The SEC is serious about preserving the audit and
the independence of the auditor.

PRESERVING

AUDITOR

INDEPENDENCE

An Interview with Michael H. Sutton

By James L. Craig, Jr.

IN BRIEF

The CPA Journal. What are the factors that led to the establishment of the independence standards board?

Michael Sutton: There are two trends in recent years that the SEC has observed--trends that some fear could negatively impact auditor performance and auditor independence, the very linchpins to our financial reporting system:

* The increasing complexity of the business and professional environment in which companies and their auditors conduct their affairs, including changes in the size and structure of the largest accounting firms.

* The growing diversity of services that auditors of public companies are marketing to audit clients and the growing economic importance of nonattest services to the firms.

A not uncommon question from a commissioner is, "How does this development or that development impact auditor independence?" Added to that have been recent studies or reports that have expressed continuing concerns about the objectivity and independence of auditors. The SEC has been focusing on these issues for some time, as have others, such as the U.S. General Accounting Office (GAO). Our consideration has included discussions with leaders from the accounting profession and others who have an interest in a strong financial reporting system.

Possible approaches that we considered were additional SEC rulemaking and more SEC interpretive guidance. As we considered the alternatives, we were drawn to the SEC tradition of seeking self-regulatory solutions and structures. Accordingly, we discussed with the Public Oversight Board of the SEC Practice Section (POB), the AICPA, and others possible self-regulatory enhancements that would address these new forces at work. Any self-regulatory process, in our view, would have to have independence, strong representation from the public, open processes with lots of "sunshine," and oversight by the SEC.

With these basic ground rules as a framework, discussions with the profession led to the concept of an independence standards board. The rest is now well known, and the board is now in place.

CPAJ: What is it exactly that the board will be doing? Presumably setting standards?

Sutton: What we had in mind at the outset was a structure very similar to the FASB--an independent, private sector process that would develop effective standards that would be authoritative--standards that auditors of public companies would be bound to follow as part of their code of professional conduct.

CPAJ: One of the criticisms of the existing guidance on independence is that it is very much rule driven. It is all very mechanical and sometimes illogical. What will be the end product of the work of the board?

Sutton: The starting point is the existing set of SEC rules and interpretations. We recognize that this guidance was developed on an ad hoc basis over many years and that some of it may be outdated. One of the tasks of the board will be to reconsider some of those rules.

CPAJ: Is the board likely to go through them all and identify the ones they want to keep and which to
discard?

Sutton: The board is expected to codify the existing rules and regulations in some manner. Then as it begins to address the various issues, it will establish new and revise existing guidance. The board also will have to address some fundamental independence issues that are not well understood nor fully developed. I think of, for example, issues around public perception of auditor independence. We may need research to gain a better understanding of the issues that are of concern to investors and the public. We think we have a reasonably good understanding of what investors' expectations are, but we could learn more.

CPAJ: It sounds like there is a need for some conceptual underpinnings?

Sutton: From the SEC's perspective, auditor independence is all about one thing--maintaining investor confidence in our capital markets. That was the objective of the securities laws that requires an independent audit, and it is the fundamental focus of the commission in addressing independence issues.

Our strong financial reporting system depends on the independent audit to provide comfort to investors and the public that information provided by management can be trusted to reveal what it should reveal. In maintaining investor confidence, the relationship between management and the auditor becomes very important, and the board will need to examine how the public can be reasonably assured that the auditor-client relationship is healthy and appropriate.

CPAJ: Is the public concerned about the expansion of the scope of services of CPA firms to include a greater dependence on nonaudit work as many recent commentators would suggest?

Sutton: I have heard two concerns expressed about the changing nature of the services offered by CPA firms. First is whether the major emphasis on nonaudit services--because of their profitability--could cause the profession to assign a lower priority to audit services. This could manifest itself, for example, by placing less emphasis on the development of the tools and skills necessary to conduct effective audits. Second is whether, or at what point, expanded and more complex relationships that CPA firms are entering into could threaten the fact or appearance of auditor independence. Clearly these are issues that the new board will need to consider.

CPAJ: Do you see the possibility that the independence standards board might establish a standard that would proscribe the auditor from performing certain types of services?

Sutton: Presently, independence rules say a CPA cannot act as a lawyer for a company and also be its independent auditor. They also say the independent auditor cannot be a broker/dealer in securities for an audit client. So, the concept of incompatible services is already a part of the landscape. The work of the board might lead to other constraints on the types of services a CPA firm could provide to its audit clients. In assessing the potential for conflicts, a key question will be whether the proposed service could involve, or appear to involve, the auditor too directly in the management of a client, or could align the interests of the auditor too closely with those of management.

CPAJ: Everywhere you turn these days, the message that seems to be going out to CPA firms is that there is no future in the traditional services--audit and tax preparation--that CPAs perform. The work of the Elliott committee says there are new assurance services that CPAs can perform, but they are focused more on the benefits to be derived by the person contracting for the services than for the public as in the case
of the independent audit of a
public company. Would you care to comment?

Sutton: From our standpoint we place extraordinary importance on the independent audit. We think the audit brings a great deal of value to the capital markets. Investors depend on it; regulators depend on it. If there is a perception that the importance the profession attaches to auditing is waning, this is of great concern to the SEC.

CPAJ: I have heard some say that this point of view does not reflect the realities of the business aspects of the complex organizations that the CPA firms have become.

Sutton: I'm not sure what "realities" means in this context. Clearly, we cannot ignore the realities of the large and complex organizations that some CPA firms have now become. We also have to recognize the realities of investor expectations that our markets be fair and honest. One of the major challenges to the independence standards board will be to develop standards that will give comfort to the public that the independent audit function continues to protect the interests of investors.

CPAJ: Do you have any thoughts as to what direction the independence board will take the profession?

Sutton: To a significant degree, the new board will chart its own course. As with any new approach, once we formulate what we consider to be the best approach to the problem in the circumstances, we have to wait and see how it performs in practice. One of the checks built into this initiative is that, within five years, we will evaluate how well the board is accomplishing its intended objectives. Is it, in fact, serving the public interest?

CPAJ: Will you attend the board's meetings?

Sutton: The SEC's oversight will include attendance at all meetings. It will include ongoing monitoring of projects and interaction with the staff of the board--the same kinds of oversight that we presently have with the work of the FASB.

CPAJ: The independence board will be unique among the other standard setters--the FASB and AcSEC--in that the standards will only apply to public companies.

Sutton: Yes that's true. But public companies--companies that solicit public funds--present more complex and demanding challenges that, historically, have called for higher standards of independence than for auditors of nonpublic entities. In the public company environment, investors have little ability to check up on the information provided by management, other than through the independent audit.

CPAJ: Is it likely that the new board will deal with some of the unresolved issues identified by the GAO in its report The Accounting Profession, Major Issues: Progress and Concerns? Throughout that report, the GAO urged that the SEC step in to shore up the auditor/client relationship, to make sure that the auditor dealt with audit issues objectively and with the public and nonmanagement users
in mind.

Sutton: The establishment of the board is partly in response to concerns raised by the GAO. I would broadly interpret what the GAO said to the SEC is that we should provide leadership in working with the profession to address auditor independence issues. This is exactly what the SEC has done and will continue to do.

CPAJ: The GAO report and the earlier recommendations of the Kirk panel on strengthening the professionalism of the auditor both place a great deal of emphasis on effective corporate governance, which includes appropriate interaction with the independent auditor at the board of directors level. Will the new board deal with these kinds of issues?

Sutton: I don't know to what extent the board will address those kinds of issues. One factor that enters the picture is that corporate governance largely has been an instrument of state law. Most direction for the makeup of boards of directors and the power they possess does not come from Federal rules and regulations. Also, we cannot overlook the role of the securities exchanges in this area. Some exchanges, such as the New York Stock Exchange, have listing requirements dealing with outside directors and audit committees. That's not to say that the SEC could not use its rulemaking authority in this area. Until now, however, it has chosen to work with the exchanges. My current thinking would be to continue to work with the private sector and the exchanges to strengthen corporate governance and address the kinds of issues raised in the Kirk panel report.

A key question that arises when considering the auditor/client dynamic is how close the relationship between the auditor and management can be before there is a perception of a lack of independence. The Kirk panel is suggesting that, by making sure that the auditor knows that investors, and the board of directors as the representatives of investors, are the client, inherent structural conflicts might be overcome. I think this approach has some promise.

CPAJ: Your immediate predecessor, like you a former partner of a public accounting firm, expressed a great deal of concern that auditors were not exercising professional skepticism. Are you seeing the same things that he did?

Sutton: This is an issue that requires constant attention by the profession. Soon after I arrived here, I discussed the staff's concerns with individual practitioners, firms, and organizations such as the AICPA's SEC Regulations Committee. What's at issue is the basic expectation that the audit will be an objective, independent challenge to management's' representations. Taking an advocacy position on an aggresive accounting issue on behalf of an audit client can be fundamentally inconsistent with that expectation. The act of advocacy does under mine the perception of auditor independence.

I think there is a greater sensitivity to this issue within the profession than there was five years ago.

CPAJ: The GAO in its report and perhaps for the full term of Charles Bowsher as auditor general expressed the point of view that mandatory auditor reporting on internal control would be a major improvement in the financial reporting process. Again, your predecessor placed greater importance on the financial statement amounts than on the control systems in place related to those amounts.

Sutton: A major concern of the SEC has been that investors and other users might take false comfort from a report on internal control when, in fact, the financial information being released to the public may not be reliable or may be misleading. I would not, however, say that assurances that internal controls are working effectively is not important. As an historical reference point, the SEC twice proposed mandatory reporting on internal control. The overwhelming response by preparers, auditors, and users was "no."

CPAJ: That comes as no surprise given the general attitude of the preparer community about increasing the level and nature of auditor reporting.

Sutton: That's true, but the issue of public reporting on internal controls has to be considered in the context of the complete financial reporting system. We continue to believe the primary purpose of the audit is to provide investors with reasonable assurances about the financial information they use for making investment decisions.

CPAJ: But as the need for high-quality financial information on a real-time basis grows, internal control systems take on greater importance. The marketplace may seek assurances on the systems that are producing the numbers.

Sutton: There is no question about it, and the role of internal controls and auditor reporting will need to be revisited from time to time. We will be watching this area very closely.

International Accounting Standards

CPAJ: The International Accounting Standards Committee is in the process of developing a set of core standards, with the objective that those standards will be accepted by the members of the International Organization of Securities Commissions (IOSCO)--of which the SEC is a member--in filings with them. Both you and Chairman Levitt have expressed your opinions that the schedule is ambitious and that only standards of the same quality of existing U.S. standards are appropriate for the U.S. securities markets. Where are we headed?

Sutton: To get at this issue, it will be helpful to review the forces influencing the movement. In the European Community, for example, there is a strong desire for a common set of accounting standards as they move toward union. In other countries, it is a different story.

In the U.S. we have a very strong, investor oriented, financial reporting and disclosure system. As a result, we believe that our capital markets are the most transparent and efficient in the world and that U.S. companies benefit from a low cost of capital. Also, on the strength of our accounting and disclosure system, U.S. companies have access to capital markets around the world.

The SEC is an active participant in IOSCO and the international harmonization initiative out of a desire to improve the efficiency of cross-border capital flows as well as to help improve financial reporting in capital markets around the world. In pursuing these goals, however, we must not compromise the interests of investors in U.S. capital markets.

I view the core standards project as just a beginning. What we need over the long haul is a framework in which national and international standard setting bodies can work together toward greater harmonization, while maintaining the ability of national standard setters and regulators to address the needs of local markets.

A primary goal of the core standards project is to get the international standards to the point that they can be considered a comprehensive basis of accounting. Will the core standards be of sufficient quality and comprehensiveness that they can be accepted in U.S. filings without reconciliation to U.S. GAAP? We don't yet know the answer to that question, but that is not the only measure of success.

CPAJ: There will be tremendous pressures from securities exchanges and securities regulators to permit the use of international standards.

Sutton: I don't believe that the commission will compromise its overriding mission to protect U.S. investors and markets; I believe it will move with appropriate caution. And by the way, I see no evidence that foreign companies coming into the U.S. markets have been disadvantaged by U.S. accounting and disclosure requirements. I believe our system of financial reporting is in no small measure responsible for the success of the U.S. markets, and it would be a mistake to compromise the interests of investors to accomodate the desires of companies who are not willing to meet high accounting and disclosure standards. Keep in mind that we aren't asking foreign registrants to apply higher standards than are required of domestic companies--we're asking that they use standards of comparable quality.

CPAJ: We have to be open to their concerns, don't we?

Sutton: That's why I think it is important for the national and international standard setters to work together. For example, the recent decision by the FASB to reopen accounting for business combinations, I think, is partially motivated by the fact that pooling of interest accounting does not have widespread support outside the U.S.

CPAJ: Fifteen years from now, it would not be surprising to see international standards as the worldwide standard.

Sutton: That's one scenario. Another scenario is that the various national exchanges will compete for investors, domestic and foreign, who will have freedom to choose which markets they want to be in. If that scenario were played out, would investors likely be attracted to high disclosure or low disclosure markets?

CPAJ: If the pace of development of international standards and harmonization with national standards continues at the pace of the last five years or so, it won't be too long before there is substantial uniformity.

Sutton: That's a possibility, but we don't want to trade off quality for speed and we don't want to compromise the interests of those investing in U.S. markets. Our goal should be to elevate global practices--including our own--rather than accommodating the lowest common denominator.

Restructuring of the Financial Accounting Foundation

CPAJ: The action of SEC Chairman Levitt to put more public members on the FASB's oversight organization, the Financial Accounting Foundation, seems to have returned a sense of stability to FASB's position as a private sector standard setter.

Sutton: I hope you are right. Certainly the choice of Ed Jenkins as FASB chair was a stabilizing event and an excellent decision on the part of the Financial Accounting Foundation.

CPAJ: What about the appearance of the ongoing threat to the FASB as a standard setter by those that seek political intervention in the process? We had the stock compensation retreat because of the threat of Congressional action. Most recently we have some seeking to put the brakes on the FASB's accounting for derivatives project.

Sutton: The SEC and, especially, Chairman Levitt have expressed strong support for the work of the FASB, as has AICPA president Barry Melancon and others. I would hope that those that don't like the FASB's decisions in this or any other project--decisions arrived at after extraordinary input and deliberation--would not seek legislative intervention. Don't misunderstand. All the FASB's constituents should give their input--that is an important part of the process. Legislators and regulators have an appropriate interest in seeing that the process of setting standards is open and objective, and is operating in an unbiased way that serves the interests of investors and the public. They should not, however, seek to override technical decisions that come from the board. We need strong leadership from the various constituents to see that what happened with the stock-based compensation project doesn't become the usual way.

Special Committee on Financial Reporting

CPAJ: You were the vice chairman of the AICPA's Special Committee on Financial Reporting. Ed Jenkins, now chair of the FASB, was the chairman. That committee's report in 1994 made recommendations for an expanded reporting model that would include, among other things, nonfinancial and forward looking information. So far, no institution or body seems to want to take charge and move those recommendations forward. At a recent AICPA symposium, it became clear that the preparer community believes that the current model embodied in the annual 10K format is fine. How do you see it?

Sutton: We heard this consistently during the time the committee was working on the project. The missing ingredient, to my mind, is a clear and consistent voice from the user community--those that speak to the needs of investors and creditors. Ed, in his role as FASB chairman, is now in a position to re-engage that audience--to explore what changes make sense and are cost effective.

It is important to understand that, as with all limited scope projects, there is only so much a special committee can accomplish. It did not fully analyze every suggestion or speak the last word on every subject. And at about the same time the committee was doing its work, the Association for Investment Management and Research, which represents the analyst community, was developing a work of its own on financial reporting. Therefore there is a need for further dialog with users. Ed is in a good position to do this, and I think it is quite logical for this to be done as an FASB activity.

The SEC will want to participate because these efforts have the potential to impact the SEC's disclosure requirements. Also, we have an interest in improving the usefulness of financial reporting to investors. But we prefer that the initiative and leadership come from the private sector.

What the SEC did last year with market-risk disclosures, for example, is very consistent with what the Special Committee was recommending. These new rules call for disclosure of forward-looking information relating to derivatives and to market risk in a broader sense.

CPAJ: Former SEC chairman Richard Breeden was very much in favor of mark-to-market accounting. The Special Committee seems to have rejected current value accounting as an end in itself.

Sutton: I think there is some misunderstanding about what users told the Special Committee. Clearly users said they were not interested in replacing the current model with a current value model for all assets and liabilities. In the area of financial instruments, however, users were very much in favor of the use of market values.

With respect to the work of the Special Committee, I think it did a good job of exploring what investors and creditors were looking for in financial information, but I don't think we had time to get a good understanding on the "whys." I hope what comes out of the next phase is a better understanding of why users think as they do and why they responded to particular issues in the way they did. With respect to their lack of interest in a comprehensive current value model, for example, was it because they distrusted the reliability or because they didn't believe the information would be useful? The answer could make a world of difference in the direction we head.

Auditing Issues and Reporting Issues

CPAJ: We have a new fraud audit standard. Do you think it will help to make auditors more effective in finding materially misstated financial statements?

Sutton: We certainly like the idea of the standard, with its emphasis on risk factors that would lead the auditor to want to focus more keenly on whether fraud may exist. However, we won't know how effective the standard actually will be until auditors have some experience with it. What seems certain is that the fundamental expectation that the auditor will detect fraudulent financial reporting will not go away.

CPAJ: The Auditing Standards Board is in the process of establishing a standard for auditors to issue an attestation report on the management's discussion and analysis section of SEC filings. Do you see the SEC making auditor reporting mandatory?

Sutton: The commission may reconsider that issue sometime in the future. Twice in the past the SEC proposed to have mandatory reporting on MD&A, but there was little support.

CPAJ: The fear probably was that requiring auditor involvement would inhibit what managements might otherwise say?

Sutton: That seems to be the case. In any event, the user community generally has not been enthusiastic about the idea. If users expressed the view that auditor involvement would improve the credibility of MD&A, then it might receive more immediate consideration.

CPAJ: Thank you for meeting with me today. Your commitment to keeping the U.S. securities markets as the best in the world is obvious and important. *

Michael H. Sutton, CPA, has been
the chief accountant of the
SEC since June 1995. Prior to that
he was a partner of Deloitte & Touche. While in the accounting profession, he served as vice chairman of the AICPA Special Committee on Financial Reporting and a member of the Emerging Issues Task Force of FASB and the AICPA's Accounting Standards Executive Committee. The SEC, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The opinions expressed in this interview are solely those of Mr. Sutton and do not necessarily represent those of the SEC or other members of the SEC staff.

A Self-Regulatory Approach

In May 1997, the AICPA and the SEC made a joint announcement about the establishment of an independence standards board. The announcement said the board would consist of eight members, four of whom would represent the public and four would be drawn from the profession, and its primary responsibility would be to establish independence standards for auditors of public companies. In addition, a nine-member independence issues committee, all active practitioners serving public companies, would help identify issues that the independence board would address. In a matter of a few weeks, appointments were made to the board, including a chairman. Administrative support and funding for the board comes from the AICPA. Arthur Siegel, formerly a partner of Price Waterhouse LLP, has been named executive director for the board.

The CPA Journal managing editor met with Michael Sutton, chief accountant of the SEC, to learn about the issues that led to the establishment of the board and what the SEC expected the board to accomplish. In addition, the interview covered some of the other major issues facing the accounting profession in its role as auditor of public companies. These include the GAO report card on the profession, international accounting standards, and the recommendations of the AICPA special committee on financial reporting.

The chief accountant knows the issues--the challenge is to
preserve the integrity, quality, and value of the independent
audit, which in his opinion is fundamental to our financial
reporting system.