ATTORNEY GENERAL OF THE STATE OF CONNECTICUT
BEFORE THE SECURITIES EXCHANGE COISIMISSION
SEPTEMBER 20, 2000
I appreciate the opportunity to speak and the extraordinary leadership and courage of Chaimman Arthur Leavitt in proposing and advocating the Commission's proposed regulations governing the independence of the accounting profession. In particular, these measures restrict the ability of public accounting firms to conduct audits of companies with which the accounting firms have consulting contracts for services such as bookkeeping, financial system information systems design, actuarial services and human resources management. I strongly support this proposal.
Public accounting firms have a special duty to ensure the accuracy of financial information about n corporations that the public trusts when investing. Never before has this special duty been so important. More people today are investing more money in public corporations than ever before. Recent figures from the Investment Company Institute indicate that more than 88 million people have a stake in the stock market. Retirement savings or college education, along with everyday needs, may hinge on the trustworthiness of information that underlies investments. Investors depend on the work performed by "independent auditors" in making their investment decisions and rely on the representation that the auditing work is truly independent. As the SLC has correctly noted, the profound and fundamental changes in the business activities of major I accounting-consulting firms have seriously eroded the concept of an "independent" auditor. When the auditor's firm is financially dependent on the consulting business it receives from the companies it audits, the auditing firm becomes in a very real sense a captive of the audited company It becomes beholden to it and dependent on it. The tough-minded questions and Vigorous standards that the public has traditionally associated with the term "independent auditor" have been compromised by the interdependent business relationship between the auditors and the audited. Truth in advertising would demand that for many large consulting-consulting firms the term "independent auditor" be replaced with the term "company accountant." Regulations adopted by the American Institute of Certified Public Accountants (AICPA) and the Securities Exchange Commission (SEC) have failed to preserve the independence of public accountants.
Indeed, during the past 25 years, management and financial consulting revenues at public accounting firms have grown from 12 % to 70% of total revenues. This booming sideline business is extremely profitable. Yet, the regulations currently allow public accounting firms to audit companies from whom they gain significant profit through consulting contracts. In fact, engagement partners are encouraged to market consultant contracts to firms that they are auditing.
Will those contract profits compromise the independence of the public accountant? Can a public accountant in that situation say no to a company that seeks to bend accounting rules to overstate earnings? When asked, 94% of stock analysts believed that significant consultant fees are likely to compromise audit independence.
Connecticut residents have personally experienced the financial hardship occasioned by the loss of independence and objectivity in the accounting profession. In the Colonial Realty real estate investment scandal that rocked Connecticut in the early 1990's, interdependent relationships between the Colonial Realty Company and its auditors Arthur Andersen & Company became a primary factor in the loss of hundreds of millions of investor dollars. My of office's investigation of the accounting work done by Arthur Andersen for Colonial Realty directly demonstrated the need for independence between auditors and the companies they audit. As detailed in our 1993 report, the most obvious compromising relationship between Arthur Andersen and Colonial Realty was the family relationship between the head of Andersen's Tax Department and one of Colonial Realty's General Partners. While not a "bloodline" relationship, the intermarriage of the Andersen and Colonial partners certainly symbolized the intermarriage between the accounting firm and its client. Other obvious independence issues involved gifts and loans by Colonial Realty to Andersen partners and staff
More subtle and more insidious, I believe, was the fact that Colonial Realty was an important client of Andersen, generating millions of dollars in fees for the accounting-consulting firm. In the final analysis, Arthur Andersen was not objective or independent in the accounting work it did for its client the Colonial Realty Company. Its examinations of the financial forecasts for Colonial's real estate deals were fatally flawed. There were no reasonable bases for the financially favorable conclusions Andersen reached. In fact, as part of its review of Colonial's financial forecasts for prospective investors, Andersen accountants reviewed the financial information that they themselves had prepared for Colonial Realty prior to Colonial's decision to purchase the investment property. Nevertheless, the aura of independence and objectivity which Andersen brought to its audits of Colonial Realty induced thousands of investors to hard over their savings over to Colonial Realty -- hard-earned savings they would never see again.
The result of this investigation was the largest penalty on a public accounting firm in Connecticut history -- $3.5 million -- which included payment to Colonial Realty's investors of the $2.5 million in fees Andersen had received from Colonial Realty for its accounting and consulting work. In addition, private litigation based on our investigation followed the release of the report. While investors eventually recovered a portion of their losses, many surely never recovered their faith in such investments or the accounting profession.
The highest standard of independence should be demanded -- avoiding this kind of real abuse and eliminating also the appearance of impropriety.
I support the proposed SEC regulation to further restrict the types of consultant contracts an accounting firm may have with a corporation that it is auditing. Indeed, I would seriously consider broader restrictions, which the SEC has under review, to prohibit audits of corporations when the accounting firm has any significant fee generating contract with such corporation. While certain types of contracts such as financial reporting and quality control consulting can generate a perception of compromised audits, there is a point where the sum of all forms of contractual relationships is so significant as to create a perceived, if not real, conflict of interest.
As Attorney General in Connecticut, I have aggressively fought for the interests of consumers, seeking legislation to require greater disclosure of information to consumers and to provide the ability to seek court restitution for damages as a result of fraud. The cornerstone of our consumer protection laws is the Connecticut Unfair Trade Practices Act, which prohibits unfair or deceptive acts or practices. At some point, audits of corporations with whom the public accounting firm has substantial consultant contracts could raise the question of whether it is appropriate for such firms to use the word "public" accountant.
I intend to speak with my colleagues in state attorneys general offices across the nation about this proposal and urge their support. As consumer advocates, I am certain that they will share the Commission's concern for protecting the integrity of the financial reporting upon which many consumers are dependent for investing their hard-earned dollars in order to ensure a secure future.
Reform is needed. The Colonial Realty scandal was only small potatoes compared to the type of work currently being performed by this nation's so called independent auditors. The Commission's rules should be tightened and clarified, not to make accounting and consulting work easier to obtain, but to protect the public interest and public trust, and the credibility and integrity of the institutions at stake.