Speech by SEC Staff:
Right to the End
Lynn E. Turner
U.S. Securities and Exchange Commission
At the Ethics Under Stress Conference of the American Institute of CPAs
American Accounting Association, National Association of State Boards of Accountancy
April 23, 1999
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Turner and do not necessarily reflect the views of the Commission or of the other members of the Commission's staff.
Thank you for the kind introduction. I was delighted to be asked to join the distinguished list of presenters for today's conference. And the conference is indeed on a very important and timely topic, that of ethics.
Ethics is a topic that touches all of us in everyday of our lives. For example, professional choices about ethics are made by the doctors who provide us medical care, scientists and engineers who provide technology that affects our workplace and safety, our religious leaders, CEO's who set the tone for diversity in our workplace , and our national leaders who have to face difficult decisions on such topics as world hunger and peace. No doubt when you have had the opportunity to read the press accounts in the past year about topics like euthanasia, ethnic cleansing, and cloning of animals, it has caused you to think about the ethical aspects of the issue.
Likewise, issues have been raised in recent years that are equally important ethical issues that confront and affect the public's perception of those of us in business and the accounting profession. In Chairman Levitt's speech last September, he expressed a growing concern about those in the business community who were pushing the envelope too far in response to the increased pressures to achieve earnings estimates.
Consistent with the Chairman's remarks, one of the most successful investors of our times, Warren Buffet, stated in the 1998 Bershire Hathaway annual report:
"Rationalizing this behavior, these mangers often say that their shareholders will be hurt if their currency for doing deals this is their stock, is not fully priced, and they also argue that in using accounting shenanigans to get the figures they want, they are only doing what everybody else does. Once such an everybody's-doing-it attitude takes hold, ethical misgivings vanish. Call this behavior Song of Gresham: Bad accounting drives out good.
"...Clearly the attitude of disrespect that many executives have today for accurate reporting is a business disgrace. And auditors, as we have already suggested, have done little on the positive side."
We also have seen the results of surveys of Chief Financial Officers in both Business Week and CFO Magazine that confirmed what the Chairman and Mr. Buffet have expressed. These financial executives were being subjected to tremendous pressures to create "Magical" numbers that did not reflect economic reality. Unfortunately, a percentage of the respondents indicated they had in fact succumbed to the pressure and cooked the books.
I was fortunate enough to have grown up on a farm with two of the most wonderful parents you could have ever asked for. From them I learned some important lessons about life that I think reflect on what are really the foundation of "ethics." I remember my mom teaching me that when I faced a difficult question, there would be easy answers and solutions, and there would be times when the answers and solutions would be painful. But no matter what the question was, she taught me to always ask myself, "Am I doing the right thing"? Not what could I get away with, but what should I do, and would she and my dad be proud of my decision.
From my dad I learned that if something is worth doing it is worth doing right, and doing it right the first time. Indeed, respect is elusive for those who see what they can get away with or who push the envelope too far and wait to see if they get caught. Such habits, once started become difficult to break. They can become and remain habit forming. It is like drug addiction.
This caused me to remember what a retired CEO once said, "Integrity is not a 90 percent thing, not a 95 percent thing, either you have it or you don't." As a business executive, or a certified public accountant, our culture is such that it is extremely difficult to stretch the boundaries of reasonableness, when and if you choose. Once you start this dangerous practice, there is seldom an ability to turn back.
Fortunately, my experiences as a partner with one of the international accounting firms and as a CFO have shown me that most of my peers really want to do, and in fact do, things right. On a daily basis, they are making the difficult choices, and by doing so, ensuring the confidence of investors and the integrity of our capital markets. They live up to the codes of conduct that have been established by the Financial Executives Institute and the American Institute of Certified Public Accountants.
But at the Commission, we do have some concerns about ethics, and I have been asked to share them with you today. I would like to summarize some of those for you.
Some of you undoubtedly have read by now, the recent enforcement action regarding PricewaterhouseCoopers, AAER 1098. In that release it notes that:
- In four instances, certain professionals owned securities of publicly-held audit clients for which they provided professional services;
- In 31 instances, individual partners and managers owned securities of publicly held audit clients.
Auditors often talk about how independence is the bedrock of our profession and how the true value of the audit function comes from the fact that we will give a totally unbiased opinion on the client's financial statements. We invite investors to rely on our integrity and impartiality, and print at the top of our audit reports that we are indeed "independent" auditors. Then something like the PWC case and its aftermath set in.
The cases that concern me do not end with those described in the PWC Order. The staff is now seeing a number of other instances where auditors may not have compiled with the Commission's, the profession's, and even their own firm's independence requirements.
Although in absolute terms the number of auditors involved in these cases is relatively small, they far surpass any number I ever dreamed in my worst nightmares would occur. Some of these cases involve clear cut violations of the rules. I have to admit, I have become somewhat discouraged by the obvious lack of attention that these individuals gave to independence issues. Although I can't go into the details today, you may be reading about these cases in the future. Again, I am not talking about close judgment calls, but about violations of simple and well-known rules of auditor independence. Not the complex rules you may hear about, but rather the simple rules everyone understands. Individuals who violate these rules should be held accountable not just by the SEC, but also by shareholders, the profession, and the individuals' firms.
If anyone doubts the SEC's commitment to provide appropriate discipline to this area, they may want to take another look at the Commission's release on the recent revisions to Rule 102(e).1 In that release the Commission said,
"Because of the importance of an accountant's independence to the integrity of the financial reporting system, the Commission has concluded that circumstances that raise questions about an accountant's independence always merit heightened scrutiny. Therefore, if an accountant acts highly unreasonably with respect to an independence issue, that accountant has engaged in 'improper professional conduct'" (emphasis added).2
In short, when we find that individual professionals in public accounting or industry, who hold themselves out as CPAs, have violated the profession's code of professional conduct and the SEC's auditor independence rules, we will take the appropriate action.
And if you believe that, should we come knocking on your door, there is a simple cure for every independence problem, you will be sadly mistaken. If the violation existed during the audit or when the audit report was signed, or, with a few exceptions, during the period being audited, then the end result is that the client does not have financial statements audited by an independent auditor. After the fact remedial actions do not change the fact the audit was not conducted by someone who was independent from the company as the federal securities laws require. Making someone or a firm independent today does not get rid of the mutual interests and relationships that existed yesterday while the audit was being conducted, and those are the interests and relationships that might cause investors to doubt the credibility of the audit report. Unfortunately, in some cases, the only alternative may be to have the financial statements reaudited by another firm.
Unless you've been on my side of the table as a CFO, you have no idea of the anguish a reaudit, caused by an auditor who defies the independence rules, can create for an audit client and its investors. The financial statements the client needs to consummate a deal or to satisfy loan covenants are now unaudited, resulting in the possibility that potential business partners and creditors will walk away from the client and leave it in a strained financial condition (which I have seen happen). The company, often without the slightest clue that there may be a problem, suddenly finds that its plans for a public offering are delayed or in some cases canceled. All because the auditor did not follow the basic ethical standards of the profession and the most fundamental requirements of an independent audit under the federal securities laws.
If I could have the chairmen of the audit committees of every public company sit in on just one meeting where the staff has had to send a company out to obtain a reaudit, I believe I would never again have to encourage an audit committee to become actively involved in monitoring the independence of the auditor of a company's financial statements those chairmen would be the most cautious and skeptical people on earth.
For now, however, the best hope of correcting this situation is for the firms that practice before the Commission to have effective quality controls that root out and resolve auditor independence issues before an audit is conducted.
Importance of Independence to a Firm
In my letter of last November to the chair of the SEC Practice Section of the AICPA, I highlighted the need for firms to ensure they had adequate quality controls over the monitoring of independence, both in the US and abroad. The AAER on the PWC matter in fact addresses quality controls both for the U.S. firms and their foreign affiliates.
I believe the quality of controls that ensure independence of a firms' partners and employees speaks loudly about how a firm and its management view the importance of auditors independence. A firm that has instituted controls:
is reflective of a firm that cares about maintaining its integrity and professional reputation. I understand some firms have instituted such systems, at significant cost no doubt, and I must applaud their efforts.
- That include electronic databases of clients and affiliates that are updated daily,
- That require all security trades by employees to be input into a database, on a timely basis, for the purpose of matching those security positions against the firms' clients for potential conflicts, and
- That automatically check new clients against security holdings of employees, which previously have been input into the system, to alert employees to potential conflicts requiring action on their part
However, the staff also is concerned that some firms may not have quality controls that are sufficient to ensure compliance with the independence standards. As a result, it would not be surprising to see the staff spend more time on this concern in the upcoming year. We also would hope that the peer review process will place more emphasis on this issue in light of the concerns expressed in our letter and the findings in the PWC matter.
Form of Practice
Let me shift my focus to one of the items the Commission and staff believe should be a top priority for the Independence Standards Board. That is the form or structure of a firm that is performing audits of publicly held clients.
This issue arises as a result of some of the competitive business pressures being exerted within the profession. These pressures include the need for smaller firms to remain competitive in terms of services being rendered to clients, being able to obtain sufficient capital for investment in technologies, personnel and product lines, and to fund retirement obligations. Similarly, larger firms need capital to fund the expansion of consulting businesses, to fund retirement obligations, as well as for investments in technology and personnel.
As a result, you have undoubtedly seen what are often referred to as "consolidators" acquiring small and middle tier firms at an increasing pace. We have also seen larger CPA firms look to access the public markets as a source of capital.
These new and perhaps innovative ways of doing business have raised some significant issues that the staff believe need to be adequately and thoughtfully considered. These include:
- Would investors believe it is acceptable for a client or a member of its senior management to hold stock in the auditor?
- Would the pressures of having public ownership, such as those to make consensus earnings estimates, potentially impact the quality of audits?
- In the case of a consolidator, if it were providing services to an audit client such as providing credit card or other financing to the client, or earning significant fees by providing travel services, how would these arrangements affect the auditor's independence when the audit work is performed almost entirely by employees of the consolidator?
- Often the partners and former employees of the CPA firm acquired by the consolidator become the employees of the consolidator. The CPA firm becomes a "shell" partnership that "rents" employees from the consolidator. The name of the shell is the name signed to the auditor's report. Should investors be made aware of this "shell" arrangement, whose staff and employees are performing the work, and the recourse available to the investor in the case of a failed audit?
These are difficult questions that the ISB will face in the next year. I am not sure anyone has all of the answers today, but hopefully through an adequate and timely public process we will arrive at answers that protect investors and capital markets.
Auditor's Auditing their Own Work
Another focus of the staff is on situations where it appears the auditor is auditing his or her own work. FRR 602.02 notes that when an auditor is placed in the position of auditing one's own work, the auditor objectivity sought by investors can be destroyed. This may happen when managerial responsibility for the client's financial operations appears to be substantially dependent upon the accountant's skill and judgment.
In recent months, we have had a number of CFO's indicate that the numbers used in valuations of In Process Research and Development (IPR&D) were "run by the auditors." This is disturbing for two reasons. The first is because the financial statements are first and foremost the responsibility of management. When those financial statements are filed with the Commission, the CFO and principal accounting officer are responsible for ensuring the results are in compliance with GAAP. Accordingly, I do not accept the notion that the numbers were "run by the auditors" and therefore are not the responsibility of the company.
A second concern I have is that in some instances it appears that appraisers within the CPA firms came up with the numbers that got recorded. Then as one analyst stated "the auditors checked nothing." As a result, the auditors did "run" the numbers, and accordingly are in the position of auditing their own work and in violation of FRR Section 602.
I have expressed my concern to the Big Five accounting firms on this topic. Again, I must give them credit because they have now agreed that they will no longer provide IPR&D valuation services to their own clients.
The ISB has recently issued an interpretation regarding auditor's providing services to their clients in connection with the valuation of derivatives. This interpretation also notes that auditors are precluded from auditing their own work when providing these services. I expect the staff will closely monitor and rigorously enforce the proper implementation of this standard.
Independence Appearance or In Fact
Let me finish with a final issue that will be further addressed later on in the day. That is the issue of whether the auditor should be independent in appearance or as some would state, "in fact."
Let me tee up a situation for you that I think emphasizes my point.
Often times you hear discussions of independence "in fact." Those discussions typically also cover the quality controls that firms have in place, and the impact those controls can have on independence are highlighted. Those controls, when they are of a sufficient quality and are monitored and enforced, can play an important role in the overall quality of an audit.
However, let me describe a situation. Often firms will have a control that says you cannot take gifts from clients in excess of some de minimis amount like $ 25. That is a reasonable rule what would an investor think if the client was giving his auditor a new Porsche? However, ask yourself if the auditor could go golfing with the client and have his green fees paid for by the client? Could the auditor fly on the corporate jet with the CFO and CEO to the stockholders' meeting? And what if the CEO invited the audit partner to fly with him to his private golf club? In light of these possibilities, is there really a $25 guideline?
I have heard Chairman Levitt note that perception often becomes reality. I share that belief.
I also believe that because the investor's perception of the integrity and objectivity of auditors is so important to maintaining their confidence in the auditing profession, that CPA's have been put in a special role. That role was most clearly defined by the Supreme Court when it said:
"By certifying the public reports that collectively depict a corporation's financial status, the independent auditor assumes a public responsibility transcending any employment relationship with the client. The independent public accountant performing this special function owes ultimate allegiance to the corporations' creditors and stockholders, as well as the investing public. This 'public watchdog' function demands that the accountant maintain total independence from the client at all times and requires fidelity to the public trust" (emphasis added). 465 US at 817-818.
Needless to say, this statement is a defining guideline for an independent public accountant. It is a guideline within which the ISB will need to craft their rules. Furthermore, I believe one would be hard pressed to even remotely think appearance was not important when the court says "total independence . . . at all times"
Change Designed to Improve Our Profession
This timely conference undoubtedly will identify challenging questions and we should seek solutions to those questions that will serve investors and our capital markets well. Some of those questions have already been raised this morning. Let me take a moment to outline what I believe are some of the solutions.
1.I believe academia needs to look at incorporating into the curriculum of business schools more coursework on ethics. Perhaps the most effective means of doing this would be to incorporate it into both the existing courses on finance, management, and accounting as well as teach separate courses on it.
2.Each and every member of the AICPA, including both those in public accounting as well as industry, needs to take personal responsibility for their compliance with the profession's code of professional conduct and the SEC's independence rules. In accepting this personal responsibility, there needs to be an attitude of maintaining only the highest level of professional conduct.
3.The accounting firms need to:
- Take an in-depth look at the adequacy of their quality control systems,
- Provide continuing emphasis on the importance of ethics through ongoing training programs, and
- Take timely and responsive actions against individual partners or employees who fail to comply with the firm's, the professional's and the SEC's independence guidelines.
4.The ISB hopefully will address issues affecting the profession on a timely basis, while getting public input on the issues. These issues include those the SEC has sent to the Board, as well as development of the ISB's conceptual framework.
5.Audit committees, management and auditors need to have robust discussions regarding the effect of the auditor's relationships, services and fees on the auditor's independence. These discussions, required pursuant to a new rule of the ISB, should be undertaken by audit committees with a keen eye and conscience towards their role as representatives of the shareholders.
6.Members of the Panel on Audit Effectiveness have raised the question of how auditor's independence affects the quality of audits. I believe that, if the Panel is to render a credible report, this is a question and topic that the Panel should address and make a subject of its recommendations.
7.The AICPA's SEC Practice Section needs to ask whether, in light of recent developments and the fact different firms do have significantly different levels of quality control systems, the current peer review process results in a thorough review of these processes. The staff believes recent investigations raise questions about why serious deficiencies in quality controls were not identified and reported on in the peer review or internal inspection processes.
8.Financial management needs to embrace the standards of the Financial Executives Institute and AICPA codes of conduct when performing their job responsibilities.
9.Regulatory agencies including the SEC, State Boards of Accountancy, and the AICPA Ethics Committee need to take timely and appropriate action against individuals and firms that violate the rules. We all need to work together to ensure that only the highest level of ethics in business and the accounting professional exist. We need to do this on a cooperative basis and with a focus on our customers the capital markets and the investing public.
Let me close by noting some sound advice that Peter Drucker has given. "Start with what is right rather than what is acceptable." That is a mantra each and every one of us in public accounting should strive for and live by. To protect the public trust in our time honored profession, we must maintain only the highest level of ethics all the time --day in, day out. Or as Abe Lincoln said:
"I do the best I know how, the very best I can, and I mean to keep doing so until the end."
1Release Nos. 33-7593; 34-40567; 35-26929; IA-1771; IC-23489; File No. S7-16-98 (October 19, 1998); 63 Federal Register 57164 (October 26, 1998)
263 FR at 57168.