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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Current SEC Developments –
“Managed Earnings” and
“The Year of the Accountant”

Remarks by

Commissioner Norman S. Johnson

U.S. Securities and Exchange Commission

at the Utah State Bar Mid-Year Convention,
St. George, Utah

March 6, 1999

At the outset I would like to express my appreciation at being invited to appear before this distinguished group. I did note, however, that the convention schedule I received indicated that my remarks would conflict with another event having much greater intrinsic interest: "Ranger Bart" Anderson's nature hike through the beautiful scenery of St. George. Accordingly, I will fully understand if, 15 minutes into my presentation, many of you sneak out to rendezvous with Ranger Bart. In truth, the only downside I can see to the nature hike is that, as a technical matter, you probably would have to forfeit your CLE credit. Then, again, I'm not taking attendance, and I promise not to tell.

In all seriousness, I always welcome the chance to visit with and address so many friends. My term as president of the Utah State Bar several years ago was among the most challenging and fulfilling experiences of my professional career. And I will always look back on that time with a special fondness. Now, even though I reside in Washington, I still consider Utah home and try to avail myself of every opportunity to return.

My topic for today is current developments at the SEC. In discussing this topic, I hope you will all understand that confidentiality requirements restrict my ability to discuss matters that the Commission has not publicly announced, and that I can speak only for myself and not for the Commission or my fellow Commissioners. In any event, the Commission has clearly indicated that its top enforcement priority for 1999 will be financial fraud, and, in particular, the problem of "managed earnings." Indeed, our distinguished Director of Enforcement Dick Walker has promised that 1999 will be "The Year of the Accountant" at the SEC. I know that the accounting profession will be delighted to hear of that news. As part of this initiative, the Commission has already brought several high profile enforcement cases, and senior Commission officials have made numerous public statements explaining our concerns in this area. Hopefully, the accounting profession will heed these messages. I am sure that the trial bar will watch with interest.

In undertaking this initiative, the Commission's goals are beyond reproach: protection of the world's best system of financial reporting, and, ultimately, the protection of investors. To be sure, I do have significant disagreements with the means sometimes favored by the Commission to accomplish its goals – most notably our use of Rule 102(e) to regulate the accounting profession. The reasons for my disagreement are set forth at length in my dissenting statements to the Commission's recent amendments to Rule 102(e). so I will not repeat them here. If you are interested, however, the dissenting statements appear in the Federal Register and are available on the SEC's website.

I do want to leave adequate time for any questions you might have, so I will jump right into the 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. While the problem is not new, it is happening with alarming frequency. Barely a week goes by without an announcement that another large company is restating its past results. There are a number of dubious practices that companies employ to manage their earnings, including such gems as: "big bath" restructuring charges, creative acquisition accounting, "cookie jar reserves," "immaterial" misapplications of accounting principles, and the premature recognition of revenue. The names for some of these techniques may be amusing, but in reality they are not amusing at all.

Fundamentally, companies may attempt to manage earnings for numerous reasons. Perhaps the single most important cause, however, 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. This factor, combined with 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. Auditors surely want to retain their clients, and are thus under pressure not to stand in the way of companies who have succumbed to these temptations.

While I know that the personal integrity of most corporate officers and directors keeps them from engaging in the practice, the incentive to manage earnings remains. And that is precisely why we require auditors to be independent from management when they examine a company's financial statements. We at the SEC are concerned that the auditors' lack of independence may have caused them to fail to detect these apparent frauds, some of which involve hundreds of millions of dollars of falsified earnings or assets. At the heart of the Commission's "managed earnings" initiative, therefore, is the notion that accountants must scrupulously maintain their independence from their audit clients, both in appearance and in fact. 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 are watchdogs for the public – they owe their preeminent loyalty to the shareholders and to investors generally, not to their audit clients.

To this end, the Commission has brought a number of high-profile enforcement cases for financial fraud that have increasingly raised questions regarding the independence of auditors. 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 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.

Digging just beneath the surface, I fear that many of these independence problems are rooted in the dramatic 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 just 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.

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.

Thus, we have fertile ground for abuse.

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 rapidly 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 accountants no less than the rest of us have legitimate concerns about protecting their financial interests. They too wake each day to an extremely competitive world. However, you can expect, in turn, that the Commission will carefully scrutinize all its regulatory and enforcement alternatives 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 strain it is experiencing.

Of all the varied independence problems, there is one that I personally find especially troubling: the efforts by accounting firms to expand into the legal services area. Frankly, I hope you are also troubled by these developments. According to recent press reports, 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. The Wall Street Journal published an article last month that described how major accounting firms are luring attorneys with promises of "dazzling pay and perks." A legal recruiter was quoted as saying that: "We're seeing more and more instances of Big Five firms aggressively courting tax lawyers" at prominent law firms.

While these developments may sound good for individual lawyers, they are hardly good for either the legal or accounting professions. 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. In January, our Chief Accountant Lynn Turner sent a strongly worded letter to the Independence Standards Board 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 the Commission on Multidisciplinary Practice 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."

As for lawyers, their duties and obligations are 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.

We have discussed some of the problems the Commission faces, but I would be remiss if I failed to mention one promising recent development. In a major speech last fall kicking off the Commission's "managed earnings" initiative, the Chairman announced a number of significant remedial measures, including the formation by the New York Stock Exchange and the National Association of Securities Dealers of a Blue Ribbon panel to make recommendations on strengthening the role of audit committees in overseeing the corporate reporting process. The Blue Ribbon panel had a very distinguished membership that included the Chairmen and CEO's of both the New York Stock Exchange and the NASD.

In February, barely four months after its creation, the Blue Ribbon panel issued a 71-page report and recommendations on "Improving the Effectiveness of Corporate Audit Committees." In preparing the report, the panel received input from a wide range of sources through a public hearing and open request for formal written comments. Representatives of more than 25 different financial and accounting organizations responded. The report sets forth a 10-point plan to improve and strengthen the role of audit committees, which includes proposals that:

  • the membership of audit committees consist solely of independent directors;

  • audit committees make public disclosure of their activities on an annual basis; and

  • the Commission require outside auditors to conduct interim reviews of quarterly financial reporting.

The Blue Ribbon panel's report has received an encouraging response so far, and we are hopeful that its recommendations will establish a firm foundation for improving the effectiveness of corporate audit committees. I expect that the Commission will promptly follow through on those recommendations that are within our rulemaking power. The report is lengthy and comprehensive, but I would encourage all of you with an interest in these issues to read it in full. You can find the report online at both the New York Stock Exchange's and NASD's websites.

These recent developments indicate that the Commission will continue to act promptly so that we may resolve, or at least ameliorate the problems we have experienced involving "managed earnings" and auditor independence. In the past, the Commission has not hesitated to bring enforcement actions in appropriate situations to combat financial fraud and to enforce the auditor independence rules. I am sure the Commission will not hesitate to take similar measures in the future, when appropriate. I have always had the greatest respect for professionals – lawyers and accountants – who practice before the SEC and other government agencies. They must address serious and difficult issues that are often highly technical, while their vocations hang by a thread.

For these reasons, it is my sincere hope that corporate management and the accounting profession will read the writing on the wall, so that "The Year of the Accountant" will ultimately result in a relatively small number of enforcement actions brought by the Commission.

Thank you.