Remarks Of William R. McLucas Director, Division of Enforcement* U. S. Securities and Exchange Commission 25th Annual National Conference on Current SEC Developments American Institute of Certified Public Accountants Washington, D. C. December 9, 1997 _____________________ * 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. McLucas and do not necessarily represent those of the Commission or the other members of the staff of the Commission. Background and Introduction Over the past decade, our capital markets have experienced unprecedented expansion. During the past three years alone, the Dow Jones average has more than doubled, from 3,700 to over 8000. Also during the last three years, nearly $3.5 trillion in securities have been registered with the Commission for sale. Foreign entities are listing in the United States markets in record numbers. There are currently over 1,000 foreign companies from 51 countries filing reports with the Commission. Our total equity market capitalization for all companies listed for public trading in United States markets is over $11 trillion. The financial information and related disclosures that are disseminated to our financial markets represent the foundation for this historic growth. Every day, millions of business and investment decisions are made based upon this information. The accounting profession has always been the key to ensuring that investors are provided with reliable, accurate and useful financial information. As Chairman Levitt has said "Accountants are the guardians of financial truth." You are perhaps the most critical component of the system of self-regulation which serves as the hall mark of our capital markets. The Enforcement Division of the SEC has not grown as rapidly or nearly in the same proportion as the markets have. Today we have approximately the same number of staff as we did three years ago. Our mission, however, has remained the same: to ensure the strongest and fairest financial markets in the world. From an accounting perspective, that requires fairly stated financial statements, full disclosure, and an audit process in which independence is a top priority. The Law Has Granted Accountants a "Statutory Franchise" in Our Capital Markets When Congress passed the Securities Act of 1933, one of the key components of the system was the requirement that financial statements be "independently audited." The contrast between the role of the independent auditor and the role of management was made clear. The auditor would be an unbiased third party who would serve as an "independent" check on the natural inclination of public entities to show themselves in the best possible light. In other words - you were, in effect, licensed by statute to grade corporate America. [An A+ had to be earned - not given to a performer who really merited only a C-.] Congress clearly recognized that the integrity of financial information being provided to investors, and the public perception of that integrity, were critical to the effectiveness of the US securities markets. It was true then and it continues to be true today: the fact and the appearance of independence are perhaps more necessary today than ever before to maintain the confidence of the investing public. Access to the public's capital in our financial markets requires independently audited financial statements. Almost since the inception of the SEC, the Commission has allowed the accounting profession to take the lead in setting accounting and auditing standards. This latitude in setting the rules, coupled with the law's requirement for audited financial statements, gives a type of "statutory franchise" to the accounting profession. Your integrity has served as the core of our financial reporting framework for more than 60 years. One of the most important elements of this franchise, from my perspective, is the duty that the profession has to promote and protect independence. Without independence, the function being served by the audit profession is meaningless. This is the bedrock that supports the investing public's faith in the integrity of the financial information on which our markets thrive. As audit firms begin to expand the scope and nature of services being offered, we have seen some disturbing trends. We have come across a number of matters in the past few years that increasingly raise questions about whether independence is becoming subordinate to the growth and expansion efforts being undertaken by the profession. These underlying issues raise some significant concerns that independence is now being treated as an obstacle, rather than as the foundation on which the profession's stature has been built. Expansion and Diversification of Accounting and Consulting Services Accounting firms are no longer stodgy bastions of conservative auditors. The stereotype of the accountant as someone who "ticks and ties" financial statements has been shed. Accounting firms are now full service financial and consulting powerhouses providing a wide range of services. The very integrity that the accounting profession has, for generations, used as its calling card, now serves as a springboard for its growth and diversification into the faster growing, and more lucrative, consulting and specialty services areas. With this shift in the mix and scope of services, the profession must be exceedingly careful about maintaining real independence from audit clients, for it is that independence which serves as the basis of the "statutory franchise" given to the profession. Change in Composition of Firm Revenues Can't Compromise Need for Independence The concern accountants face from a public policy standpoint is that most of these "non-audit" opportunities do not raise the same type of independence issues as auditing engagements traditionally have. Consultants can perform many of the same roles as management. They can be advocates. They can be strategic partners. These roles, however, begin to muddle the carefully crafted checks and balances that were instituted in 1933. It is imperative that the market's perception of auditors as independent in "fact and appearance" not be compromised by the transformation of auditing firms into full service entities. Certain independence issues are easy to resolve. The AICPA Code of Conduct clearly outlines many specific examples that are unacceptable. On these brightline, clear-cut prohibitions, we likely all agree. While many of the independence issues we see may appear to be more complicated, once the underlying facts are examined, the conclusions often seem quite clear. The collateral affiliations that are emerging with audit clients are violating the basic notion of independence. Let Me Mention a Few of the Independence Issues That We've Seen: Last week the Commission instituted public administrative proceedings alleging that KPMG Peat Marwick lacked independence because, among other things, KPMG organized and capitalized an entity named BayMark which was to be used in the "corporate turnaround" business. Later, KPMG installed an owner of BayMark as the President and CEO of Porta Systems Corp, a financially troubled audit client of the firm. KPMG also made a direct loan to this individual, who was, in effect, the management of the audit client. Also, by the nature of the relationship, KPMG was entitled to a percentage of the earnings, disposed inventory and restructured debt of its audit client. Because this matter is being litigated, I'm not going to discuss the facts in more detail. However, this matter, at a minimum, is indicative of some of the more intricate ways that accounting and auditing firms are becoming involved in other areas of their client's operations. In another matter, the Commission alleged that an accounting firm lacked independence because of financial dealings between its partners and two companies audited by the firm. The Commission alleged that, among other things: * over 50 of the firm's partners were members of real estate partnerships that received over $15 million in loans from the client, and * certain partners received personal loans from the client that were not made under normal lending terms Clearly, this kind of conduct does not advance the public trust that investors place on the independence of auditors. In other instances, positions taken by accountants or auditors sometimes appear to be so far outside the parameters of professional standards, that the staff can only suspect that the auditors' independence has simply eroded. The Commission has been justifiably skeptical of many positions that are being creatively offered up as a means to an end; that is, simply as an accounting justification for a position which is insupportable. Increasingly, the Enforcement staff must assess the effect that large and lucrative consulting arrangements may have on the accounting being recommended to management and on the auditing opinions issued. Where consulting revenues materially exceed audit fees, the staff will be skeptical about the implications that those services may have on the audit function. We will scrutinize those instances in which auditing decisions seem to be colored by consulting advice or by a fear that special work may be compromised unless a particular accounting position is embraced by the audit team. These matters call into serious question whether the profession is providing impartial, intellectually honest advice, or whether accountants are compromising their objectivity to provide the answers that the clients want to hear. My concern is that under the label "professional judgment," auditors are too often providing "professional accommodation." These situations will be closely examined at the SEC and the staff will likely be prepared to challenge the profession more frequently on independence issues. Any less on our part would compromise a system which demands that the accounting profession function in an objective and impartial manner and would be a disservice to investors who rely on the financial statements the profession audits. Other Matters - FASB Under Siege Any changes in or challenges to our system for setting the rules for accounting and auditing, which also might erode the investing public's belief in the integrity of the financial reporting process, should be approached cautiously. What may look like a convenient solution today, may have longer term ramifications on the accountant's professional role. In the past few years, the FASB has encountered blistering criticism, at least in part, for attempting to do its job. Under the current system, the Commission looks to the FASB and the AICPA to establish credible and useful accounting and auditing standards. To do its job adequately, the FASB must be independent. There have been an increasing number of attempts, however, to override or interfere with the FASB's mandate. The business and political firestorm that erupted in 1993, over the proposed accounting for stock options is one recent example. The contentious positions taken with respect to derivatives accounting reflect a second example. The business community and Financial Executives Institute have attempted to increase their influence on the FASB and its agenda. Chairman Levitt has opposed any initiative that would compromise the FASB's effectiveness or the fact or perception of its independence. The accounting profession's own role in these difficult issues should also be a source of reflection. Too frequently, when looking to their colleagues and peers for objective, far-sighted input to craft accounting standards that will provide credible and useful financial information, the FASB has been besieged with client advocacy arguments. These arguments, advanced by the accounting professionals themselves, pose a threat to the fundamental structure of the entire standard setting process. The public's perception that accounting rules are advanced on an impartial basis for the benefit of all market place participants, cannot be enhanced when advocacy outstrips objectivity. Independence Standards Board One vehicle which has been created to consider some of the emerging independence issues is the Independence Standards Board. With Commission oversight, this Board provides for direct participation of members chosen from the public sector, along with members from within the accounting profession. Hopefully, the ISB will begin to make constructive progress on many of the challenging independence issues which have begun to surface. The AICPA has submitted a White Paper on independence matters to the ISB in response to the ISB's request for educational materials bearing on the concept of auditor independence. Although significant additional research and input will be necessary before a consensus will emerge on which regulatory approach would best serve the public interest, we need to ensure that the investing public is well represented and considered in this important endeavor. Accounting Mergers The Commission is also aware of the potential independence implications which may result from consolidation in the profession. Even though the disappearance of the Big Eight means it will no longer be confused with the former college football conference (which is something that can't be said for the SEC), the consolidation in firms marks yet another significant change for the accounting profession. The consolidation also highlights the various independence concerns that have been emerging in the past several years - namely the balance of power between the consulting arms of the firms and the traditional auditing arms. As these concerns accelerate on a worldwide stage, the Commission will be particularly wary of instances in which audit independence could be adversely affected. Summary and Closing Public trust in the accounting profession has always been the basis for its prosperity. It is the primary reason that you are on the forefront of change in today's marketplace. This trust is a function of the independent and objective manner in which accountants and auditors go about their daily business. It was this independence that was seized upon by Congress in granting this profession a statutory franchise by requiring publicly traded companies to be independently audited. John Carey, who was a former senior staff officer of the AICPA, wrote in his 1946 book entitled Professional Ethics of Public Accounting, that independence "is the certified public accountant's economic excuse for existence." The concept of independence in public financial reporting is more important today than ever before. The profession must ensure that independence remains a top priority and not merely an obstacle to overcome. Anything less could critically impair the system of self-regulation that has served our capital markets so well. - END -