech: Remarks at AICPA National Conference on Current SEC Developments (R. Walker)
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Speech by SEC Staff:
Remarks Before the AICPA National Conference on Current SEC Developments

by Richard H. Walker

Director, Division of Enforcement
U.S. Securities & Exchange Commission

December 5, 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. Walker and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Good morning. I am pleased to join you again this year at your annual conference. Much has happened since we last met, and there is a lot of ground to cover at this conference. Among other developments, the O'Malley Panel has issued its report on audit effectiveness, the Big 5 and several other firms have agreed to participate in a voluntary look-back program to address independence issues, and last but not least, the Commission has adopted comprehensive new auditor independence rules. Each of these initiatives resulted from joint efforts - not always easy efforts, but cooperative efforts nevertheless - among responsible leaders of the accounting profession and members of the Commission and its staff.

This morning I would like to share with you my views - and they are my views and not necessarily those of the Commission or its staff – on the important progress we have made this past year in the areas I've mentioned, and on two other areas where we need to focus our attention in the coming year. These two areas are the accessibility of foreign working papers and the statutory requirement to report illegal acts discovered during an audit. More on these subjects in a moment. But first, let's reinforce some of the positive lessons we've learned.

During each of the last two years, I have stood at this podium and declared that combating financial fraud was the Division of Enforcement's top priority. It remains so today, but given some of the milestones that have been achieved over the last year, I am confident that we are closer than ever before to our goal of proving that the "numbers game" is every bit as foolish and risky as Russian roulette.

In prior years, our efforts to combat earnings management involved some tough talk. For example, as stated, we trumpeted that combating financial fraud was our "top priority," and that sanctions would be stiff and criminal referrals routinely made where warranted.

The accounting profession countered with some pretty strong salvos of its own. Certain members of the profession vigorously denied that there was a crisis in financial reporting, and, in the independence area, boldly asserted that there wasn't a scrap of evidence that the performance of consulting services for audit clients impairs independence.

As the old saying goes, actions speak louder than words. Tough talk and abject denials cannot build or restore investor confidence.

This past year, however, was one of action. The rhetoric gave way to real and meaningful progress towards shoring up infirmities in the financial reporting process.

For starters, from an enforcement perspective, we continued to bring an increasing number of cases in this area. We just tallied our numbers for fiscal year 2000, which ended September 30. We brought approximately 100 financial reporting cases, which is a ten percent increase over last year. The total included cases stemming from some of the larger frauds in recent memory, such as at Cendant and McKesson.

We also made extremely meaningful advancements on the regulatory front. And make no mistake, the profession deserves real credit for crossing some big bridges with us this past year to help make these advancements possible.

In particular, I single out two projects that demonstrate that when we lay down the gloves and start working with each other, we can strengthen investor confidence and the integrity of our markets. The first of these projects, of course, is the auditor independence rules, which four of the Big Five firms have publicly supported. Second, is the auditor independence "look-back" program that we announced in June with the support of the Big Five firms. This program provides a safe harbor from enforcement actions for certain categories of self-reported violations stemming from stock ownership in a firm's audit clients.

I personally participated in the discussions that led to the look-back program. I met on numerous occasions with members of the Big Five firms, and since then have met with members of all participating firms. Our dialogue has been frank and extensive. I hope it will help to serve as a model for our exchanges in the future. Over the years, the Commission has developed open channels for communication with various industry representatives, such as the Securities Industry Association, the Bond Market Association, and the Investment Company Institute. Regrettably, we have not had the same opportunities for a regular and sustained dialogue with the accounting profession.

My involvement in the look-back program confirmed for me what I knew from my experiences with the other groups I mentioned. The process works best when we sit down and exchange ideas, consider each other's views, and work to resolve differences.

I hope that we can use the events of this past year as a springboard towards a more cooperative future. With my remarks today, I'd like to continue the momentum we've begun by pointing out two areas in particular where I believe joint efforts will be beneficial to all.

Enforcement Access to Foreign Audit Workpapers

I'd like to begin by discussing an issue with a long and frustrating history - the difficulty the Commission staff has encountered in obtaining foreign audit workpapers. The staff's interest in reviewing audit workpapers located abroad generally has arisen in one of two contexts.

The first is when the staff is looking into financial statement irregularities of foreign issuers registered with the Commission. In general, these foreign issuers retain a non-U.S. accounting firm – often an affiliate of a U.S. Big Five firm – to audit the financial statements they submit with their Commission filings.

The staff also has sought access to foreign audit workpapers in investigations relating to the financial statements of U.S. corporations that have overseas operations. In these situations, though the auditor signing-off on the company's financial statements typically is a U.S. firm, that U.S. accounting firm will have relied on one of its foreign affiliates to conduct the portion of the audit relating to the client's foreign operations.

While historically, the need to obtain workpapers located abroad has arisen only sporadically, more recently the staff has faced this challenge with increasing frequency. This trend is not surprising, and, I believe, results from the confluence of three trends.

Number one, the globalization of American businesses undoubtedly has led to a surge in the number of U.S. companies with foreign operations. As a result, the task of auditing these firms has become a cross-border undertaking, requiring U.S. accounting firms to look to their foreign affiliates or other foreign firms for assistance.

Factor two, the number of foreign issuers seeking to enter the U.S. capital markets is growing. For the fiscal year ended September 30, 2000, the Division of Corporation Finance registered more than 200 new foreign private issuers, a record that exceeds by 1/3 the number of such new registrants in past years. Of the approximately 14,000 issuers registered with the Commission, almost 10% are foreign private issuers from almost 60 countries. Since most foreign registrants retain foreign accounting firms or foreign affiliates of the U.S. Big Five, as the number of foreign registrants continues to grow we can expect the number of audit opinions signed by foreign firms to increase as well.

The third factor that has brought the foreign audit workpapers issue to the fore is the rise in financial fraud - about which I've frequently spoken – and the Division's resulting commitment to fight it aggressively. Investigating and prosecuting financial fraud cases frequently require that we carefully examine auditors' work, including reviewing their workpapers.

With the globalization of American business and the flood of foreign companies entering our markets, U.S. investors more and more often are relying on financial statements that in whole or in part were audited abroad. And isn't it logical that if foreign issuers want to take advantage of our capital markets, they should be required to provide the same access to information underlying audits of their financial statements as wholly domestic issuers are required to provide in SEC investigations? To effectively carry out the Commission's mission of investor protection, it is critical that the Commission's staff have ready access to audit workpapers, regardless of where they are located. Unfortunately, this generally has not been the case.

The Commission signaled its growing concern regarding the difficultly in obtaining foreign audit workpapers in a Concept Release on International Accounting Standards published in February of this year.1 The Commission explicitly sought comment on "ways to assure access to foreign working papers and testimony of auditors who are located outside the United States."2 We asked whether the Commission should amend Regulation S-X to require a representation by the auditor that, to the extent it relied on auditors, working papers, or information from outside the United States, the auditor would make the working papers and testimony available to us.3 We also asked for comment on whether there was another mechanism for enhancing our access to audit working papers.4

The profession supplied few substantive responses to these questions. Not surprisingly, the Commission's allusion to the possibility of rulemaking in this area garnered a negative reaction,5 but, unfortunately, no new alternatives were advanced on how the Commission could make significant progress in addressing this problem.

In their comment letters on the Concept Release, and in individual investigations in which the staff has sought to obtain foreign audit workpapers, accounting firms have resisted efforts to solve this problem.

The first argument the profession regularly raises is that the staff cannot expect U.S. firms to assist its efforts to obtain access to foreign workpapers - including those created by a firm's foreign affiliates - because the foreign affiliate is a completely separate legal entity, and thus the U.S. firms do not have possession, custody, or control of the workpapers.6 I find this argument particularly unpersuasive. You can expect that we will aggressively challenge such claims in the future through swift subpoena enforcement proceedings.

Both U.S. and foreign issuers retain Big Five auditors, including their foreign affiliates, as a signal to the market that the company is sound, and its financial statements have been rigorously reviewed and tested by a reputable firm known worldwide for standing by its work. Likewise, the Big Five accounting firms market themselves to such issuers as global organizations capable of providing comprehensive services to even the largest, most far-flung multinational corporations. Indeed, clients are told that one advantage of retaining a Big Five firm is that it provides global one-stop-shopping. The Big Five firms capitalize on the fact that their names are equally recognizable in Moscow, Mexico City, and Minneapolis. The subliminal message they seek to communicate in their marketing is: "Retain us once in New York or Chicago, and don't worry about having to deal with numerous contacts around the world. We'll take care of that – we're one seamless international organization."

That is - until something goes wrong and the SEC staff comes calling. When the Commission subpoenas foreign audit workpapers from a U.S. affiliate of a foreign firm, the U.S. firm generally tells the staff - sorry, we'd like to help you, but our foreign affiliate - the one that bears the same name and logo as we do, the one that we may have pointed to in marketing our firm to the multinational issuer you're investigating - that firm is, in fact, a separate legal entity over which we have no control or influence.

Accounting firms cannot, and should not, have it both ways. A U.S. accounting firm should not represent itself to clients as part of a seamless worldwide operation, while telling the Commission staff that each of the firm's foreign affiliates is a discrete entity from which the U.S. firm is unable to obtain cooperation, including production of documents.

It is particularly disingenuous for a U.S. accounting firm to take this position when it has relied on the work of the foreign affiliate - or for that matter any foreign firm whether affiliated or not – in signing an audit opinion filed with the Commission, as is often the case. If a U.S. firm can put its name on an opinion that relies in part on audit work performed by a foreign affiliate or firm, the U.S. firm ought to have access to the workpapers underlying that audit.

In this regard, we often are told – almost reflexively – that foreign accounting firms, including foreign affiliates of U.S. firms, are precluded by so-called secrecy or "blocking statutes" from supplying certain information to outside regulatory authorities.7 It is the staff's belief, however, that such legal prohibitions are far more rare than the profession would have us believe. In short, while we understand that blocking statutes may occasionally complicate requests for foreign audit workpapers, rest assured they will not stop us from developing a reliable means of obtaining such workpapers, either through subpoena enforcement proceedings where we believe access has been unlawfully refused, through amendments to Regulation S-X as outlined in the Concept Release, or through some other means.

So what do I think the profession should be doing in this area? The Big Five and other international accounting firms should stand behind their work, regardless of whether the work was performed in the U.S. or abroad. If the staff seeks your assistance in obtaining foreign workpapers, don't dismiss our requests by disclaiming your ability to obtain the documents or influence your foreign counterparts to cooperate with us. This is an area where we will not take no for an answer.

Exchange Act Section 10A

A second topic deserving attention by the profession is auditor responsibilities under Exchange Act Section 10A. This provision requires auditors to bring "illegal acts" to the attention of senior management and the audit committee, and if remedial action is not taken, to report those acts to the SEC. An improved dialogue between the SEC and the profession is necessary to help you understand our expectations and to make sure that the statutory objectives are met.

Addressing this conference a year ago, I expressed concern that we had received fewer than a dozen 10A reports since the law was enacted at the end of 1995. A year later, my concern remains. We have received only a handful of additional reports - fewer than five - during the past year.

I have heard innocent explanations for the low number of reports advanced by members of the profession and the bar. They argue primarily that the phenomenon is a result of issuers taking swift action to correct problems brought to their attention by auditors, thereby negating the reporting requirement.

An alternative, more-troubling rationale for the low number of reports is, unfortunately, becoming more plausible - namely, auditors may be failing to fulfill their 10A responsibilities. In the past month, the Division of Enforcement brought not one, but two cases charging auditors with 10A violations. These are the first cases of their kind, but assuredly not the last. In every financial fraud investigation, we will examine whether the auditor complied with Section 10A.

Since we will be focusing on compliance with this statute regularly, it is imperative that you understand our views on what Section 10A requires and how it works. Accordingly, I'd like to share with you my thoughts on some important 10A points.

First, let me address some of the confusion over the breadth of 10A. The statute is drafted in broad fashion, requiring notification to senior management and the audit committee of "illegal acts" that are not clearly inconsequential. Many have queried what exactly is meant by "illegal acts"? Where does the term begin and where does it end?

Section 10A broadly defines "illegal act" as any "act or omission that violates any law, or any rule or regulation having the force of law." Read literally, this definition casts the widest possible net, potentially including violations of any and all federal, state, local, and foreign laws.

So where do we draw the line? We start by recognizing that 10A actually creates two categories of illegal acts - (i) those that need to be reasonably detected by audit procedures, and (ii) a broader category that need to be reported if they otherwise come to the attention of auditors.

As to the first category, Section 10A mandates that audit procedures be designed to detect those illegal acts "that would have a direct and material effect on the determination of financial statement amounts." Sounds nice, but what does this mean?

My own view is that laws that govern the accuracy and integrity of financial statements - such as tax laws and the securities laws - are most relevant. Applying this test, the required procedures should be designed to detect, at a minimum, the following categories:

  • Violations of the federal securities laws that impact financial statement disclosure;

  • Violations of the books and records provisions of the federal securities laws;

  • Violations of the internal control provisions of the federal securities laws; and

  • Violations of the anti-bribery provisions of the federal securities laws.

It is important to note that while the statute only requires that audit procedures be designed to detect illegal acts having a direct and material effect on the determination of financial statement amounts, it goes on to require that any illegal act detected during the audit must be reported to management, regardless of whether it has a direct and material effect on the financial statements, unless it is clearly inconsequential. Thus, even illegal acts that do not have a material effect on the issuer's financial statements may have to be reported to management.

These acts often are violations of laws relating to an entity's operating aspects rather than to its financial aspects and include, among others, violations of laws relating to occupational safety and health, equal employment, and environmental protection.

Perhaps the most common misunderstanding of Section 10A is the belief - relatively widespread - that only illegal acts having a material impact on the financial statements need to be disclosed. This is wrong. Auditors must notify senior management and the audit committee of illegal acts even if they are "immaterial" to the financial statements.

This conclusion in inescapable based on the clear language of 10A. Section 10A explicitly states that an auditor's reporting obligations are triggered "whether or not [the illegal acts are] perceived to have a material effect on the financial statements of the issuer." According to its text, the concept of "materiality" is relevant only in the context of designing audit procedures and in the auditor's assessment of the need to notify the SEC of illegal acts that have not been remedied. As we said in SAB 99, "an intentional misstatement of immaterial items in a registrant's financial statements may violate [the books and records provision] of the Exchange Act and thus be an illegal act."

I also want to make clear today my belief that 10A responsibilities extend to interim quarterly reviews. Such reviews are, of course, now mandated by new SEC rules adopted in December 1999. Although Section 10A only applies to illegal acts learned of by the auditor "in the course of conducting an audit," interim reviews cannot be divorced from the conduct of an audit. I was pleased to see that the AICPA shares this view, as expressed in an October 2000 Practice Alert.

One final point on 10A. As I mentioned, the provision requires notification to the SEC if the auditor concludes that senior management has not taken "timely and appropriate remedial actions." Mere promises by senior management to right a wrong are not enough. Rather, remedial action involves specific tangible steps to correct the problem. Auditors would be wise to use the interim reviews to obtain appropriate verification that senior management has indeed remedied prior illegal acts brought to their attention. If not remedied, a report must be made as soon as practicable to the issuer's board and, if necessary, immediately thereafter to the SEC.


We've accomplished a lot over the past year. We've joined each other at the table to tackle issues no one ever thought possible to resolve. For the first time in my experience we've established a framework for talking with one another rather than at one another. Today I've spoken to you bluntly and directly about some additional concerns I have regarding foreign audit workpapers and timely reporting of illegal acts. I've done so with the hope that based on the progress we've made over the past year, you'll understand that we're anxious to resolve these problems with your help. If we can untangle the complex and difficult issues surrounding auditor independence, I'm confident that we will have little difficulty addressing the matters I've spoken to you about today. Thank you very much.

1 International Accounting Standards, Exchange Act Rel. No. 42430 (Feb. 16, 2000).
2 International Accounting Standards, Exchange Act Rel. No. 42430 (Feb. 16, 2000), App. A, Question 20.
3 Id.
4 Id.
5 See, e.g., Comment Letter of Arthur Andersen, dated May 16, 2000 (located at [hereinafter "Andersen Letter"], Comment Letter of American Institute of Certified Public Accountants (located at [hereinafter "AICPA Letter"].
6 See, e.g., Andersen Letter.
7 See, e.g., AICPA Letter, Comment Letter of Deloitte Touche Tohmatsu, dated May 22, 2000 (located at [hereinafter "Deloitte Letter"].