Remarks Of Isaac C. Hunt, Jr. Commissioner* U.S. Securities and Exchange Commission Washington, D.C. A Securities Regulator's Top Accounting and Auditing Priorities for 1998 25th Annual National Conference on Current SEC Developments American Institute of Certified Public Accountants Washington, D.C. December 9, 1997 ______________ * The views expressed herein are those of Commissioner Hunt and do not necessarily represent those of the Commission, other Commissioners or the staff. U.S. Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 Introduction Thank you for inviting me. I am delighted to address this 25th Annual AICPA National Conference on Current SEC Developments. For two days, you will hear from many accounting experts -- among them experts in my agency's Office of the Chief Accountant and our Division of Corporation Finance. SEC staff members will discuss a host of accounting, auditing, and disclosure issues. You will hear about what the staff observed in recent reviews of registrant filings and whether what the staff saw pleased, or troubled, them. You will learn about projects on the staff's 1998 agenda. And you may get an even more tangible benefit from this fine conference: the staff's answer to a difficult and not- so-hypothetical question. Perhaps that answer will save your company or client a lot of time and effort. I wish that good fortune for all of you. I know that it is this direct interaction with the staff on specific technical issues that draws many of you here each year. But, today, you'll also hear more far-reaching remarks from Mike Sutton, the Commission's Chief Accountant, and Bill McLucas, our Director of Enforcement. Mike and Bill are two of the most dedicated public servants with whom I've worked. I've heard both of them discuss with genuine conviction why financial statements are the cornerstone of our full disclosure regulatory approach, and why the quality of those financial statements are dependent upon the accounting principles used to prepare them. In part because of their conviction, I decided to focus a large portion of my efforts at the Commission on accounting and auditing issues. So when Mike or Bill talk about the larger issues affecting our markets I listen, and I hope that you will too. But I won't give Mike and Bill all the credit for why I wanted so very much to be with you today. You see, for most of my career before the Commission, I'd been a user -- albeit a special kind of user -- of financial statements. Now, you probably know that I don't have an accounting or auditing background. I also never actively traded individual stocks. What I did do was teach the federal securities laws to law students at three law schools over 15 years. In my classes on the federal securities laws, students got a healthy dose of why quality financial statements and quality accounting standards mattered to investors and to markets. I used accounting fact patterns: to illustrate the concept of "materiality," to discuss the different reporting schemes under the Securities Act of 1933 and the Securities Exchange Act of 1934, and to explain why "shelf registration" was appropriate. Now, as a Commissioner, I still use financial statements. I'm still a special kind of user, but I'm a more passionate user than I was before. My ardor didn't come from winning the lottery after taking my oath of office; my investment portfolio still is not much to write about despite occasional inquiries from reporters with too much free time on their hands. Instead, I am passionate because I deal with accounting- and auditing-related issues or, at the very least, the consequences of good or bad accounting and auditing decisions, every day. Please know that I'm not just talking about the 15%-or-so of our enforcement cases which somehow touch on accounting and auditing decisions. Discussions at the Commission about such matters do not begin and end around the table in our closed meeting room where we consider many enforcement cases. Trust me on this -- so many other important Commission or staff initiatives are predicated on the accuracy and care by which you do your jobs. Let me give you just two less-obvious examples: (1) My faith in the overall quality of the work done by members of this audience, as well as regulatory changes in disclosure with respect to financial reporting, is a large reason why I am able to support legislative efforts to repeal the Public Utility Holding Act of 1935. (2) My faith in your work allows me to consider proposals regarding whether the Commission agency should dramatically change the offering process for the issuance of securities. (To those of you from the Division of Corporation Finance, please note that I said "consider" such changes -- not "support" or "oppose." To those of you not from the Division, I apologize for this inside-the-agency comment.) Having said all this, I will move on to the main topics I want to cover today. While I no doubt will concur with much of Mike Sutton's and his staff's agenda for the next year, I wanted to spend the rest of my remarks on two of my priorities for 1998. The first is further progress towards high-quality cross-border accounting standards, and the second relates to auditor independence. International Accounting As you may know, securities regulators around the globe are working on several projects designed to reduce differences in reporting and disclosure requirements. The International Organization of Securities Commissions ("IOSCO"), of which the SEC is a member, has been working with the International Accounting Standards Committee ("IASC") for the past several years on a project to develop a core set of accounting standards that might become a framework for financial reporting in cross- border securities offerings. The Commission has supported this initiative. The work of IOSCO, both independently and with IASC on its core standards project, is an important effort to improve capital market reporting and, therefore, global capital market efficiency. Because of the importance of this project, and because the Commission ultimately will consider whatever core standards are advanced, the Commission's staff has been active in IASC's project. In April 1996, IASC announced that it would try to complete a core standards work plan by March 1998. Also in April 1996, the Commission issued a statement in support of the efforts of IOSCO and IASC. The Commission's statement indicated that, if IASC successfully completed the agreed-upon work plan, the Commission would consider allowing foreign issuers to use IASC standards in securities offerings in the U.S., but only if those standards satisfy certain criteria. The Commission's statement then identified three criteria necessary for IASC's standards to gain the Commission's acceptance. First, the core standards must constitute a comprehensive, generally accepted basis of accounting. Second, the core standards must be of high-quality. Third, the core standards must be rigorously interpreted and applied. Last year, in addressing this conference, Chairman Levitt stressed the importance of the third criterion: the need for rigorous interpretation and application. Today, I'll stress the second: that the standards be of high-quality. I feel a bit odd doing so; after all, who could argue against the need for high- quality accounting standards in cross-border transactions? But, of course, there can be different views among regulators from different countries as to what constitutes high- quality. So let me explain why I believe that the core standards must be of high-quality, and what I think high-quality means. I believe strongly that the success of the U.S. capital markets is directly dependent on the quality of our accounting and disclosure systems. And we are successful. A good benchmark of whether our markets are strong and whether our accounting and disclosure systems are good ones is how many foreign companies list here in the U.S.. When Chairman Levitt spoke to you last year, that number was about 850. Just one year later, we've broken the 1,000 mark. The exchanges are rightfully proud of this accomplishment, and so is the Commission. What breaking the 1,000 barrier suggests to me is that foreign companies want to list in the U.S. because the benefits of abiding by our accounting and disclosure systems far outweigh their costs. The U.S. accounting and disclosure systems give investors confidence in the credibility of financial reporting even in fluctuating markets. If you would, please imagine how much more wild the last two months would have been for our equity markets if investors thought -- not knew, just thought -- that most major companies' financials could not be trusted because they hid losses through questionable accounting practices .... if your imagination fails you, just call a friend living on the other side of the international dateline. But just because I believe in the high-quality of the U.S. disclosure and accounting systems, does not mean that the world's capital markets must adopt our standards. What it does mean is that any set of accounting standards seeking global acceptance must provide full disclosure. They must be transparent. The Commission went into IASC's initiative hopeful and enthusiastic. I remain so. You may know that IASC recently extended the timetable for completing its core standards -- that's now set for late 1998. This delay is not of great significance to me. What is important is not when the standards are finalized, but what's in the standards. But while I am enthusiastic and hopeful about what IASC can accomplish, let me repeat something Chairman Levitt said to you last year. He wondered out loud whether the message of the Commission's April 1996 statement, which first recognized the significance of the challenge taken on by IASC, somehow glossed over a second, equally important, message: that acceptance of IASC's standards by the Commission "is not a foregone conclusion." I agree. The Commission's decision as to whether or not to accept IASC's standards should be made only after the core standards are completed, based on what is in those standards, and whether those standards satisfy the three criteria identified in the Commission's April 1996 statement. Auditor Independence Let me switch gears now to another top priority for me in the new year: promoting auditor independence. I know that some of you in the audience aren't auditors, but I hope you will not mind the discussion. My guess is that I won't be the last person at this conference to discuss the issue. In preparing my remarks on this subject, I did three things that I wanted to share with you. First, I went on-line to the Web-site for Bartlett's Quotations. I wanted a quotation that would put everything in context, and one that had some panache. I thought that there was a passage in A Midsummer Night's Dream which touched on the three concepts I was looking for: Independence, Truth, and Passion. What a magnificent way to begin a discussion of auditor independence! How better to express what I expect from auditors in reviewing financial statements than to quote a musing from Mr. Shakespeare on these three qualities? Alas (poor Yorick), I did not find what I was looking for. But I did find a wonderfully patriotic poem entitled Hail Columbia. Some of you may know of it; I did not. It was written by Joseph Hopkinson, who was a jurist and whose father signed the Declaration of Independence. Mr. Hopkinson's poem begins: Hail! Columbia, happy land! Hail! ye heroes, heaven born band... Of course, he was talking about those who gave their lives in the American Revolution, and not last week's opening of the MCI Center and the Washington Wizards's opening night victory there. But it was the second stanza of Mr. Hopkinson's poem which caught my eye: Let independence be your boast, Ever mindful what it cost, Ever grateful for the prize, Let its altar reach the skies. Stirring words, aren't they? And how appropriate! So with my first task completed, and still on the Web, I went to the Commission's site. I looked for a recent speech I gave on auditor independence to the National Association of State Boards of Accountancy. In the speech, I traced a bit of the history of how and why Congress mandated that the financial statements of issuers of publicly held securities be certified by independent public accountants. I explained how the auditor was to be an independent overseer of the integrity of information provided to the capital markets, and how this role was granted as a public trust to the profession. I was very pleased with that speech. But in rereading it, and then some of my others speeches, I noticed something odd. I used the word "notably" a lot at the beginning of sentences. It's a good word -- a safe word. It can mean anything from "what follows is sort of interesting to me but I doubt anyone else would care about it," to "what follows, for god's sake, is the most critical thing I have to say." I also use the word "concerned" a lot. It's a good word -- a safe word -- a regulator's word. It can mean anything from "it's not something worrying me right now but here's a marker I'm putting down" to "it's the end of the world as we know it." I vow not to use either word -- "notably" or "concerned" -- in this discussion of auditor independence. Instead, I'll try to be a bit more transparent in offering my views. So, with tasks one and two completed, I checked out the AICPA's Web-site -- my third task. It's a terrific site; very informative and very easy to use. I first looked for and found the White Paper report submitted to the newly formed Independence Standards Board by the AICPA. The report suggests that broad principles of conduct regarding auditor independence should be adopted across-the- board, and then that each firm may develop and enforce its own codes of conduct. I haven't read the entire report yet, but I will go out on a limb and make this point: I do not believe that the writers of the White Paper report see the core issues the same way that I do, and they do not perceive the same risks that I perceive from a failure to maintain auditor independence both in fact and in appearance. Next, I came across on the AICPA's site several letters that noted how the CPA is being called upon to provide a wider range of services, reshaping the traditional definition of "certified public accountant." One letter talked about a "New Finance" program designed to help CPA's retool and develop new skills "encompassing the essence" of this new CPA role. Another letter offered five answers to the hypothetical question of "What will the new CPA look like?" -- here's one answer given: Not exclusively, or even primarily, the traditional auditor and attestor of financial statements, that role giving way to that of a trusted financial-services and business-strategy adviser. Now what do I think of all this as a securities regulator? And I promised not to use the word concerned, right? Well, I believe that I will have my work cut out for me in 1998. With my three tasks completed, I set out to write my remarks. I believe the increased reliance on fee income from consulting services, as well as the growing number of business relationships between auditors and clients, calls into question the ability of auditors to be independent when carrying out their statutory responsibilities. The first item -- reshaping the auditor to be a trusted financial services and business strategy adviser -- raises the question of whether auditors will continue to appear to be independent. Auditors must maintain not only independence "in fact," but also "in appearance." Auditors must avoid all suggestions of mutuality of interest with the management of registrants for which an auditor provides services. We all know the simple stuff -- members of audit firms can't invest in client firms, can't be related to or borrow money from clients, and can't participate in management activities of audit clients. But regulators and some firms seem to be developing different views as to when an auditing firm is providing non- audit services while auditing their own work. Granted, those can be harder questions. In looking at these so-called "scope of services" questions, the Commission focuses on how an auditor's services would affect a reasonable investor's perception of the auditor as an unbiased professional. We ask whether a reasonable investor, knowing all facts and circumstances, would continue to perceive the auditor as: (1) having neither mutual nor conflicting interests with its audit client, and (2) exercising objective and impartial judgment on all issues brought to the auditor's attention. We answer the question by considering all relevant circumstances and all relationships between the auditor and the client. Of course, this includes the provision of consulting or other professional services to the client. And, sometimes, like last week, we answer the question by instituting an administrative proceeding. In 1998, we should continue to bring solid enforcement cases in this area, and we should be willing to take any "heat" coming our way when we do. Too much is at stake. The auditor's objective "second-look" at an issuer's financial statements, and how they were prepared, provides investors with a sense of confidence in the reliability of those statements; it encourages investment in the securities of public companies. This sense of comfort and confidence depends on reasonable investors perceiving auditors as independent professionals who, above all else, are looking out for the investors's welfare. Challenging the profession about this is not an attempt to limit the growth or development of an accounting firm's scope of services. The Commission's independence regulations do not address providing consulting or other nonaudit services other than when they are provided to an SEC audit client during periods covered by the firm's audit reports or during the performance of the audit. My agency won't tell firms that they cannot enter a particular business or provide a particular service. But we may say that if an auditor provides a particular service to an SEC audit client, it may impair the auditor's independence with respect to the audit of that client's financial statements. In 1998, the Commission will work closely with the Independence Standards Board ("ISB") on this issue. ISB will provide the auditing profession with the opportunity to participate through a self-regulatory process. Its mission is to establish independence standards applicable to audits of public entities in order to serve the public interest and to protect and promote investors' confidence in the markets. It has eight members: four public members, three senior partners from SEC Practice Section firms, and either the President of the AICPA or another representative. The Commission will oversee ISB as we do the Financial Accounting Standards Board: by attending meetings, meeting with ISB and its staff, and reviewing comment letters. I have high hopes that ISB will develop workable solutions. But ISB's existence does not impair the Commission's ability to exercise its authority, including the authority to maintain our current independence regulations and to write new ones, and to institute enforcement actions where appropriate. Further, if ISB does not meet its mission, the Commission should consider other alternatives. I want the Commission to move in 1998 on the auditor independence issue. Some very positive things are happening as the year winds down: a few weeks ago I had the chance to sit down with Chairman Levitt and Olivia Kirtley, Stuart Kessler, Bob Mednick, and Barry Melancon of the AICPA to discuss how the Commission and the AICPA were looking at this issue. It was a good meeting -- very constructive. I look forward to more meetings like that in the next year, and I believe that they could go a long way to resolving some outstanding issues. Conclusion In closing, I probably would be remiss if I did not take note of the recent proposed mega-mergers: KPMG Peat Marwick with Ernst & Young, and Price Waterhouse with Coopers & Lybrand. I recognize that the reasons for such mergers are many: clients who demand a presence around the world, the ability to fund and develop new technology and internal systems, and probably some cost-cutting. I'm sure you appreciate that it's difficult for me to comment on the impact or desirability of the proposed mergers. But we've all seen news reports asking whether four major firms will be enough to audit the vast majority of corporate America, and what the mergers' impact will be on conflicts of interest, auditor independence and, indeed, our entire regulatory and self- regulatory process. According to newspaper articles citing the Public Accounting Report, a merged Ernst & Young/KPMG will audit 37% of all public companies in the U.S. currently audited by Big-6 firms; a merged Price Waterhouse/Coopers & Lybrand 26% more. According to the Financial Times, potential concentration of auditing services in the United Kingdom would be greater, since 88 of the so-called "FTSE 100" companies are audited by one of the four firms. I'll leave you with my preliminary thoughts on the mergers -- just four words, in fact .... Notably, I am concerned. Thank you.