Speech by SEC Staff:
20th Century Myths
Lynn E. Turner
U.S. Securities and Exchange Commission
New York University
November 15, 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.
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 other members of the Commission's staff.
Good evening. As always, I must preface my remarks with a disclaimer: As a matter of policy, the Securities and Exchange Commission disclaims responsibility for any private publication or statement by any of its employees. The views that I express are my own, and do not necessarily reflect the views of the Commission, or other members of the Commission’s staff.
I was delighted to be asked to speak at this dinner tonight, which honors Seymour Jones. Cy was a fellow partner of mine at Coopers & Lybrand; I have been acquainted with him for probably 20 years or so. I initially met Cy when he was in charge of the portion of our practice that dealt with growing, emerging businesses. Cy was indeed a visionary—at that time, many people in the firm had strong beliefs that profits could not be made by serving startups and small-to-medium-sized businesses. But Cy, and others who followed in his steps, continued to grow the business in size and profitability. Today, given the changes in the public markets and the opportunities they provide to startup and small-to-medium-sized businesses—which often evolve into large companies in just a few years—we all can see that Cy’s vision was right-on twenty years ago.
Much like the misnomers and myths that Cy faced twenty years ago, there are myths that exist today about the public accounting profession. I have seen a number of these grow in stature during the past ten years or so. As a partner and business unit leader in a prominent accounting firm, as a vice president and chief financial officer of an international semiconductor company and, currently, as Chief Accountant at the Securities and Exchange Commission, I have found these myths to be just that—myths. They lack a rational basis and in some instances appear to have been continued solely to further the agendas of individuals, rather than to further the true mission of certified public accountants—a mission that first and foremost must have one purpose—serving the investing public. So let me get started with the myths:
Myth No. 1: You Can’t Make Money Auditing
In various newspaper and business periodicals, I have read articles that discussed the auditing practice of a public accounting firm’s business. From time-to-time, these articles state, as if a matter of fact, that auditing is a loss-leader for the rest of the firm’s practice. Its growth is slow and the work is mundane, without glamour, and something that is unattactive to today’s college graduates. When I see these articles, I can’t help but note that these ideas just didn’t spring up from nowhere. They had to come from somewhere. The most likely source is from within the profession itself. Unfortunately, there has been a lack of leadership from within the profession in responding to these myths.
So I will lay out some facts. As a business unit leader in a public accounting firm, and through discussions with CEOs of other firms in my capacity as Chief Accountant, I have been privy both to the revenues and the profits arising from auditing work. I can tell you that the audit practice, or assurance practice as it is sometimes referred to today, is very profitable. Both the profits and margins and resulting cash flows are good. The audit practice is not a loss leader. On some audit proposals, I have seen audit fees priced lower to obtain the client. But even here, it is usually expected that the engagement team will get these fees up to an acceptable level within a reasonable period of time. I also might note that adjusting pricing on one segment of a service solution package for a client, in order to win the proposal, is not unique to public accounting—it is something that occurs frequently in a number of industries.
It is also a fact that the revenue growth of the consulting segments of the firms has outstripped the revenue growth of the audit practices. Notice that I say the growth of the audit practices—they are growing too. And lest people forget, when there is a downturn in the economy, as there was in the 80’s and early 90’s, it will be the consultants who will go first. The audit practices, as rock solid annuities, will continue to generate profits and cash flows that will carry the firms.
I must note here that it is also a fact that the Chairman of the Independence Standards Board ("ISB") asked for financial information from the CEO’s of each of the large firms over a year ago. The purpose of the request was to provide the public ISB members with information so that they will be able to make informed decisions about the policies and procedures of the public accounting firms and how those policies and procedures may affect auditor independence. It is profoundly interesting that, to date, the auditors have not, for whatever reason, responded to the Chairman’s request and provided this information. Is it because the firms don’t want others to know the story about the profitability of their audit practices? Without this information, and without the guidance of the research that was anticipated and discussed in Financial Reporting Release 50 (Codification of Financial Reporting Policies section 601.04), one must wonder how the ISB will be able to make informed decisions.
Here’s one other fact to consider. The audit partners in the accounting firms do very well financially. Their compensation puts them in the highest one percent in the country. And while they do not get stock options and cannot share in the gains that options may generate, in my experience as an advisory board member for a venture capitalist, the stock options for about eight out of ten of VC-funded companies do not pan out. It seems as if people always believe that the grass is greener on the other side of the fence. Perhaps they would be better off with a little watering and some fertilizer.
Now let’s turn to the notion that auditing is mundane and lacking glamour. I think this is an important issue because perhaps the public may think the auditors of companies such as Rite Aid, Cendant, Sunbeam, Waste Management, and others, thought their audits were mundane, glamourless, mechanical processes without the need for critical thinking. That couldn’t be further from the truth. Auditing today requires an in-depth knowledge of a business, and the many risks its management team faces daily. It requires the keen ability to understand, dissect, and analyze complex transactions and financial instruments. In a global, international business world that is in a constant state of flux, auditing is more challenging today than ever before.
And it takes one who can excel to become a certified public accountant. Indeed, many who have the ambition and drive to take the CPA exam do not pass. It’s not for lack of trying, but because it takes one who is at the top of the class to get there.
After achieving that goal, responsible professionals must continue their training. My own experience tells me that there is no better on-the-job training than working as an auditor with a public accounting firm. The firms are to be commended for the fine training they do provide their staff. I suppose some of you here have been beneficiaries of those training programs.
For example, on a recent Saturday morning, I "plugged in" a training video that Arthur Andersen ("AA") had sent me. It dealt with the tantalizing topic of auditing revenues. I planned on watching 5, or so, minutes of it so that when folks at AA asked me about it, I would at least be able to respond. But I must tell you, it was great—excellent! I spent the morning watching the whole video. One of the other staff members even came by and joined in. While it may not win an Oscar, it did provide great insights into the business risks that would need to be considered, not only by investors, but also by CFO’s, controllers, and other business executives. If this video is indicative of the training that staff receive at AA, then new college hires at the firm can rest assured that they will be receiving a "world class" education.
Perhaps my belief that the auditing profession is a tremendous career for college graduates can best be summed up by noting that I did a presentation to the Beta Alpha Psi chapter at Creighton University last week. I got the opportunity to speak one-on-one with a number of the students and then to join a panel presentation for the entire group. The moderator asked me what career I thought these students might have. While I told them I thought public accounting opportunities, as well as opportunities in industry, gave them a great variety of choices, it was the person who sat next to me that really evidenced what being an auditor in public accounting could mean. He echoed my comments. That gentleman, a CPA and former auditor, was none other than the Chairman and Chief Executive Officer of ConAgra, Inc.
Myth No. 2: The Zero Defect Effect
Let me turn to the second myth. If you read the testimony presented at public hearings looking into the work of the public accounting profession, you will find a common theme. No matter whether it was the Moss/Metcalf hearings of the 70’s, the Dingell hearings in the mid-80’s, or the recent O’Malley Panel hearings, someone always gets up and testifies that the list of alleged failed audits is short because 99.999 percent of all audits are ok. As a result, they conclude that the current professional standards, and oversight processes, work. They argue that investors and regulators are asking for a zero defect rate, which is not achievable given the human nature of the business. As a result, continuous improvement just never happens because it never gets started.
But you need to keep in mind a few key points when you next hear this recurring argument. First, you only hear about a failed audit if the company fails or if their financial statement restatements get a lot of attention from the press or from analysts. For example, in my role with my prior firm—and I believe we were no different than other firms—I did see several situations where the audit team did not get the job done and we required a restatement. Quite often, this happened when an issue, due to various reasons, was brought to the attention of the national office later than it should be. And much to the credit of the people in these positions, restatements were required to fix what had been an audit miss. However, I always wonder about those situations today that do not get brought to the attention of the national office, like those cited in the recent enforcement releases involving the auditors of WR Grace or California Micro Devices.
Unfortunately, the number of restatements that are being reported in the press today is becoming significant. Perhaps more disconcerting is the rapidly accumulating amount of investor losses, especially given the market capitalizations and price-earnings ratios of these companies. As a result, we are studying the amount of these losses, which is well into the tens of billions of dollars. Given the billions of dollars that the public lost in the savings and loan crisis of the 80’s, one must ask if these costs don’t justify more effective audits today—before it becomes hundreds of billions of dollars—and before a market turndown exposes further cracks in the foundation of quality financial reporting that our capital markets are built on.
At the recent O’Malley Panel hearings, one CEO, Jim Copeland of Deloitte & Touche, did speak out on the need for individual responsibility and accountability within the profession. He noted the need for changes to improve our current system and cited the processes within the airline industry as an example of a public-oriented process. He clearly demonstrated his ability to be a thought leader within the profession. I applaud him for his efforts and vision. They say if two ride a horse, one rides behind. It seems to me that Jim intends to be the one in front with the reins in his hands.
Myth No. 3: Safeguards Assure Quality
Before I ever got to the Commission, the public accounting profession made a presentation to the Commissioners that included a discussion about the safeguards that assure independence and quality audits. During one of those presentations, it was pointed out that a firm’s personnel could not accept gifts from a client. Then questions were raised about whether an auditor would permit the client to pay for a round of golf, offer a trip on the company’s jet to a stockholder meeting or offer to fly the auditor to a golf club for a round of golf. The answers to such questions make the safeguard of "no client gifts", which initially sounds good, appear to be less than forthright.
The enforcement release done in January 1999 involving PwC also raised serious questions regarding existing safeguards. And it has not only been PwC. Subsequently, the Commission issued a release regarding Moore Stephens. The staff also is investigating several other situations that concern me—it is becoming clear that appropriate safeguards do not always exist today. In other situations, safeguards that do exist are not being complied with fully. I am concerned that the "tone" within the firms perhaps has been less than loud and consistent; as a consequence, some members of the organizations may not have focused sufficiently on compliance with all of the standards of their firm, the profession, and the SEC. That is unfortunate—and unacceptable. It demonstrates a lack of individual professionalism, accountability and discipline. As a result, I fully expect the staff of the SEC to consider what type of guidance will be appropriate. The AICPA SEC Practice Section is developing guidance that is a step in the right direction. But we’ll need additional steps, made quickly and carefully, to complete the journey.
And safeguards are not just an independence issue. Often the peer review process is viewed as a safeguard. I personally believe that a substantive, in-depth peer review process, carried on by an ever-vigilant oversight body, can contribute to quality audits. Whenever performing audits, I always had in the back of my mind that if someone looked at the audit I had done, I wanted to be sure that they would give me an A on the report card.
But today, many peer reviews result in comments about whether the attorneys’ or management’s representation letters had the correct dates on them. More substantive comments are usually not noted. As a result, earlier this year, I joined other SEC staff in their review of a couple of peer reviews. Based on our reviews, the staff was and is concerned about whether substantive issues that appeared to be appropriately raised in the field were adequately dealt with and addressed. In fact, the staff followed up on these matters with the staff of the Public Oversight Board. I suspect that, because of our concerns, we will be giving peer reviews greater scrutiny in the future. And we will need to consider whether our findings continue to be consistent with findings on the peer review process that we have reported in the past in our annual report to Congress.
Today, the O’Malley Panel is conducting a review of the effectiveness of the profession’s audits. Based on the questions it has been posing, it appears that the Committee members are undertaking to examine all facets of the profession that may impact the quality of audits. This includes audit procedures, independence, oversight, and disciplinary mechanisms. I truly believe this committee has an ability to produce a credible report that covers the topics I just mentioned and provides clear guidance that will well serve the profession and the public.
Myth No. 4: Accounting Standards Setters Issue Standards That Are Too Complex, Too Burdensome (The Two-Headed Monster)
It is interesting to listen to people ask for simple, less complex standards like in "the good old days." But I never hear them ask for business to be like "the good old days," with smokestacks rather than high technology, Glass-Steagall rather than Gramm-Leach, and plain vanilla interest rate deals rather than swaps, collars, and Tigers!! The bottom line is—things have changed. And so have people.
Today, we have enormous pressure on CEO’s and CFO’s. It used to be that CEO’s would be in their positions for an average of more than ten years. Today, the average is 3 to 4 years. And Financial Executive Institute surveys show that the CEO and CFO changes are often linked.
In such an environment, we in the auditing and preparer community have created what I consider to be a two-headed monster. The first head of this monster is what I call the "show me" face. First, it is not uncommon to hear one say, "show me where it says in an accounting book that I can’t do this?" This approach to financial reporting unfortunately necessitates the level of detail currently being developed by the Financial Accounting Standards Board ("FASB"), the Emerging Issues Task Force, and the AICPA’s Accounting Standards Executive Committee. Maybe this isn’t a recent phenomenon. In 1961, Leonard Spacek, then managing partner at Arthur Andersen, explained the motivation for less specificity in accounting standards when he stated that "most industry representatives and public accountants want what they call ‘flexibility’ in accounting principles. That term is never clearly defined; but what is wanted is ‘flexibility’ that permits greater latitude to both industry and accountants to do as they please." But Mr. Spacek was not a defender of those who wanted to "do as they please." He went on to say, "Public accountants are constantly required to make a choice between obtaining or retaining a client and standing firm for accounting principles. Where the choice requires accepting a practice which will produce results that are erroneous by a relatively material amount, we must decline the engagement even though there is precedent for the practice desired by the client."
We create the second head of our monster when we ask for standards that absolutely do not reflect the underlying economics of transactions. I offer two prime examples. Leasing is first. We have accounting literature put out by the FASB with follow-on interpretative guidance by the accounting firms—hundreds of pages of lease accounting guidance that, I will be the first to admit, is complex and difficult to decipher. But it is due principally to people not being willing to call a horse a horse, and a lease what it really is—a financing. The second example is Statement 133 on derivatives. Some people absolutely howl about its complexity. And yet we know that: (1) people were not complying with the intent of the simpler Statements 52 and 80, and (2) despite the fact that we manage risk in business by managing values rather than notional amounts, people want to account only for notional amounts. As a result, we ended up with a compromise position in Statement 133. To its credit, Statement 133 does advance the quality of financial reporting. For that, I commend the FASB. But I believe that we could have possibly achieved more, in a less complex fashion, if people would have agreed to a standard that truly reflects the underlying economics of the transactions in an unbiased and representationally faithful fashion.
I certainly hope that we can find a way to do just that with standards we develop in the future, both in the U.S. and internationally. It will require a change in how we approach standard setting and in how we apply those standards. It will require a mantra based on the fact that transparent, high quality financial reporting is what makes our capital markets the most efficient, liquid, and deep in the world.
Let me close by citing Harry S. Truman who said, "I never give them hell; I just tell them the truth and they think its hell!" Well, tonight I have tried to dispel some myths about our profession by discussing some truths. I hope that others will also join in clarifying the record about what is truly a tremendous profession that plays one of the most critical roles in our capital markets and economy today. I believe that despite the need for continuous improvement, and the shortcomings we need to shore up to maintain investor confidence, in the end, we will rise to the top, just like the crème-de-la-crème.