"Auditor Independence and Related Issues" Remarks of Isaac C. Hunt, Jr. Commissioner* U.S. Securities and Exchange Commission Washington, D.C. National Association of State Boards of Accountancy Maui, Hawaii September 23, 1997 ______________ *The views expressed herein are those of Commissioner Hunt and do not necessarily represent those of the Commission, other Commissioners or the staff. Introduction Thank you for inviting me. It is a pleasure to address the National Association of State Boards of Accountancy. My remarks will concern the subject of "auditor independence," including some comments on the newly formed Independence Standards Board. I also will discuss an auditor's responsibility to report fraud under the new Litigation Reform Act. Finally, I'll talk about communication between the State Boards and the Commission. Before I begin, please know that my views do not necessarily reflect the views of the Commission, my fellow Commissioners, or the Commission's staff. Auditor Independence Let me start with a brief history of the requirement for audited financial statements and auditor independence. The Securities Act of 1933 and the Securities Exchange Act of 1934 were written and adopted when confidence in our markets was at an all-time low. To add public trust and credibility to the financial information that fuels these markets, Congress mandated that the financial statements of issuers of publicly held securities be certified by independent public accountants. The auditor was to be an independent overseer of the integrity of information provided to the capital markets, and this role was granted as a public trust to the profession. The profession pays a price for its special role. Notably, the profession must maintain not only independence "in fact," but independence "in appearance." Auditors must avoid all suggestions of mutuality of interest with the management of registrants for which an auditor provides services. At the simplest level, the requirement for auditor independence means that members of audit firms can't invest in client firms, can't be related to or borrow money from clients, and can't participate in management activities of audit clients. Moreover, auditors can't provide non-audit services that leave them auditing their own work. This last area (often labelled "scope of services") raises difficult auditor independence issues. One reason that these issues are so difficult is that they lack simple solutions that maintain the appearance, as well as the fact, of independence. In addressing scope of services issues, the Commission focuses on how an auditor's services would affect a reasonable investor's perception of the auditor as an unbiased professional. In each case, one of the first questions we ask is whether a reasonable investor, knowing all facts and circumstances, would continue to perceive the auditor as: (1) having neither mutual nor conflicting interests with its audit client, and (2) exercising objective and impartial judgment on all issues brought to the auditor's attention. To answer this question, we consider all relevant circumstances and all relationships between the auditor and the client. Of course, this includes the provision of consulting or other professional services to the client. We use a "reasonable investor" standard because, as the U.S. Supreme Court stated in 1984 in the case U.S. v. Arthur Young, the primary reason that financial statements filed with the Commission are subject to an independent audit is to "obviate the fear of loss from reliance on inaccurate information, thereby encouraging public investment in the nation's industries." The Court's statement reflects the belief that an independent auditor's objective "second-look" at an issuer's financial statements, and how they were prepared, provides investors with a sense of confidence in the reliability of those statements and encourages investment in the securities of public companies. This sense of comfort and confidence depends on reasonable investors perceiving auditors as independent professionals who, above all else, are looking out for the investors's welfare. This vision of the independent auditor's central role in maintaining the credibility of financial reporting and, in turn, the securities markets, is reflected in the federal securities laws. Under these laws, the auditor is the only professional that an issuer must engage prior to making a public offering of securities and the only professional with the express duty to act independently from management. As I noted earlier, both the fact and appearance of independence are necessary to maintain the confidence of the investing public. Therefore, I have been concerned with whether investor's confidence in audited financial information can be maintained in the face of recent trends in the auditing profession, including: (1) the declining financial importance of the audit function to audit firms, (2) the increase in provision of nonaudit services, and (3) the growing number of business relationships between auditors and their audit clients. These trends continue -- despite concerns raised about the potential impact on the public's perception of the auditor as an independent professional capable of performing an objective and unbiased review of the client's financial statements. For example, the General Accounting Office, in a report published last year, noted that auditor independence is a concern that may grow larger as accounting firms move to provide new services that go beyond those traditionally provided by auditors. The GAO report summarizes similar concerns raised by others with an interest in financial reporting, including the Public Oversight Board's Advisory Panel on Auditory Independence (the so-called Kirk Panel) and the American Institute of Certified Public Accountants (the "AICPA's") Jenkins's Committee. At the federal and state levels, we regulators should be concerned about the proliferation of services being provided by auditing firms to audit clients, especially when the additional services would appear to the investing public to create a mutuality of interests. Challenging the profession about this is not an attempt to limit the growth or development of an accounting firm's scope of services. Notably, the Commission's independence regulations do not address providing consulting or other nonaudit services other than when they are provided to an SEC audit client during periods covered by the firm's audit reports or during the performance of the audit. My agency won't tell firms that they cannot enter a particular business or provide a particular service. But we may say that if an auditor provides a particular service to an SEC audit client, it may impair the auditor's independence with respect to the audit of that client's financial statements. Therefore, we ask whether a mutuality of interests is created, for example, when a company's auditor also provides that company with consulting and investment adviser services. We also are concerned when an auditor performs services traditionally considered management responsibilities. For example, according to press reports, some managements have outsourced to auditors services related to the internal audit function, tax compliance, human resources, and even the performance of the business's basic operations, such as sales, marketing, product development, operations, and their financial and administrative departments. Independence Standards Board To address these and other independence concerns, we considered several alternatives. We could have required more disclosure of non-audit services. We could have followed in the footsteps of accounting and auditing standard setting, and let the auditing profession take the lead in establishing and improving auditor independence criteria. Those supporting this latter approach point to the Commission's historic reliance on self-regulation -- not only in accounting and auditing, but also in regulating other market participants. They also cite the resources and expertise that the profession would bring to the resolution of complex auditor independence issues. Nevertheless, these arguments did not convince us that we should turn over primary responsibility on these issues to the exclusive control of the profession. Because of the built-in conflicts of financial interest that members of the profession would face in addressing these issues, we recognized that a separate, private-sector independent board would be worthy of the public's trust only if, in addition to marshaling the resources and expertise of the profession, it also provided for direct, meaningful participation by independent-minded members of the public, and for our active oversight. Therefore, the Commission and the AICPA agreed that if such a board could be constructed, it should be given a chance to bring logic and continuity to the array of current Commission and professional independence regulations. That's how the Independence Standards Board ("ISB") was born. It will provide the auditing profession with the opportunity to participate through a self-regulatory process that includes public participation and Commission oversight. The ISB's mission is to establish independence standards applicable to audits of public entities in order to serve the public interest and to protect and promote investors's confidence in the securities markets. The ISB is expected to: (1) create a framework for developing standards that will meet investor expectations and assure public confidence in the integrity of the audit; and (2) promulgate standards and ratify its staff's positions, and help develop a process for providing guidance on issues affecting independence. The ISB will have eight members serving on a part-time basis: four public members, three senior partners from SEC Practice Section member firms, and either the President of the AICPA or another AICPA representative. Standard-setting meetings will be open to the public. The Commission will oversee the ISB in the same way we oversee the Financial Accounting Standards Board: by attending meetings, meeting with the ISB and its staff, and reviewing comment letters. Another group, the Independence Issues Committee, will be an important part of the ISB. That Committee will assist the ISB through timely discussion of emerging independence issues and also by addressing broader interpretive issues. The Committee will consist of nine CPAs drawn from SEC Practice Section member firms that audit SEC registrants and who are knowledgeable of current independence literature. The staff of the Commission's Office of the Chief Accountant will be a non-voting observer to this Committee. I have high hopes that the ISB will develop workable solutions. But note that the ISB's existence will not impair the Commission's ability to exercise its authority, including the authority to maintain our current independence regulations and to write new ones, and to institute enforcement actions where appropriate. Further, if the ISB can't meet its mission, the Commission may consider other alternatives. Current Issues Regarding Auditor Related Activities Having talked at some length regarding my hopes for major rationalization and strengthening of guidance in the area, let me mention some other issues which might be of interest to you as regulators of CPAs. Enforcement. The Commission, in reviewing enforcement cases involving improper accounting or auditing, often looks at whether there are matters that call into question the independence of an auditor associated with the financial statements of the company. For instance, the Commission recently settled an action against an audit engagement partner who owned stock shares in the company he was auditing. We brought the case even though the dollar amount of the shares was immaterial to the engagement partner's net worth. In another recent case, we found that an audit firm's independence was impaired where the audit manager participated in the audit after he had accepted employment with the client. The auditor's conduct in this case required the client to obtain a new audit. Section 10A. The responsibilities of independent auditors also has been recognized recently by the U.S. Congress. In late- 1995, Congress passed the Private Securities Litigation Reform Act. This legislation included Section 10A of the Securities Exchange Act of 1934. Section 10A codifies certain professional auditing standards and expedites the obligations of auditors to timely report certain uncorrected illegal acts to management, and, if the illegal acts are material and are not corrected, to the Commission. Section 10A codifies much of the current literature by writing portions of the current standard on fraud, SAS 54, into the statute. Section 10A differs from the current standard in that it broadly defines "illegal acts" to include "an act or omission that violates any law, or any rule or regulation having the force of law." This definition is especially significant when considered in relation to the specific determinations an auditor must make and the expanded responsibilities of auditors to timely report certain uncorrected illegal acts. For example, Section 10A specifies that when the auditor becomes aware of information indicating that an illegal act may have occurred, the auditor must make certain determinations regardless of the perceived impact of the illegal act on the issuer's financial statements. The auditor must: (1) determine whether it is likely that an illegal act has occurred; (2) if so, determine the possible effects on the issuer's financial statements, including any contingent fines, penalties, and damages; and (3) as soon as practicable, inform management of the illegal acts and assure that the issuer's Board of Directors is informed adequately. If the auditor reports to the Board that: (1) the illegal act is material to the financial statements; (2) management and the Board have not corrected that act; and (3) as a result, the auditor reasonably expects to modify the audit report or resign, then the Board must inform the SEC of the auditor's conclusions within one business day of receiving the auditor's report. If the issuer fails to inform the SEC, then the auditor must notify the SEC within the next business day. The Commission issued a rule to implement the reporting requirements of this new law. The rule sets forth the kinds of information to be included in any reports to the Commission and, also, how the report should be submitted. Notably, these reports are exempt from the Freedom of Information Act to the same extent as Commission investigative records. Of course, our experience with reports submitted under Section 10A has been limited to this point. The staff will be monitoring compliance carefully in this area in order to verify that the requirements of Section 10A are being followed. Communication Let me wrap up by focusing on communication, because we at the SEC want to know what we can do to help you. Also, frankly, one reason I am here is to ask you to help us. As many of you are aware, Commission staff has a long- standing program whereby it informs the appropriate State Boards of Accountancy when final disciplinary action has been taken by the Commission against one of the Board's licensees. The staff does this regardless of whether the accountant's involvement is as an auditor, officer, director, employee, insider trader, or in some other capacity. The staff sends to the relevant State Board a copy of our release and other public documents related to the case. We also include a reminder of how a state agency can gain access to our enforcement files. The Commission believes that cooperation with the State Boards is terribly important. This is not only because the Commission, under Rule 2-01(a) of Regulation S-X, relies on the State Boards to determine whether an accountant initially is qualified to practice before the Commission. It also is important because of the State Boards's broad public interest responsibilities and disciplinary powers. After all, while the Commission may suspend an accountant's privilege of practicing before us, a State Board has unique authority over the accountant's ability to conduct all other accounting, auditing, and related professional services. While the Commission believes this program is working to our mutual benefit, I encourage the State Boards to provide us with feedback when final disciplinary action has been taken at the state level against one of these accountants. Although a few states currently provide us with this information, more information would allow us to better evaluate our program. The Commission is a small agency with a big mission -- protecting investors. We rely on efficient coordination with state and other regulatory agencies to avoid duplication of activities and to keep track of local issues. We would appreciate your continued help in bringing matters of mutual interest to our attention -- as you will recall, the Office of the Chief Accountant is the Commission's established contact with NASBA. The Commission and the State Boards can best serve investors and the public when we work together, and I would appreciate your ideas in how we can improve our working relationship with NASBA and with the Boards. Thank you.