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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Independence: A Covenant for the Ages

Remarks by

Lynn E. Turner

Chief Accountant
U.S. Securities & Exchange Commission

International Organization of Securities Commissions
Stockholm, Sweden

June 28, 2001

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

Thank you for asking me to speak to you today. Before I begin, I am obligated by Commission policy to tell you that the views I express here are mine and do not necessarily reflect the views of the Commission, the Commissioners or other members of the Commission's staff.

I want to thank our host, the International Organization of Securities Commissions (IOSCO), for asking me to speak at this prestigious conference. I want especially to thank Michel Prada, President of the Commission des Operations de Bourse, France. I have had the good fortune of working with President Prada and his Chief Accountant, Philippe Danjou, in recent years and they truly stand for transparency, quality, integrity and confidence in capital markets. And so, once again, it is my privilege to join this discussion with our moderator.

Trust, Integrity and Confidence in the Numbers

Let me start by stating a point upon which we can all agree. The enduring confidence of the investing public in the integrity of our capital markets is vital. In America today, approximately one out of every two adults has invested their savings in the securities markets, either through the purchase of individual stocks or shares in a mutual fund or by setting aside funds for their future in pension plans, which in turn have been invested in companies. These investments have provided trillions of dollars in capital for companies in the United States and around the globe. That capital is providing the fuel for our economic engine, funding for the growth of new businesses, and providing the necessary investment in new plant and job opportunities for tens of millions of workers.

But I must remind you, the willingness of investors to continue to invest their money in the markets cannot be taken for granted. On more than one occasion, investors' confidence has withered like a vine without water, and stockholders have sought safe havens for their hard earned money. It has happened before, and can happen again.

Public trust begins, and ends, with the integrity of the numbers the public uses to form the basis for making their investment decisions. To make my point, I often ask my audiences, "How many of you would invest in a company where you knew the numbers in the financial statements were 'fudged' or did not accurately portray in a consistent fashion, the actual economic results that had been achieved?" No one ever raises their hand.

Accordingly, investors in the U.S. capital markets have depended for over a hundred years on an independent third party, an external auditor to examine the books and financial reports prepared by management. Investors and the New York Stock Exchange demanded independent audits first in the 1890's after confidence in the markets had ebbed due to fictitious financial reporting. They demanded it again in the 1930's after a bull market in the "new" technologies of radio and automobiles crashed. And they still demand it today, perhaps more than ever, after the Asian market crisis and demise of the dot.coms in this "new" age of technology and information.

But despite all the changes we have had and continue to experience in business, it is the report of the independent auditor that provides investors with the critical assurance that the numbers in the financial statements have been subjected to an impartial, unbiased, and rigorous examination by a skilled professional. But in order for that report to have credibility with investors, to add value to the process and investors, it must be issued by a person or firm that the investor perceives is free of all conflicts -- conflicts that may or will in part, weight on or impair the auditor's judgments about the accuracy of the numbers. As both a former partner in one of the "Big Five" international accounting firms and as a vice president and chief financial officer (CFO) of an international semiconductor company, I know that many of the most critical judgments and decisions an auditor must make are not questions whose answers are black or white; but rather they often involve shades of gray where a bias one way or another can have a significant impact.

Storm Clouds on the Horizon

In the United States, we have been watching developments in financial reporting that indicate a growing concern with the quality of the numbers provided to investors by both U.S. and international domiciled companies. These developments include:

  • Surveys of CFO's in which CFO's report they often are asked to misrepresent the numbers and all too often do so.
  • Recent surveys showing a rapid rise in the number of restated financial statements.
  • Tens of billions of dollars in lost market value associated with alleged financial frauds and restatements, perhaps aggregating $100 billion in the last six to seven years, for those companies that have had restatements.
  • Press coverage of many of the these alleged financial frauds such as Lernout and Hauspie, Cendant, Microstrategy, Waste Management, Sunbeam and many, many more. These are press stories about accounting and accountants that used to be considered so mundane that only deceased reporters wrote about them. Yet today they have received the full attention of the public and are now cover stories such as last Friday's article in USA Today [6/22/01] entitled, "Fuzzy Accounting Raises Flags, Investors Feel the Pain when Companies Fudge the Facts." Unfortunately that article cited cases of growing concern, if not in some cases an outright lack of confidence by investors in the numbers in the financial statements. One investor was quoted as saying, "The numbers are all bull. These (companies) can take their numbers and then state this and then restate that." A well-respected academic added, "I find a lot of problems. There's no shortage."
  • A survey of international companies titled International Accounting Standards Survey 2000 by David Cairns, Former Secretary of the International Accounting Standards Committee (IASC), which cites numerous instances of noncompliance with IASC standards in financial statements that were accompanied by a "clean bill of health" in the report of the external auditor.
  • Testimony during 4 days of unprecedented public hearings on auditor's independence held by the Securities and Exchange Commission, in which a number of those testifying, including accounting practitioners, academics, and law enforcement officials cited instances in which a lack of auditor independence did play a role in the lack of an appropriate audit and it is not just an issue in the U.S. Brand Finance testified during the public hearings that of 292 London equity analysts surveyed, a majority are concerned about the independence of accounting firms and over 90 percent believed that significant non-audit fees are likely to compromise auditor independence.
  • A March 19, 2001 Forbes article entitled "Five of the Great Audit Failures of the Past Two Decades," that discussed the correlation of the lack of quality audits and the auditor's relationships to their clients.
  • Recent disclosures of audit and non-audit fees in filings with the SEC that highlight how the business of accounting firms has changed rather dramatically. Where as recently as the early 1980's, the accounting firms' principal source of revenues were from the performance of audits, a survey of 563 of the Fortune 1000 companies showed that for every $1 of revenues generated for the performance of the reviews and audits of the quarterly and annual financial statements in 2000, $2.69 in revenues were generated by providing other services. Those other services accounted for 73 percent of total fees billed by the accounting firms to the companies surveyed.

Perhaps one way to sum this up is to go back to the argument the accounting profession often puts forth, and that is why would any firm or any professional put their reputation and career on the line for the sake of a single audit client? Quite simply, I must respond I don't know why. But then again, I don't understand how, not just one, but rather an entire team of auditors, often with two to three partners and an experienced manager, with probably 40 plus years of combined experience, can simply miss errors totaling hundred of millions of dollars, even billions. Errors that have transcended not just one audit, but multiple audits. And as enforcement releases of the Commission on W.R. Grace, Sunbeam and Andersen discuss, errors the auditors found, and knew were incorrect but consciously chose not to demand be corrected and chose notto disclose to the auditors' own customer, the investing public. I must again ask the same question the profession does, if it is not the power of the economics, then why is it the audit engagement team and auditing firm have subjected the firm and the individual professionals to civil litigation, serious charges of fraud, fines for the firm and a likely end to the public accounting careers of the individuals involved?

The Road to a New Rule

The Commission proposed and adopted new rules last year governing auditor independence. As many know well, the process of working towards an effective but workable final auditor independence rule was a long, and often difficult one. Along the way, there were some heartfelt differences of opinion on how best to handle certain issues. There was a strong difference of views even among the professionals, including the Big Five accounting firms. The Commission's staff heard the specific concerns of thousands, including all of the Big 5 firms and the American Institute of Certified Public Accountants (AICPA), and the final rule reflects, to a great extent, their concerns. I firmly believe that the final rule strikes a balance that provides much greater transparency and serves the interests of America's investors while remaining flexible and adaptable for the unforeseen changes in tomorrow's marketplace.

America's accounting firms have established a proud heritage of excellence through the years, fulfilling a mandate established in 1933 to provide investors with information that is both comprehensive and reliable. But 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 concerns over the culture and controls within the firms, raise significant public policy issues that require serious consideration. Accordingly, the Commission proposed and adopted the changes to our auditor independence requirements in response to these developments. We received thoughtful and constructive input from a broad spectrum of interested parties. That input, which included almost 3,000 comment letters and written and oral testimony during four days of public hearings (about 35 hours of testimony from over 100 witnesses including David Brown, Chairman of the Ontario Securities Commission) helped us to better understand the sincere and strongly-held views on all sides, and to shape final rules. I would encourage you to read the public comment letters, public testimony and final rules which are available on our website at www.sec.gov.

The final rules, among other things:

  • Significantly reduce the number of audit firm employees and their family members whose investments in audit clients are attributed to the auditor for purposes of determining the auditor's independence.
  • Shrink the circle of family and former firm personnel whose employment impairs an auditor's independence.
  • Identify certain non-audit services, such as legal services, bookkeeping and the issuance of valuation reports and fairness opinions, that, if provided by an auditor to a public company audit client, impairs the auditor's independence. These prohibitions do not extend to services provided to non-audit clients.
  • Provide accounting firms with a limited exception from being deemed not independent for certain inadvertent independence impairments if they have sufficient quality controls and satisfy other conditions.
  • Finally, the new rules for the first time in the U.S. provide greatly enhanced transparency as most public companies and their audit committees are now required to disclose in their annual proxy statements, among other things, certain information related to non-audit services provided by their auditor.

These rules, with very limited exceptions, must be fully complied with by auditors of companies domiciled in the U.S., by auditors of foreign subsidiaries of those companies, and by auditors of foreign companies who file with the Commission. As the new rules provide greater clarity and certainty to the regulations, exceptions or waivers to the rules will not be granted by the staff.

A Conceptual Framework That Works

One question I am asked from time to time, is why didn't the Commission adopt a conceptual approach to auditors independence as opposed to a rule based, proscriptive approach. More directly, why was a "threats and safeguards" approach rejected?

In the final release, the Commission did adopt a conceptual approach based on four principles outlined in the preamble of the rule. These principles have been the bedrock of the accounting profession's own rules for decades. The four principles specify an auditor would not be considered independent when the auditor:

  1. Has a mutual or conflicting interest with the audit client.
  2. Is placed in the position of auditing his or her own work.
  3. Acts as management or an employee of the audit client, or
  4. Is in the position of being an advocate for the client.

These basic principles are then followed by more definitive rules which bring greater clarity and certainty to the application of the principles.

Guarding the Henhouse

Reading the final release, you will find where the Commission discusses and then specifically rejects a "threats and safeguards" approach. The Commission noted this approach is dependent on a firm's self analysis and self review. The threats and safeguards approach does not provide the type of definitive guidance or transparency that enhances investor confidence in a firm's ability to make unbiased and objective audit decisions. Under the "threats" and "safeguards" approach investors will not know when a threat exists, whether any safeguards are in place or what the firm thinks is an acceptable level of risk. A "threats" and "safeguards" approach also provides the auditor with the ability to reduce the level of independence risk to an acceptable level based on his or her own determination. Investors are asked to blindly believe that the auditor will do the right thing. The "threats" and "safeguards" approach has been referred to in some circles as the "fox guarding the henhouse" approach because the accounting firm becomes the sole and final arbiter of whether the accounting firm's independence has been impaired. Some might say that financial fraud cases such as those I have mentioned, raise the specter that the pressures on a firm's partners and management to grow their non-audit businesses and create revenues for partners in the firm is too great for them to be able to be an unbiased arbiter for such important independence matters.

Under the SEC rule, investors know that regardless of how much risk the firm wants to take, some things are just out of bounds not because of the risk that the firm is willing to take, but because of the amount of risk that investors should have to take. This view is espoused in the Commission's auditor independence release.1

Another concern the Commission had with a "threats and safeguards" approach is the lack of compliance, both in the U.S. and internationally, with the previously existing rules of the Commission and profession. Our 1999 enforcement release, In the Matter of PricewaterhouseCoopers L.L.P., provides an insight into this lack of compliance, which we have seen broadly across the profession and which we are actively investigating. Where warranted, the staff will recommend the Commission seek appropriate remedies in these cases. The look-back program the staff negotiated with the eight largest accounting firms last year is also an outgrowth of our concern over lack of compliance. The bottom line to this noncompliance is that we believe a regulator would be short-sighted to rely on "safeguards" a profession is espousing while, at the same time, they may not be complying with existing regulations, the accounting profession's or even the accounting firm's very own rules.

The Necessity of Quality Controls

But don't get me wrong. We do believe that each accounting firm practicing before the Commission should have effective quality controls that provide investors with reasonable assurance that the firm is complying with all of the applicable rules governing their independence. The Commission's release sets forth the types of quality controls it believes firms should have on a worldwide basis. Many of those quality controls are currently required for non U.S. affiliates of the accounting firms, while those related to "tracking systems" are to be implemented by the foreign affiliates by the end of 2002. Unfortunately, we have become aware of a number of instances where a foreign affiliate of an accounting firm has not followed the rules, causing very significant issues for the firm's clients, and in some cases resulting in a change of auditors. All of this has happened despite our letter to the leadership of the profession and accounting firms two and half years ago, citing the need for improvements in these internal controls. Hopefully, the two public reports the Public Oversight Board is to issue in 2001 on the design, implementation and operational effectiveness of quality controls the accounting firms have agreed to implement, including those they announced to the public over a year ago that they would implement during 2000, will inform the public about the status of these quality controls.

Quality of Audits Not Diminished

And speaking of quality, let me add a sidebar to the debate that occurred. The accounting profession argued that accounting firms must be allowed to continue to provide non-audit services such as consulting for information technology projects in order to maintain the quality of their audits. But in our public hearings, the former CEO of Deloitte and Touche, Mr. Michael Cook, and Mr. Philip Laskawy, the Chairman of Ernst and Young, testified that quality audits have and will continue to be provided not withstanding any restrictions on such services. The leadership of the firm formerly known as Andersen Consulting, now named Accenture, testified there was very little crossover in knowledge between the auditors and consultants. And finally our study of 563 Fortune 1000 companies who had filed the proxy disclosures with the Commission by the end of April 2001 shows that 437 or 77.6 percent of these companies had not engaged their auditors for information technology consulting. This in turn raises the question, how many of these companies auditor's have claimed their audits of these registrants are not quality audits.


Let me close by stating that the independence of auditors of public companies has been and continues to be an issue of paramount importance to investors, the accounting profession and regulators alike. It is a subject that cannot be a question, but rather must be a given. But all too often today, the question is being asked, "Did the auditors provide an unbiased and truly independent report on the numbers?" To maintain their value to the capital markets and regain the confidence of investors, auditors around the globe must renew their covenant with investors; a covenant that says each auditor will remain inquisitive, skeptical and rigorous; that he or she will remain free from a web of entanglements or arrangements that threaten the appearance of his or her objectivity; that with the auditor's stamp, the numbers speak the truth. I hope those currently in the profession, and those who will join it in the future, will honor this covenant made in the past by many a proud independent accountant who have traveled the road before us.


1 Release No. 33-7919 at section IV.D.2.
"We are concerned, however, that a 'safeguards' approach, which is dependent on a firm's self-analysis and self-reviews, will not provide a definitive standard. In our view, independence is better assured by consistent and uniform rules, rather than by rules that rely on the auditor's assessment of the extent of its own self-interest. Furthermore, it has been our experience that the existence of safeguards or quality controls alone does not ensure compliance with even the most basic independence regulations."




Modified: 07/06/2001