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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
The Year of the Accountant

Remarks by

Norman S. Johnson

Commissioner, U.S. Securities & Exchange Commission

At the Practicing Law Institute's SEC SPEAKS

February 26, 1999

Just last month I participated in a securities conference that also had in attendance many senior Commission officials, including our distinguished Director of Enforcement Dick Walker. Dick led off his presentation with a discussion of what has become the Commission's top enforcement priority: financial fraud, particularly the problem of "managed earnings." Dick further predicted, facetiously but accurately, that 1999 promises to be "The Year of the Accountant" at the SEC. Dick's phrase seems quite fitting so I will use it as the point of departure for my remarks today.

I know that other SEC officials at this conference, including Lynn Turner and Walter Schuetze, will also address various aspects of the Commission's initiatives in the accounting area. Like Lynn and Walter, I have long had an interest in accounting issues, and I fully agree with the Commission's goals in this area: protection of the world's best system of financial reporting, and, ultimately, protection of investors. To be sure, I do have significant disagreements with the means sometimes favored by the Commission to accomplish these goals -- specifically our use of Rule 102(e) to regulate the accounting profession. Because I have set forth the reasons for my disagreement at length elsewhere, I will not repeat them here.

In any event, my time is limited so I will focus my remarks on an issue that is at the heart of the Commission's recent initiatives: the notion that accountants have failed to maintain adequate independence from their audit clients. An auditor's independence is not an abstract ideal. Rather, it is at the bedrock of our system of financial reporting. Auditors of public companies owe their preeminent loyalty to the shareholders and to the public investors generally, not to their audit clients.

Of late 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, within the last year or so, the Commission has settled actions against

  • an auditor who continued to audit a client while negotiating employment with the company at the same time,

  • an auditor who worked as an employee of the company he was auditing,

  • an auditor who performed management functions that had been improperly delegated to him by his client,

  • 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 of his client while performing an audit, and who then concealed those problems when he went to work for the company.

Those cases are troubling and I hope that the profession has learned from them, so that others do not commit similar missteps. The Commission will continue to take appropriate action when faced with such situations.

I fear that many of these independence problems may be rooted in the organizational changes that have taken place in the accounting profession 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 maximum business and 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, or watchdogs for public investors.

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. Now, I don't mean to be overly judgmental without knowing all the specifics -- clearly accounting firms have legitimate concerns about preserving and protecting their financial interests. You can expect, however, 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, given the economic and regulatory strains it is experiencing.

Of all the varied independence problems, there is one that I personally find particularly troubling: the efforts by accounting firms to expand into legal services. As reported recently in the press, these efforts include providing legal representation before the IRS and providing advice on structuring corporate transactions and benefit plans. The movement to permit the provision of both accounting and legal services by professional firms seems to be most pronounced abroad, but one recent news article 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 simply cannot be reconciled with the appearance of independence, at the least. Attorneys have an ethical duty to represent zealously the interests of their private clients, and it is impossible to reconcile this role as private advocate with the duty accountants and auditors owe to the investing public.

The Commission has taken forceful steps to combat these developments. Last month our Chief Accountant Lynn Turner sent a strongly worded letter to the Independence Standards Board or ISB that discussed various independence issues, including the encroachment by accounting firms into the provision of legal services. Lynn's letter to the ISB quoted a Commission interpretation that stated:

an accountant-attorney relationship with a client is inconsistent with the appearance of independence. This is due in part to the primary concerns attorneys have with the personal rights and interests of their clients and the advocacy role they are expected to undertake.

I fully endorse these views.

As one might expect, the ABA has also taken an interest in the provision of legal services by accounting firms, and has established a Commission on Multidisciplinary Practice, which is studying this issue. Recently Lynn Turner sent a letter to the Chair of that Commission in which he explained the staff's views on the impairment of auditor independence that occurs when a professional firm provides both auditing and legal services to an issuer or registrant required to file financial statements with the Commission.

Auditors have been granted a special charter under the federal securities laws. Issuers seeking to raise capital from public investors must hire independent auditors to certify their financial statements -- by contrast, issuers have no obligation to hire lawyers. With these special benefits come special obligations -- obligations auditors owe to the investing public. As the Supreme Court indicated in the Arthur Young case, independent audits enhance the credibility of financial information, and, as a consequence, have a paramount role in ensuring investor confidence in our capital markets. If an auditor's independence is impaired, even if in appearance only, investors may lose confidence in the quality of the financial information reported. Thus, auditors must carefully guard their independence, and place investors' interests above all else, including their own interests and those of their clients. Otherwise, as the Supreme Court stated in Arthur Young: "If investors were to view the auditor as an advocate for the corporate client, the value of the audit function itself might be lost."

The duties and obligations of attorneys are, of course, quite different. Attorneys owe their primary allegiance to their private clients, whose interests they are ethically bound to protect. As Lynn Turner stated in his letter to the ABA, the staff believes that an auditing firm's independence from a registrant will be impaired if the firm provides legal services to the registrant or its affiliates. Again, in matters involving the encroachment by accounting firms into the legal area, Lynn and the staff have my full backing, and, I think it safe to say, the full backing of the Commission.

In the past, the Commission has taken measures to enforce the independence rules when an auditor has provided services incompatible with that independence. I am sure that the Commission will not hesitate in the future to take similar measures if auditors persist in their efforts to expand into the legal area. It is my fervent hope that the profession will read the writing on the wall, and that "The Year of the Accountant" at the SEC will turn out to be an anticlimax.

Thank you.