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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
Remarks to the Panel on Audit Effectiveness of the Public Oversight Board

by Chairman Arthur Levitt

U.S. Securities & Exchange Commission

Public Oversight Hearings
New York, N.Y.

October 7, 1999

Mr. Chairman, members of the Committee, thank you for giving us the opportunity to present our views on this very important issue. I would also like to thank the Public Oversight Board for their sponsorship of this endeavor.

Today, America's capital markets are the envy of the world. Our efficiency, liquidity and resiliency stand second to none. That hasn't happened by accident. For a good part of this century, our system of financial reporting has come to be characterized by its high quality and transparency. This has instilled an unparalleled degree of confidence and trust.

But that confidence and trust can become all too fleeting if the public interest suffers under the weight of financial pressure. A year ago, I expressed concern that the motivation to satisfy Wall Street earnings expectations may be overriding long established precepts of financial reporting. While the problem of inappropriate earnings management is not new, it has risen in a market unforgiving of companies that miss Wall Street's consensus estimates.

The dynamic nature of today's capital markets creates issues that increasingly move beyond the bright line of right and wrong. New industries spurred by new services and new technologies are creating new questions and challenges that must be addressed. More often, these issues fall under a gray area where there are no easy answers. It is in this realm where judgment, experience and integrity are indispensable to high-quality and transparent financial reporting.

In light of this environment as well as recent industry trends, I fear that the audit process, long rooted in independence and forged through professionalism, may be diminished – perhaps even sacrificed in the name of more financial and commercial opportunities. In recent years, the amount of revenue generated by accounting firms in areas of business other than traditional auditing services has increased exponentially. Some firms – perhaps preferring to distance themselves from the roots that have given them such opportunities – prefer to think of themselves as "multi-disciplinary organizations."

Public accounting firms and business competitors outside the traditional public accounting firm structure have taken different approaches to handling this market driven growth in non-audit services. For example, some new arrivals – which offer other financial services – are acquiring accounting and auditing firms. As we all know, some accounting firms have even considered floating IPOs as part of their consulting practices. And, some have even gone so far as to question whether the traditional public accounting firm structure is still relevant in an environment where the revenue streams are so diverse.

As firms increasingly have branched out to generate other sources of revenue, the basic audit model, not surprisingly, has undergone changes. In an era that calls for greater risk management, the industry has migrated to what they call the "risk-based" model. It sounds right on target. Because of the challenges of executing these new standards well, I wonder if the public interest is being better served. We cannot permit thorough audits to be sacrificed for re-engineered approaches that are marginally more efficient, but significantly less effective.

Public companies operate uniquely through the separation of ownership and control. Without the ability to independently measure performance through high-quality financial reporting, both the aggressive oversight of that reporting and the commitment to the shareholder interest fall by the wayside. The fragile asset of investor confidence wanes; liquidity dries up; and opportunities disappear.

As I look at some of the audit failures today, I can't help but wonder if the staff in the trenches of the profession have the training and supervision they need to ensure that audits are being done right. I wonder if the younger people in the profession – those who have decided not to become Internet entrepreneurs – are receiving the necessary guidance and lessons in value judgments from their older, more experienced colleagues. I have long believed in giving young people opportunity. But, while putting a recent college graduate on the front lines of an audit without the proper training and experience may serve a firm's bottom line, it is a dreadful disservice to investors.

I also wonder about compensation – especially among the line partners. What drives their compensation? Is it the audit function, or is the audit merely a conduit to the cross-selling of other, more lucrative firm services?

Now, appointing committees has never been a natural inclination of mine. But, in this case, a thorough review of the audit process by members of the corporate and legal community, academia and the profession is absolutely critical. Our efforts in this area should not rest solely in the hands of government. Together, we must bring about a strong, productive public-private sector partnership that maintains the credibility of an audit process worthy of the investor interest.

The weight of your mandate is heavy. You will no doubt face obstacles. But our markets and its investors – long enriched by an audit process that has cultivated trust and transparency – deserve results that won't gloss over problems or turn a blind eye to conflicts. Over the next two days, you have a unique opportunity to hear from leading members of every aspect of the profession. I strongly urge you to ask tough, probing questions. Don't settle for stock responses. Regardless of what conclusions you reach, you need to be confident that the audit process remains fair and trustworthy.

Your questions will be many and the answers you find may be difficult or even troubling. How can the profession maintain its objectivity, its historical reputation for excellence against the legitimate need to control costs, compete for talent and keep pace in this era of rapid change? Are firms keeping a professional distance from their clients so that objectivity and independence is being safeguarded?

What is the state of the self-regulatory process? Not too long ago, I met with the board of the AICPA. I had a nice visit with them. It is an organization that performs many valuable services for the profession. But I was struck by the fact that while the board was made up of the different constituencies of the Institute, it had only limited public representation. I think that's a mistake. If the AICPA is going to be a professional body that protects the public interest, it only makes sense that there be greater public representation on the board. It has worked for the FASB and FAF and it can work for the Institute.

More generally, has the accounting profession become so big and complex that we need a full-time SRO? Are the alphabet soup of regulatory bodies – the POB, the AICPA's PEEC, the SECPS, the ASB and the ISB – really workable?

As more markets and companies operate on a global level, are the firm's international structures sufficient to maintain high levels of quality control? The firms have been quite successful in branding their names world-wide. But an affiliated firm in South America or Asia, in many cases, is just that – affiliated. The organizing agreement between affiliating firms and the parent may be loose and the controls over the quality of the audit lacking. The World Bank has questioned the quality of audits in the international arena and I share their concerns. If we want investors to have confidence in the numbers on a global basis, then auditors need to ensure that the highest quality independent audits are being conducted everywhere and anywhere.

As I look at the talent, experience and integrity represented on this committee, I have no doubt that the public interest will be served. I cannot express to you how grateful I am for your service. I know you all have invested a tremendous amount of time to take on this important endeavor. On behalf of the Commission, I pledge our cooperation and help in any way possible. I urge the profession, corporate CEOs and CFOs, boards of directors and, most especially, investors to engage themselves in the panel's deliberations.

Before I respond to any questions you may have, let me turn to Lynn Turner, the Commission's Chief Accountant and Dick Walker, the head of Enforcement.