Speech by SEC Staff:
Current Developments at the SEC
Walter P. Schuetze
Chief Accountant, Office of Corporate Practice,
Division of Enforcement, U.S. Securities and Exchange Commission
at the 17th Annual SEC and Financial Reporting Institute Conference, Leventhal School of Accounting, University of Southern California, Los Angeles
May 14, 1998
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any publication or statement by its employees. The views expressed herein are those of Mr. Schuetze and do not necessarily reflect the views of the Commission or the other staff of the Commission.
There is nothing new under the sun on the accounting side at the Division of Enforcement. Over the years, I have heard every Chief Accountant of the Division speak at forums like this one, and I have heard nothing new. There are only so many ways to cook the books. I too am going to sound like a broken record.
Actually, I bring good news. Despite what we occasionally read in the press about accounting lapses, from my perspective as the Chief Accountant of the Enforcement Division, financial accounting and reporting is in good shape. I say this based on the number of open cases that the accounting staff is working on. These are the cases involving accounting issues, financial statement disclosure issues, MD&A disclosure issues, auditing issues, and auditor independence issues. And there are one or two cases that potentially involve bribes paid by public companies to government officials. We have between 200 and 250 open cases involving accounting staff of the Home Office in Washington, DC and the Regional Offices. Of the 200--250 cases, 120 are in the Home Office. Those 120 cases came onto our work program as follows: 1991--two cases, one of which is on hold because there is an ongoing criminal investigation and one of which is on appeal; 1992--one case, which is in settlement negotiations; six cases were opened in 1993; twelve cases originated in 1994; twenty-one started in 1995; twenty-four in 1996, forty-one began in 1997; and to date in 1998, thirteen cases have been opened. (These years are calendar years, not Commission years, which run from October through September.) In the Home Office, we have twenty accountants, so the workload is about six cases per accountant.
When I look at the statistics of about 250 open accounting cases across the entire Commission, that compares very favorably to the total number of possible cases. Those 250 cases arose over about a five-year period. Assuming that as many cases were closed as were opened during that five-year period (and I do know the actual number), the 250 becomes 500. During that five-year period, approximately 15,000 registrants filed financial statements with the Commission. Thus, over the five years, there were 75,000 opportunities to get the accounting, auditing, and independence right. Then, when I divide 500 cases by 75,000 opportunities, the result is about 0.7%. One of the old hands in the Enforcement Division tells me that it seems to him that we bring about 100 accounting cases each year. If I divide 100 cases by 15,000 opportunities, the result is about 0.7%. These percentages are very small. To be sure, the percentages, whatever they are, are not Six Sigma, but nonetheless are very small. What that says to me is, that by and large, the participants in our vast public marketplace are conforming to the rules.
The percentages would be cut about in half were I to include broker/dealers and investment companies in the statistics. In addition to the 15,000 -- 16,000 public company registrants that file financial statements and audit reports with the SEC, there are about 7,000 broker/dealers and about 7,000 investment companies that also file financial statements and audit reports with the SEC. So, if I add 7,000 broker/dealers and 7,000 investment companies to the 15,000 -- 16,000 issuer/registrants, the total is about 30,000. Then, 100 cases divided by 30,000 opportunities equals 0.3%. Over the years, we have had only a limited number of accounting cases involving broker-dealers and mutual funds. I think that it is instructive to observe why that is. I think that there are not many cases involving broker/dealers and investment companies because those companies mark their assets to market.
Let me now turn to the kind of problems that we accountants in the Enforcement Division actually work on. In the six months that I have had to look at the problems, I see that we do not deal much with esoteric accounting problems such as foreign currency translation or the in and outs of pension accounting or postpretirement benefits other than pensions. We deal with more pedestrian issues. For example, on the auditor independence issue, we have one case where the outside auditors of a company wanting to raise money went around to their other clients and promoted the stock of the issuer, passed out the subscriptions for the issuer's stock, and then took the checks that their clients wrote for the shares of the issuer's stock and delivered the checks to the issuer. The SEC has a very clear rule that says that the external auditor may not be a broker for his or her client. So does the AICPA.
Another independence case that we have is the one involving KPMG Peat Marwick, which the Commission filed in December of 1997. The assertions by the Commission are as follows, which I am quoting from the Commission's Order:
"(8) As described in detail below, in approximately January 1995, KPMG Peat Marwick organized and capitalized KPMG BayMark, a purportedly independent firm owned by Edward R. Olson and three others. KPMG Peat Marwick planned to use KPMG BayMark as a vehicle to engage in new lines of business, including the "corporate turnaround" business. Later in 1995, as part of a turnaround engagement, KPMG BayMark installed its principal Olson as the President/COO of Porta, a financially troubled audit KPMG Peat Marwick's Long Island office.
"(9) When KPMG Peat Marwick audited Porta's 1995 year-end financial statements and prepared its audit report, KPMG Peat Markwick's financial and business relationship with its audit client Porta and with KPMG BayMark impaired KPMG Peat Marwick's independence from its audit client, in both fact and appearance. In particular, KPMG Peat Marwick lacked independence because: (1) KPMG Peat Marwick loaned $100,000 to the President/COO of its audit client Porta; (2) KPMG Peat Marwick capitalized the separate business owned by the President/COO of its audit client Porta; (3) KPMG Peat Marwick capitalized the "affiliate" of its audit client Porta; (4) KPMG Peat Marwick was entitled to a percentage of the earnings, disposed inventory and restructured debt of its audit client Porta; and (5) by reason of their contractual ties and interdependence, KPMG Peat Marwick and KPMG BayMark should be considered a single entity for independence purposes.
"(10) Despite warnings from the Commission's OCA staff concerning independence issues arising from its relationship with KPMG BayMark, KPMG Peat Marwick completed its audit of Porta's 1995 year-end financial statements and issued its "Independent Auditors' Report," dated March 22, 1996, which represented that it had " conducted our audits in accordance with generally accepted auditing standards" ("GAAS"). Porta incorporated KPMG Peat Marwick's report as part of its 1995 annual report on Form 10-K, filed with the Commission on April 2, 1996."
KPMG has responded by denying the Commission's assertions about KPMG's lack of independence. The matter soon will be heard by an Administrative Law Judge.
Let me move on to some of the accounting issues with which we are dealing. The Enforcement Division was formed in the 1970s. As I said earlier, over the years, I have heard every one of the Division's Chief Accountants give speeches wherein they described their cases. Well, nothing has changed. Registrants are still doing the same things.
Premature revenue recognition. Deferral in the balance sheet of costs that should have been reported in income as operating expenses. Assigning inflated, often outrageously inflated, dollar values to exchanges of nonmonetary assets, particularly with related parties. Assigning inflated, often outrageously inflated, dollar values to nonmonetary assets contributed to the corporation in exchange for stock of the corporation. Not disclosing the existence of related parties and/or transactions with related parties. Recognizing officers' salaries as receivables. Recognizing cash taken from the corporation by officers as cash in bank or as a direct reduction of stockholders' equity instead of as a charge to expense. Bleeding into income, without disclosure, "reserves" established in business combinations or in so-called restructurings. Treasury stock carried as an asset in the balance sheet at market, with gains on sale of treasury stock credited to income. (I'm not making this up.) Increasing fixed assets and crediting cost of sales. Recognizing revenue when right of return exists. Shipping product to company warehouses or employees' homes and recognizing sales revenue. Recognizing revenue in advance of the customer's acceptance of the product. Keeping the sales journal open after the end of the quarter or year but back-dating sales invoices. Not booking all of the accounts payable; just put the invoices from suppliers into a desk drawer. Not writing down or writing off uncollectible receivables. Booking barter trade credits as if they represented bona fide US dollars. Such is the grist of our accounting mill. Not very esoteric stuff. If I draw an analogy to police work, what we see is stolen automobiles with finger prints on the door handles, not murders where there are no clues except for dogs that did not bark.
On the audit side, I now have seen several nonaudits. Auditors accepting, with little or no evidential support, values ascribed to both monetary and nonmonetary assets. Art work by unknown artists booked as assets at huge amounts in nonmonetary exchanges but without any support for the assigned value and no inquiry by the auditor about independent valuation of the artwork. Receivables acquired from collection agencies for pennies but booked at dollars without any documentation and no auditor inquiry as to the basis for the value. Auditors not doing substantive audit work but relying on so-called analytical procedures where the evidence, or lack thereof, cries out for substantive audit work. Auditors not doing cut off work for sales and purchases, with the result that sales of the next period are booked in this period with a corresponding increase in receivables from customers, and accounts payable for purchases of inventory of this period not booked until next period with the inventory recognized in the balance sheet resulting in understated costs of sales and overstated margins. And, of course, we see cases where the auditors were lied to or were not given all of the documentation that they should have been given. But, sometimes I wonder whether the auditors asked the right questions.
Let me return to my major theme. Although the issues that we deal with in the Enforcement Division are messy and quite distasteful, they are a very small fraction of the universe. Maybe that is because marketplace participants know that the Enforcement Division is paying attention to what goes on and that the penalty for infractions is or can be quite severe. I am fairly well satisfied that the number of transgressions that we see is quite small given the size of the population from which they arise. The state of financial accounting and reporting is good, and we need to keep it that way through constant vigilance.
The SEC's enforcement program regarding practicing accountants is accomplished primarily but not completely by bringing cases against accountants under Rule 102(e) of the SEC's Rules of Practice. Rule 102(e) reads as follows:
"The Commission may censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before it in any way to any person who is found by the Commission after notice and opportunity for hearing in the matter:
(i) Not to possess the requisite qualifications to represent others; or
(ii) To be lacking in character or integrity or to have engaged in unethical or improper professional conduct; or
(iii) To have willfully violated, or willfully aided and abetted the violation of any provision of the Federal securities laws or the rules and regulations thereunder."
The Washington, DC Court of Appeals, on March 27, 1998, remanded a case, the Checkosky and Aldrich case, to the Commission and instructed the Commission to dismiss the case. Briefly, the facts in the Checkosky case are as follows. Savin Corporation, a Coopers and Lybrand client, in its 1981, 82, 83, and 84 financial statements deferred in its balance sheet "start-up" costs related to Savin's effort to develop and bring to market a copying machine. In 1985, pursuant to an SEC enforcement action, Savin restated its 1983 and 1984 financial statements writing off the deferred start-up costs as R&D costs. The Commission then brought an administrative action against the Coopers' audit partner and manager, asserting that they had engaged in unprofessional conduct by allowing Savin to capitalize start-up costs which should have been charged to expense as R&D costs.
In 1989, after a lengthy hearing, an Administrative Law Judge found that Checkosky and Aldrich had engaged in improper professional conduct by violating GAAS and GAAP in five audits over four year (1981-1984) by allowing Savin to improperly defer $37 million of research and development costs as startup costs, and by failing to adequately audit the deferred costs. The ALJ suspended the two auditors from practice before the Commission for five years. Checkosky and Aldrich appealed the ALJ's decision to the Commission. In 1992, the Commission upheld the ALJ's findings, determined that Checkosky and Aldrich had acted recklessly, and stated that "a mental awareness greater than negligence is not required for improper professional conduct," but reduced the sanction to a two-year suspension. Two years later in 1994, the DC Circuit Court of Appeals remanded the Checkosky and Aldrich case back to the Commission with instructions to address its interpretation and application of Rule 2(e)(1)(ii). Over two years later, in January 1997, the Commission issued an opinion and order that affirmed its first opinion and order, based on Checkosky's and Aldrich's reckless conduct, but added some language to which Commissioner Johnson in January 1997 and the Court of Appeals on March 27, 1998, took exception. The Commission's majority opinion stated: "We believe that Rule 2(e)(1)(ii) does not mandate a particular mental state and that negligent action by a professional may under certain circumstances, constitute improper professional conduct." The Court of Appeals, in its decision pursuant to the second appeal, said "elementary administrative law norms of fair notice and reasoned decision making demand that the Commission define those circumstances with some degree of specificity. It has not done so." The Court went on to state "there are strong signs that the Commission is unlikely to settle on a uniform theory as to the necessary mental state for a violation of Rule 2(e)(1)(ii) anytime soon;" pointing to Commissioner Johnson's dissent in Checkosky, his separate concurrence in Potts, and to Commissioner Wallman's dissent in Potts. (Potts is another 2(e) case that is on appeal.) The court concluded "it would be futile to allow the SEC a third shot at the target." The case was remanded with instructions to dismiss the charges against Checkosky and Aldrich.
Since Checkosky was handed down on March 27, the staff has been considering a number of recommendations to the Commission on how to respond to Checkosky. One way, but it is only one way, would be for the Commission to issue for review and comment by the public a revised Rule 102(e) wherein the Commission would set forth the standard that it will use in applying Rule 102(e) against professionals. Just last week, the American Institute of CPAs petitioned the Commission to issue such a Rule for review and comment. The AICPA's petition was accompanied by the AICPA's proposed Rule, which reads as follows:
"Improper professional conduct" as used herein shall mean conduct showing that the professional is
(1) substantially unfit to practice before the Commission by reason of:
(a) the commission of a knowing violation of applicable professional standards, or
(b) conduct showing a conscious and deliberate disregard of applicable professional standards, or
(c) a course or pattern of conduct showing repeated failure to conform to applicable professional standards; and
(2) constitutes a current threat to the integrity of the Commission's processes or to the financial reporting system; in each case found after due notice of the conduct charged and a fair hearing thereon."
These criteria suggested by the AICPA would be very high hurdles indeed.
I obviously do not know how the Commission is going to come down on this matter or the form that a Commission decision will take. All I can suggest is that you stay tuned to this frequency.
The final matter that I want to raise today relates to fraternization between auditors and their clients. It appears to me that some auditors and their families through social contacts are getting so close to and so involved with their clients and their clients' families that a disinterested observer would question whether the auditor's objectivity had not been clouded or perhaps even enveloped. Let me give you two examples. In Business Week, February 23, 1998, there is an article that talks about auditors and their families having social contacts with their clients and their clients' families through such joint activities as picnics and baseball games. The Enforcement Division recently came across an Audit Planning Memorandum of a Big Six firm wherein social events between the auditor and client are explicitly set forth. I quote from that Audit Planning Memorandum. (I have not used the names of sports teams actually used in the memorandum. I have substituted other names.)
"Summer and Other Social Events
- The University of Texas football games (Oklahoma, Texas A&M, and Arkansas)
- NCAA Basketball final four tickets
- San Antonio Spurs tickets
- Houston Astros tickets
I wonder what "shopping" means. Alpaca sweaters? Golf clubs? Bally's leather jackets?
I wonder how investors or potential investors would react if they were aware of these facts. Would investors believe that the auditor's objectivity is not affected when the auditor and his or her family are engaged in periodic baseball games and picnics with the client and the client's families? Would investors believe that the auditor's objectivity is not affected if the auditor and client personnel regularly attend sporting events together? Whether paid for by the auditor or paid for by the client? Would investors perceive that gift giving, whether from auditor to client or client to auditor, can go on for very long without compromising the auditor's objectivity? How would an underwriter who is about to take $100 million of stock of that company react to these facts? A mutual investment manager who is about to invest $100 million in the stock of that company? Should auditors have to follow the same rules with respect to their public company audit clients that I as an employee of the US Federal Government have to follow with respect to regulated entities or persons? I leave you to ponder those questions.