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U.S. Securities and Exchange Commission

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.