SELF REGULATION, CONSULTING SERVICES AND AUDITOR INDEPENDENCE BY: WILLIAM R. MCLUCAS* ---------------------------------------- * This speech was given before the Annual AICPA National Conference on SEC Developments on December 10, 1996 at the Grand Hyatt Hotel in Washington, D.C. * 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 the authors and do not necessarily reflect the views of the Commission or of the authors' colleagues on the staff of the Commission. Over the past 10 years, we have experienced remarkable growth in our securities markets. As of yesterday, the Dow closed at 6464, which while down somewhat from last week, still eclipses even the most optimistic predictions of a year ago. Securities offerings have continued to set records, with approximately $1.2 trillion in securities being registered with the SEC during fiscal year 1996. Of that amount, approximately $185 billion involved initial public offerings. By virtually any standard, our capital markets have proven a remarkable vehicle for entrepreneurial opportunity. This opportunity has not been restricted to U.S. companies. As of October, 1996, more than 850 foreign companies from 47 countries have registered their securities with the SEC and are listed for trading in our markets. This past year alone, 132 new registrants from foreign countries have come into our markets. This growth and success of our markets should give us cause for tremendous pride in our system and market structure. We continue to boast of the most liquid, most efficient and the fairest capital markets in the world. In no small measure, the success of the U.S. capital markets is due to an accounting system that has been characterized by professionalism, discipline and independence, in reporting fairly on the financial fortunes of those who seek access to investor capital. This profession, perhaps to a far greater extent than the lawyers and the investment bankers, holds the keys to the credibility of a company's representations as to its financial performance and its ultimate worth to the market. Thus, accountants are largely responsible for the degree to which investors perceive our markets to have a level of integrity that is unmatched world wide. Our unique system of a private accounting and auditing profession, with public responsibilities, has, with all of its anomalies, worked remarkably well. Before we get too comfortable with this success, however, or too complacent with our track record, there is reason to be cautious about the future. The hall mark of our capital markets is self- regulation. At its most basic level, this principle is evidenced in the full disclosure requirement which is applicable to public companies in corporate America, and which is policed by the independent auditors. In the securities industry, the self-regulatory bodies--like the New York Stock Exchange, the American Stock Exchange, and the National Association of Securities Dealers--have a different but analogous relationship to the behavior of market professionals. Ultimately, the SEC sits atop this pyramid of self-regulation. While the system has remained intact and worked remarkably well for more than sixty years, the sophisticated markets today present new challenges. The pressure has never been greater on those in the system who are charged with a role in preventing fraud and policing the basic principle of full disclosure. I'd like to take a moment to talk about an example of how those pressures resulted in one serious failure of self- regulation: the SEC's recent case involving the NASD and the NASDAQ market. Then, I want to turn to an issue near and dear to the accounting profession's heart--and also, apparently, to its pocketbook: the issue of retaining true independence while expanding the services provided to audit clients. Why is the NASD's experience relevant to the accounting profession? Well, just as your profession is a critical part of the remarkable success and growth of our capital markets over the past decade or so, the NASD has overseen the fastest growing -- and some would argue, the most successful -- stock market in the United States -- the NASDAQ stock market. More than 85% of all new public companies list their securities on the NASDAQ. It has proven a remarkable vehicle for entrepreneurial capital formation. Yet, in spite of this spectacular success, something was amiss in the perspective of the NASD -- as a regulator -- regarding this market. It is this same danger -- the risk of losing perspective -- which provides an apt analogy to the accounting profession -- perspective in a market environment which is, by most indicators, remarkably strong and successful. The perspective I'm referring to is more conventionally known to accountants as independence. The NASD Case In August of this year the SEC sanctioned the NASD for failure to enforce its own rules as well as the federal securities laws. The SEC also issued a 132 page Report of Investigation in conjunction with the enforcement action. While the Commission cited a variety of failures on the part of the NASD, the fundamental problem was the failure of this self-regulatory organization to ensure that the NASDAQ stock market operated in an open and freely competitive manner. As a regulatory body -- whose most important constituency is public investors, not listed companies and not the securities industry -- the NASD failed in several respects. Among a laundry list of deficiencies cited by the Commission, it failed - to ensure that market makers traded at their public quotations; - to enforce the requirement that trades be accurately and promptly reported to the market; - and, most significantly, it failed to take action with respect to anti-competitive behavior by market makers. This last matter -- the lack of competition -- went to the heart of the case and, indeed, to the heart of a free and competitive marketplace. Since securities in the NASDAQ market trade at prices reflected by "a bid" for a buy, or an "ask" for a sale, the "spread" (which represents the difference between the two), is where a market maker makes its profit on trades. The Commission charged that the spreads were maintained at artificially wide levels, as part of a widespread pattern of anti-competitive behavior. The Commission found that most quotes in the NASDAQ market were in increments of 1/4's (or even eighths). In turn, when prices moved, they tended to move up or down, not in 1/8th or a 1/16th point increments, but in increments of 1/4. There seemed to be an aversion -- indeed -- a conscious avoidance -- of odd eighth quotes, that was inexplicable, but for apparently concerted activity by market makers. Investor interests were obviously not well served by these practices. We had empirical data consisting of statistical analysis of the market showing how securities were priced and traded, coupled with testimony and taped conversations - - albeit episodic and anecdotal -- clearly evidencing the anti-competitive purpose of the conduct. And what was the explanation from the traders?...that quoting only in even-eighths was the "professional" way to behave -- or the "ethical" way to trade -- and in more blunt terms -- that the narrowing of spreads (and thus the improvement in prices) raised an unnecessary cost to buy securities from customers, and needlessly lowered the price on sales of securities to investors. In short, the economic self-interest of the market makers took priority over competition. Thus, the market makers acted together in a well enforced arrangement to prefer their own economic self- interest, over the interests of investors. The NASD, while it operates and oversees the NASDAQ market, is also charged with protecting investors. The organization, however, failed to make inquiry into these practices, even when put on notice by critical academic studies and litigation. Indeed, the NASD vigorously defended the market and denied any anti-competitive practices existed. In the words of Chairman Levitt: The NASD was not blind to these practices in the marketplace. It simply looked the other way. As the issue of the pricing convention was brought to the attention of the NASD, as the press and others raised it ... the NASD sounded no alarm; it conducted no investigation. I will not recite the terms of the settlement or the changes that have occurred or are now taking place at the NASD and in the market as a result of this case. Suffice it to say, changes are underway to ensure a more competitive market where investors get a fair shake, market activity is more transparent, and where competition is ensured. The Accounting Profession My point, as it bears upon the accounting profession, is that the NASD's perspective as a regulator seemed to have been compromised by its dual role, on the one hand, as an entrepreneurial organization running a marketplace, and, on the other, as an organization whose mandate must be investor protection. The accounting profession runs this very same risk. As auditors, you are hired and paid by those whose conduct, you both audit and police. Auditors do this in an increasingly competitive environment. As the competition has escalated, and the business world has offered new entrepreneurial opportunities, the relationship between the auditor and the client has changed. These new avenues of entrepreneurial growth for the accounting profession go above and beyond even traditional consulting arrangements. Opportunities now exist for joint ventures with the client, for handling the client's internal audit functions and back office accounting work. Accounting firms are now involved in providing investment banking services, financial risk management, actuarial services, strategic services for mergers and acquisitions, and a host of other kinds of services. Revenues from management consulting now exceed one-third of total revenues for the profession. Indeed, I would expect that with this trend line, determining the independence question for the auditor has become a growth industry, in and of itself. All of these services have an impact on auditor independence. Independence and the SEC On the issue of independence, there are several concerns. Most recently, the SEC and the Financial Accounting Foundation, the parent of the FASB -- announced an agreement on how to restructure the FAF's 16 member Board. The substance of the agreement was that a balance in Board membership would be achieved between those with a stake in how accounting standards are set -- for example, corporate representatives -- and those who are independent, and without such a direct interest. Why did the SEC embark on this effort in the first place? Because earlier this year a group comprised of corporate financial officers issued a series of recommendations to the FAF to reduce the size of the FASB, make its members part-time, reduce the number of staff, and give control of the agenda setting process to an external corporate body. While this issue involved at the broadest level, independence related to who sets the rules for financial accounting and auditing, it is indicative of the pressure on the accounting profession and the necessity for it to retain its independence from influence by clients. Recently, a study published in Accounting Today showed that for the 100 largest accounting firms in the United States, revenue from consulting and related services increased by 36% during 1995. This figure compares to only a 1% increase in revenue from traditional auditing and accounting work. If that trend line continues, then auditing is likely to decline significantly in overall importance to the accounting profession's bottom line. The more important question, however, is not from whence the accounting firms will generate revenue; Rather it is what the impact will be of these additional relationships on the auditors' objectivity. For instance, when the accounting firm has identified and recommended an acquisition candidate, or provided valuation expertise which is given to shareholders for approval of a corporate combination, does that impair subsequent audit independence? These are not insignificant issues. The profession can and has mustered a variety of arguments to support the development of these relationships and indeed, to make its case that such services actually enhance audit performance. We will hear that such additional work enables the firm to know and better understand the client's business, and thus may actually lead to improved auditing. We'll also hear that the synergy provided by such a variety of services will lower costs and actually benefit investors through efficiency. Years ago we heard the argument, long since abandoned, that an equity position in a client would improve the quality of the audit. As the relationships between the auditing firm and the client expand, however, these arguments, in my view, carry less weight. The issue is not the competence of the firms to perform these services; nor is it cost efficiency; the issue is independence -- independence in both fact and appearance. Let me return for a moment to the analogy I drew from the NASD case. That organization's failure to perceive and address the issue of anti-competitive behavior in the NASDAQ market, occurred while the market was generally perceived as remarkably successful and strong. Perhaps the very success of the markets blinded both the industry and the self- regulatory body from the ability to see the problem. When we consider the issue of auditor independence, the same temptations are present and the same apparent success of our markets is a fact. The impact of incremental erosion in the discipline of independence, however, will provide a false sense of comfort that the relationship is both sound and healthy. As each new entanglement is established and the relationship with the client gets more complex, the sky is unlikely to fall suddenly and no apparent ruination of the system will be in evidence. In turn, the rationalization that these relationships are entirely appropriate and good for the markets, as well as for the profession, will solidify. As auditors get more involved and entangled with the clients, however, it is all a matter of time and degree. Eventually these compromises will make independence a dead letter. No one event is likely to make clear the downside of this expansion of services. Over time, however, we will have dramatically altered the overall discipline in the auditor's role. In enforcement cases over the years, I've found that it is not the complete audit failures that present the thorniest issues. When management is stealing the company blind or blatantly cooking the books, the assessment of accounting treatment and audit performance is easy, for both the SEC and the auditors. It is the "grey zone", however, where there is ample room for interpretation and elasticity, both as to GAAP and as to audit standards, where the auditors more frequently accommodate or, pejoratively speaking, "cave" to the interests of the clients. Because accounting as a discipline embodies so much judgment, the seduction of the accounting profession to "lean", if not "bow" to the pressure of the clients and, indeed, the firm's own economic interests, will escalate dramatically. That is why the complex of entanglements with the clients poses such a subtle, but clear, threat. These are not easy issues. In 1996, the Public Oversight Board's Advisory panel on this topic, issued a report on the subject. Likewise, an AICPA Special Committee issued a report on auditor independence in 1994. Both reports explored and suggested a future agenda for financial reporting and for the governance process that surrounds it. The issue of the auditor's relationship to the client is exceedingly more complicated today than a decade ago. While the problem is complex and the competitive climate intense, the independence concept remains both a basic and a simple principle. If too much baggage is attached to this principle, it, too, will begin to emerge as a fungible commodity in our financial reporting system. This would not only diminish the auditor's professionalism, it would damage the system and the markets.