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SECURITIES ANDEXCHANGE COMMISSION

Washington, D. C. 20549(202) 755-4846

For Release: 12:30 p.m., January 4

PROFESSIONAL SELF-GOVERNANCE:AN INTERIM REPORT

An Address By Harold M. Williams, ChairmanSecurities and Exchange Commission

AICPA Fifth National Conferenceon Current SEC Developments

January 4, 1978

Last spring, a Senate subcommittee chaired byLee Metcalf held pUblic hearings concerning theaccounting profession. Those hearings, the staffstudy which preceded them and the Committee report.which followed, are part of a broad examinationof the profession. That examination has servedto highlight the increasing public and Congressional

,interest and concern over the important role inour economic life of a profession which, in thepast, has enjoyed relative obscurity. Much could-- and has -- been said about particular substantiveissues aired before the Metcalf Committee. Thetestimony of witnesses raised concepts such asmandatory rotation of firms, federal licensing ofaccountants, direct governmental involvement in theformulation of both accounting and auditing standards,and other steps which would radically alter theautonomy of the profession as we know it today.

While the Committee report, issued lastmonth, did not propose any of the more extrememeasures recommended by some, it would obviouslybe a very serious mistake for accountants toconclude that Congressional interest in theaccounting profession will relapse into the •

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dormancy which was long c h a r a c t e r i s t i c . Apar t

from t h e merits of t h e v a r i o u s s u b s t a n t i v e

i s s u e s d i s c u s s e d , t h e Metcalf h e a r i n g s conveyed

one very d e f i n i t e and c l e a r message -- a sense

of e x p e c t a t i o n and urgency f o r t h e p r o f e s s i o n

and, a s neces sa ry , t h e Commission, t o a c t t o

b u i l d t h e p u b l i c ' s conf idence i n t h e

independence of accoun tan t s , i n t h e i r r e s o l v e

and a b i l i t y t o engage i n meaningful s e l f - d i s c i p l i n e ,

and i n t h e p roces ses by which account ing s t a n d a r d s

a r e e s t a b l i s h e d .

The h e a r i n g s a l s o conveyed a second message

-- t h a t many people i n and o u t of Congress

a r e c r i t i c a l of t h e Commission f o r what it is , o r

is n o t , doing with r e s p e c t t o t h e a u d i t i n g and

f i n a n c i a l r e p o r t i n g of p u b l i c c o r p o r a t i o n s and

f o r not being agg res s ive enough or r e s p o n s i b l e

i n t h e d i s c h a r g e of i t s o v e r s i g h t r o l e . I have

v e r y l i t t l e d e s i r e t o p r e s i d e , du r ing my f i v e

y e a r s a s Chairman, over i nc reased r e g u l a t i o n of

t h e account ing p r o f e s s i o n . S i m i l a r l y , I have no

wish t o see l e g i s l a t i o n passed t h a t would p l a c e

t h e r e s p o n s i b i l i t y on t h e Commission -- or some

o t h e r government body -- t o r e g u l a t e accoun tan t s .

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Nevertheless, time is rapidly running on theopportunity for voluntary initiatives.

Congressman Moss has indicated his intent tocontinue this pUblic examination of the professionby holding hearings, perhaps as early as this month.In addition, Senator Metcalf plans to hold follow-uphearings this spring. Senator Metcalf's recentletter to me conveys the sense of urgency which,I believe, is important for every member of theprofession to bear in mind. That letter, referringamong other things to the unanimity of theSubcommittee report, concludes:

IIIhave received disturbing reports that manyin the accounting profession believe thissubcommittee has completed its accountinginquiry, and that substantive changes arenot necessary because we have expressed ourpreference for the profession and the SECto implement reforms. I assure you that isnot the case. We plan to hold follow-uphearings this spring, and we look forward toseeing substantial progress from those whotold us they could do the job themselvesalmost a year ago. Ii

In my own testimony at the Metcalf Hearings, theCommission undertook to submit an annual report toCongress, the first by July 1, 1978, analyzing theprogress of the profession and the Commission in. .address1ng the challenges before them. I would

tJ

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like to review with you today some of the centralissues which I discussed at the Metcalf Hearingsand which will be the focus of the Commission'sannual report to Congress later this year. Thus,in a sense, I hope to provide you with some ofthe pieces with which the profession can prepareits own interim report on its progress. If theinterim results are not sufficiently positive, itmay well be that the opportunity to prepare afinal report on voluntary initiatives will nevercome.

IndependenceAs I see them, the issues on which the

accounting profession's progress will be evaluatedare three: Independence; quality control,. includingself-discipline; and the accounting and auditingstandard-setting processes. The issue of independenceis the key one. It is key because everything else fitswith it. In many ways the public has expectations ofthe profession and of what the auditor's report meansthat exceed reality. However, to the extent that thepublic views the auditing process as a wholly unbiasedreview of management's presentation of the corporate

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financial posture, I believe that the expectations arefully justified. Independence is the auditor's singlemost valuable attribute. If the profession cannotsatisfy its obligation to maintain both the appearanceand the fact of independence, ultimately the politicalprocess will compel changes in the profession so thatit is more likely to do so -- even at the risk ofother shortcomings.

The objective of the profession and the Commis-sion should be to institute those measures availableto them which enhance and reinforce independence --whether in the audit process, through standard-setting,through disciplinary actions, or otherwise. The mostobvious factor which erodes independence -- or, atleast, its appearance -- is the fact that the auditor'scompensation -- and the continued utilization of hisservices -- are dependent upon the wishes of theclient's management, the same group toward whichthe auditor is expected to be independent. Theultimate test and key to independence is the amountof pressure that management can bring on an auditdrand the ability of the auditor to withstand thatpressure.

In that connection, the Commission has proposeda rule amending Form 8-K to require disclosure of

-6-the reasons why an auditor was dismissed andwhether the dismissal and the reasons for it werediscussed with and approved by the board of directorsor the audit committee. Similarly, the Commission hasproposed a change in the proxy rules to require adiscussion of why the auditor was terminated. Theformer auditor would also be given an opportunity tocomment on that discussion.

In the area of management advisory services andthe concern voiced about the impact of those serviceson independence, the Commission has proposed a rule torequire proxy disclosure of all services the auditorprovided to the registrant and a breakdown of thefees. We are also asking for comments on whethercertain management services should be prohibited.

Many of the public comments on these proposalshave raised serious questions concerning their realpotential to improve the cli~ate for auditor inde-pendence. On the other hand, in the letter Imentioned earlier, Senator Metcalf stated that"the proposed disclosure requirements fall farshort of our views regarding the proper scopeof services which independent auditors mayprovide." He added that the "most simple and

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direct method * * * for enhancing independenceand preventing unfair competition would be toprohibit accounting firms from providing anymanagement services to publicly owned corporationswho are their audit clients.1I The Commission will,of course, be grappling with all of the inherentissues in its pending proceedings.

In any event, while the Commission may be ableto take some steps to enhance auditors' independence,the pressures that auditors are subjected to -- interms of audit cost, scope of audit, application ofaccounting principles or auditing standards, orpressure to complete the audit early -- are pressuresthat ultimately only the individual auditor himselfcan withstand. The basic problem here is one ofprofessional attitude, which cannot be legislated,although legislation will undoubtedly be resortedto if self-discipline fails.

What we are dealing with is a sense of profes-sionalism and judgment which must exist ifaccounting is to continue to be viewed and treatedas a profession. That sense of professionalism hasto exist at the top of each of the firms, and inthe profession as a whole, and it obviously has to

-8-permeate the entirety of the firm. It is the essenceof your responsibility individually. And it is also,I believe, fair to say that it is becoming increasinglya matter with which the AICPA, as a body, must concernitself. The Institute must instill in the publicand in Congress confidence that it is an independent,professional organization -- not a trade association inthe sense of being a promotor of the financial interestsof its members and not a lobbying arm for its members'corporate clients. If the Institute is unable to doso, Congress will surely -- and properly -- demandthat a different body assume the self-regulatoryresponsibilities for the accounting profession.

I would like to offer one important example ofwhat the profession should do to stimulate confidencein its own independence. As I have stressed, and asmy predecessors have stressed for many yea~s, one ofthe avenues readily available for strengthening auditorindependence is the formation of audit committeescomposed of independent corporate directors. Incompanies where the auditors report to an independentaudit committee, a potentially important buffer isprovided to insulate accountants from inordinatemanagement pressures and to strengthen the auditorin his relationship with management -- and hence

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his independence. Stated differently, the absenceof an audit committee may diminish or impairthe ability of an auditor to be independent.Determining, as a legal matter, the independence ofan auditor can be a cloudy issue at times, and thelack of an audit committee tends to make thedetermination of an auditor's independence thatmuch cloudier; it clearly is a negative factorin arriving at the ultimate jUdgment. Not allaudit committees will function effectively.Many will, however -- particularly if auditorsrecognize the critical role they can play inhelping make the audit committee a meaningfuland effective tool.

For these reasons, I believe that publiccompanies should establish independent auditcommittees. The Commission will watch withgreat interest the work of the AICPA specialcommittee organized to study whether and how theAICPA should promulgate an ethical or aUditingstandard which would require that an auditcommittee, composed of outside directors, beestablished as a condition to an accountant'saccepting an audit engagement with a pUblicly-owned

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company. The profession should and can move forwardin this important area. I strongly support theAICPA's effort -- indeed it is long overdue andam hopeful that the special committee involvedin this project will recommend a standard whichwill require independent audit committees inpUblic companies.

Independence is, most appropriately, primarilya concern of the profession itself. The professionmust take whatever steps are reasonably availableto it -- such as insisting that their clientsmaintain audit committees -- to insure andenhance its independence. If the profession isreluctant to take steps of that nature voluntarilyand of its own accord, the Commission will needto understand why and how that reluctance can bereconciled with a profession which desires tomaintain the initiative for self-regulation andself-discipline.

Self-Regulation and Self-DisciplineA second important area about which there is

a sense of expectation and urgency is the needfor enhanced professional self-regulatory and

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disciplinary mechanisms. Those mechanisms arevital, not only for the sake of disciplining thosewho have failed in their professional undertaking,but to reinforce independence. If the profession'sown disciplinary proceedings are more effective,and more visible, it will strengthen the independenceof the auditors, and the perception of independence,as well as warding off legislative alternatives.

I recognize the substantial strides the profes-sion has made in a few months to develop the AICPADivision of CPA Firms as a framework for such aprogram. Looking to the future, we need to berealistic about what is likely to succeed andbe acceptable -- to the Commission as well as tothe Congress -- as a self-regulatory program.

The profession has made progress inaddressing certain key issues in the contextof the requirements of the firm membershipprogram. Mandating second partner review andcontinuous professional education clearly willhelp to enhance quality control over the workperformed. In addition, mandating audit partnerrotation on an engagement will strengthenindependence.

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More broadly, however, the jury is out onwhether the AICPA program of self-regulation willbe successful. But clearly the key to success liesin the Public Oversight Board and its ability tofunction effectively. If the quality, stature, andcommitment to independence of the individualsselected to the Board are sufficiently high; ifthe Board can devote the time and is providedwith adequate staff and budget; if it is not impededin performing its functions and responsibilities;and if it can effectively oversee the disciplinaryframework; then the overall program should containthe major necessary ingredients. The effectivenessand credibility of the Public Oversight Boarddepends on its independence, including its willingnessto be critical when called for and its ability tomake pUblic its conclusions, recommendations, ,andcriticisms. It is this publicity that providesthe board with its greatest clout in overseeing theactivities of the SEC Practice Section and inenhancing its own, and the profession's, credibility.

A second key to the success of the AICPA's pro-gram of self-regulation is the effectiveness of thequality control process, including its disciplinary

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framework. Clearly the program needs to encompassadequate sanctioning capability. Sanctions go toreinforce both independence and quality control.The situations in which self-regulatory effortsare most likely to fail are those in which seriousproblems surface involving one or more major firmsin the self-regulated industry or professionalorganization. Thus, if the disciplinary frameworkis to be effective, the sanctioning power of theSEC Practice Section must be used, as appropriate,against both large and small members. Conversely,if the potential sanctioning power does not haveadequate substance, the program itself will notbe credible.

Third, mandatory peer review of the firm'saccounting and audit practice is a significantpart of the quality control effort. Severalaspects of the peer review process should beconsidered in developing the standards forconducting such reviews. One of the principalissues is whether the review should be firm-on-firm as contrasted to being directed by a peer

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review committee or the Public Oversight Board.Consideration should also be given to whetherthe staff performing the reviews should be fromone firm or whether it should be composed ofindividuals from several firms as well as indivi-duals from outside the profession. The questionhere becomes one of balancing the benefits derivedfrom the enhancement of the objectivity, or at leastof the appearance of objectivity, against theincreased costs and inefficiencies, if any, of sucha review process.

Another principal issue is the scope of thepeer review. Should any limitations be placed onthe conduct of such reviews? What are theappropriate criteria? Arbitrary exclusions ofparticular offices, engagements, or personnel frompossible review present problems. For example,automatic exclusion of cases in litigation fromthe scope of the review could place a major cloudover the review process. The issue is one which goesto both the substance and appearance of credibility.Possible alternatives to a full review of thoseengagements should be given careful study.

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Another question concerning the scope of reviewsis whether, to meet the expectations of the users offinancial information, quality control reviews mustinclude a review of an accounting firm's internationaloffices. As American businesses have grown into multi-national corporations, the need for achieving the samehigh level of auditing standards in foreign countrieshas grown commensurately. Foreign operations todayrepresent a significant portion of the business ofmany u.s. Corporations. Investors are entitled to

-expect and should receive the same level of profes-sionalism and judgment from an independent auditorin these foreign countries as they expect and receivein the United States.

The Standard-Setting ProcessThe final area of concern is the process by

which accounting principles and auditing standardsare formulated. I believe that the responsibilityfor standard-setting belongs in the private sector,and hope that it will be able to show the resolveand capacity effectively to fulfill that respon-sibility. I am firmly convinced that the privatesector -- the profession -- is in a much betterposition to maintain and assume responsibility

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for its own destiny than is any governmental body.The Commission's role should be one of oversight-- the prodding, guidance, and reviewnecessary to insure that the profession meets thechallenges facing it in a manner which harmonizeswith our responsibilities under the federalsecurities laws.

There are encouraging signs that the professionis coming to grips with its responsibilities inthis area. I endorse the changes in the FASBstructure. Similarly, I believe that the professionshould consider the recommendations of the CohenCommission very seriously. My judgment is thatthose recommendations are by and large appropriatefor the profession today. Furthermore, in decidingwhether to adopt them, you ought to take intoconsideration not only whether you believe theyare appropriate, but also how those recommendationsreflect public expectations.

Beyond these initiatives, accountants mustgive serious and careful thought to the theoreticalunderpinnings of the profession. One of theimportant -- possibly the most important -- of

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the issues confronting the profession in thisfield is the FASB's conceptual framework project.Not only is it sUbstantively important, but theeffort also exemplifies the kind of fundamentalundertaking through which accountants can demonstrateto Congress and to the profession's critics theireffectiveness and resolve in confronting theimportant issues affecting it. The fruits of thatwork should provide a rational framework withinwhich to establish accounting principles and areporting model for a disclosure system thatwill serve the profession and the business com-munity regardless of the changes in the economicclimate which our society may experience in thefuture. The project is also the logical focusfor consideration of whether the FASB shouldrestrict its scope to financial statements orwhether it should expand it to cover financialreporting in general.

I would urge that, within the conceptualframework, there be both mandatory disclosureof the impact of inflation on the firm and itsfinancial statements and the flexibility to

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encompass any type of disclosure which is determinedto provide meaningful information to users, notonly that incorporated within the traditionalfinancial statements. Examples of these types ofdisclosures include management's discussion andanalysis of the summary of operations, forecasting,interim reporting, etc. The inclusion of suchdisclosures in financial reporting is a trendwhich the Commission has favored in recent years.

Closely associated with this concept of theFASB assuming an expanded scope in the overallarea of financial reporting is the issue ofwhether the auditor should be associated withsuch information and perform an independentreview of it. Auditors must recognize that, asthe Cohen Commis~ion's tentative conclusionsreflect, they are increasingly expected to reviewany information of a financial nature issued bymanagement.

The degree of association that an auditorshould be expected to have with the informationdisclosed by management anQ the auditing standardsapplicable should depend upon the hardness or

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softness of the data presented. The statementon auditing standards concerning replacement costdata is an example of how aUditing standards canbe developed to review information that isrelatively less precise and therefore is softerthan the traditional information contained inaudited financial statements. I envision thatthe auditor's report could similarly evolve intoone that covers all aspects of financial reporting.

ConclusionI hope my remarks have made clear that the

Commission strongly supports the goal of fosteringa strong private accounting profession capable ofproviding the public with independent assurance andverification of the financial information disseminatedby companies. We intend to work actively with theprofession and the Congress in that effort. At thesame time, however, ,each of you must bear in mindthat there is a timetable running or a clockticking characterize it as you will. What itamounts to is that the profession must, as it hasbegun to do, assume a much more aggressive rolein shaping its own destiny. The profession must

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accomplish a number of very specific things in arelatively short period of time if, indeed, it is tomaintain the initiative to determine its own future.

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