Speech by SEC Commissioner:
Current Regulatory and Enforcement Developments Affecting the Accounting Profession
Remarks by
Norman Johnson
Commissioner, U.S. Securities & Exchange Commission
at the 26th Annual Securities Regulation Institute Conference,
San Diego, California
January 20, 1999
Thank you, Dean.
Dean Ruder has asked me to discuss current regulatory and
legislative developments. I am sure you will all understand that
confidentiality requirements restrict my ability to discuss
matters that the Commission has not publicly announced, and that,
as always, I speak only for myself and not for the Commission or
my fellow Commissioners.
Rather than spend my limited time reciting a laundry list of
items currently on the Commission's agenda, I thought I would
devote my remarks to what has become the Commission's top
enforcement priority: financial fraud, particularly the problem
of "managed earnings." Similarly, the Chairman and other senior
Commission officials have repeatedly spoken out on a related
issue of great concern, the notion that accountants have failed
to maintain adequate independence from their audit clients. I
have long had an interest in accounting issues, and I fully agree
with the recent emphasis the Commission has placed on these
issues.
No one who follows the financial pages could escape
awareness of the recent allegations of apparent large-scale
financial fraud, often involving hundreds of millions of dollars
of manufactured or "managed earnings," at many prominent public
companies. Many of these apparent frauds seem to arise from
multiple causes. Perhaps the single most important cause is the
pressure imposed on management to meet analysts' earnings
projections. The severity with which the market punishes
companies failing to meet analysts' expectations is
extraordinary. The recent increased emphasis on stock options as
a key component of executive compensation has also placed greater
pressure on management to achieve earnings expectations. The
pressure to meet analysts' estimates and compensation benchmarks
have both operated to increase the temptation for management to
"fudge" the numbers.
On a related point, the Chairman and other senior Commission
officials have given numerous speeches stressing the importance
of auditor independence. The Commission has brought a number of
high-profile enforcement cases for financial fraud that have
increasingly raised questions regarding the independence of
auditors who review financial statements.
For example, the Commission has settled actions against
- an auditor who continued to audit the company while
negotiating employment with the client,
- an auditor who worked as an employee of the client,
- an auditor who performed functions that should have been
performed by management,
- an auditor who put himself in the position of auditing his
own work by keeping the books for his client, and
- an auditor who learned of problems with the financial
statements while performing an audit, who then concealed the
problems when he went to work for the company.
Many of these independence problems seem rooted in the
organizational changes that have taken place in the accounting
world over the last several years. Accounting firms have found
that the audit business that has been their bread and butter from
the start of the profession does not allow for sufficient
financial growth. So accounting firms have looked for new
sources of income and have ventured into services well beyond
their traditional businesses, which may conflict with their
established roles as auditors. As a result of these changes, we
have observed that
- the financial importance of the audit function to accounting
firms, particularly the larger ones, is declining,
- the provision of non-audit services is increasing, and
- the business relationships between auditors and their audit
clients are increasing and expanding.
The conflicts of interest, or at the least, the appearance
of conflicts of interest arising from these developments are
troubling. It hardly seems accidental that financial fraud has
increased at the same time non-audit services performed by
accounting firms have proliferated and become more profitable.
Accordingly, you can expect that the Commission will carefully
scrutinize all its regulatory and enforcement remedies in order
to redress the problems posed by the lack of auditor
independence. The accounting profession itself must face some
moments of truth.
Within the last few weeks, there have been many important
developments affecting auditor independence, including two
matters involving "Big 5" accounting firms. Just last week, the
Commission announced the institution and simultaneous settlement
of a significant auditor independence case against
PricewaterhouseCoopers LLP or PWC. The case was based on the
firm's lack of independence arising from the fact that numerous
PWC accounting personnel had invested in the stock of audit
clients, as had the pension plan of one of PWC's predecessor
firms. The settlement consisted of three key elements. First,
PWC was required to conduct an internal investigation to
determine whether the firm suffered from any additional
independence problems. Second, the firm was required to
implement a series of procedures for assuring independence that
were much more stringent than its preexisting procedures.
Finally, PWC agreed to make a substantial financial payment of
$2.5 million to be used to educate the accounting profession
about the importance of the Commission's independence rules.
The second matter involved another "Big 5" firm and likewise
illustrates the high degree of importance the Commission places
on the strict application of the independence rules. The firm
had proposed the creation of an affiliate to operate its
consulting business. Under this proposal, the firm would retain
a controlling interest in the affiliate, while selling a minority
interest in a public offering or private placement. With the
full backing of the Commission, our Chief Accountant Lynn Turner
-- who will speak at another session of this institute on Friday
-- sent strong letters to both the firm and the Independent
Standards Board or ISB expressing the view that the firm's
proposed offering might affect its independence as an auditor "in
both fact and appearance." The proposal raised several very
serious independence issues, including the ability of the firm to
continue to audit clients who had invested in the offering, and
its relationships with other firms, such as underwriters and
broker-dealers, who would necessarily be involved in the offering
process and in the secondary market.
In his letter to the ISB, Lynn further expressed the staff's
deep concern about press reports describing ossible expansion by
accounting firms into legal services, including representing
clients before the IRS, providing advice on structuring corporate
transactions and benefit plans, and providing expert witness
testimony for clients. One recent press report even stated that
an international accounting firm was considering acquiring a New
York City-based law firm. In my view -- and I know of no
disagreement at the Commission on this issue -- an accountant-
attorney relationship with a client is totally inconsistent at
least with the appearance of independence. Attorneys have an
ethical duty to zealously represent the interests of their
private clients, and it is impossible to reconcile this role as
advocate with the duty accountants and auditors owe to the
investing public.
Finally, I think it highly significant that the ISB approved
new rules earlier this month requiring auditors to disclose any
relationships they have with audit clients that might affect
their independence. Under the new rules, which take effect in
July, an accounting firm must give written notice to the
company's audit committee of any relationship that could pose a
conflict of interest, including consulting work performed for the
company, employment of former auditors at the company or any
other interest that the auditors may have in the company. The
written notification must also explain why the relationships have
not diminished the auditor's independence or objectivity.
You can surely expect that the Commission, working closely
with the ISB and other bodies overseeing the accounting
profession, will pursue further initiatives in 1999 designed to
ensure that accountants maintain their independence from audit
clients in both fact and appearance.
Thank you.
http://www.sec.gov/news/speech/speecharchive/1999/spch248.htm