The perfect qualifications for the job
Auditor Independence as the
SEC Chief Accountant Sees It
An Interview with Lynn E. Turner
By James L. Craig, Jr., and Douglas R. Carmichael
Been There, Done That
The new chief accountant of the SEC has the ideal experience for the position. About ten years ago, he served as an SEC fellow in the Office of the Chief Accountant. He later returned to Coopers & Lybrand as a partner in their Denver, Colorado, office, where he had both client and SEC consulting responsibilities. Just prior to taking the chief accountant position, he was the chief financial officer and vice president of a large international semiconductor company.
CPA Journal editors James L. Craig, Jr., and Douglas R. Carmichael met with Lynn E. Turner recently to discuss the progress being made by the Independence Standards Board, now just about a year old, and the September 28th speech of SEC Chair Arthur Levitt. In that speech Levitt raised some major concerns about practices that are threats to the sound and credible financial reporting system, an important component of the U.S. capital markets.
Turner's broad background will not make it easy for either registrants or their auditors to come before his office unprepared. He raises a very fundamental issue relating to auditor independence--the strength of character of the audit partner when dealing with the registrants that may be pushing the envelope.
This interview, in some respects, is a sequel to an interview last year with then chief accountant Michael Sutton. The Sutton interview occurred around the time the Independence Standards Board was formed. Sutton saw the Independence Standards Board as a self-regulatory answer to the SEC's concerns about auditor independence. One of those concerns was the evolution of the large CPA firms from primarily auditing firms to multifaceted personal service organizations, where auditing might become less and less important. The expressed fear was that the auditing aspect of firms might not receive the necessary resources and attention to remain as the effective tool for financial statement reliability that the capital markets are dependent upon.
The CPA Journal: Why Lynn Turner as Chief Accountant of the SEC? You were a bit of a dark horse of a candidate, based upon the various names that appeared in the financial press.
Lynn E. Turner: The answer to that question would have to come from Chairman Levitt. I can only point to my background including prior experience at the SEC as an accounting fellow. Another quality I have to offer, which perhaps others did not, is experience as both an auditor and the chief financial officer of an SEC reporting company.
And I view this as a wonderful opportunity to give something back to the profession and to the commission. My earlier time here at the commission was extremely beneficial to me. I had the chance to meet and know outstanding professionals and businesspeople. I felt the time was right for me to make a contribution to a regulatory system that has made our capital markets the best in the world.
CPAJ: Have there been any surprises?
Turner: The biggest surprise is the increase in the number and complexity of issues the Office of the Chief Accountant is called upon to deal with. Two that immediately come to mind are the liaison with the Independence Standards Board and involvement with international accounting standards. It is my office that will help the Commissioners evaluate whether the core of international accounting standards will be acceptable for filings in the U.S. And the securities markets have never been hotter and more expansive. But our head count in my office is the same as back then. The job market for CPAs and others with securities markets experience is very tight, and it is difficult for us to attract the caliber of people we need to help with the workload. We offer no stock options, and we have to deal with a government pay scale. Managing the demands on our limited resources is a major challenge, and the time to do that effectively is my biggest surprise.
Prior to assuming the position I met with the CEOs of the major firms, their national offices, the FASB, the Public Oversight Board, and the SECPS. As a result there have been few surprises on the issues.
CPAJ: What about the general condition of what you are seeing, the quality of financial reporting, and the way the issues are being presented to your office?
Turner: The general size, and, until recently, the upside nature of the securities markets, have amplified some of the practices that come to my office, such as restructuring charges and other abuse areas noted in Chairman Levitt's September 28th speech on earnings management and other financial reporting abuses. I don't recall 10 years ago any enforcement cases on improper uses of reserves. Now we have many. In-process research and development write-offs following an acquisition were virtually nonexistent prior to the 1990s. Now they are common, and in some mergers involving even highly reputable companies, the write-offs appear to be so large that they don't meet the common sense test.
CPAJ: That is a new phenomenon, is it not?
Turner: The literature that gives guidance on this goes back to 1975 to a FASB interpretation. The first large write-off that the SEC questioned was in 1991. But now we are seeing many companies trying to get purchased goodwill behind them through this approach. In good times that's what companies want to do.
CPAJ: It is remarkable how you have appeared to hit the ground running, being able to immediately become involved with the issues and the concerns.
Turner: I attribute that to the time I spent meeting and talking to the various groups with which we interact. Before I arrived in Washington I wanted to make sure I had plenty of input. I felt that if I waited until I arrived on the scene, many would not be as open or inclined to talk about the issues. In the three months since then, I have continued to meet with groups, some of which are not as well known to me. I met with securities analysts, chief financial officers, other professional bodies such as the Auditing Standards Board, and AICPA president Barry Melancon. We thoroughly discussed the issues--as they saw them--and the potential solutions.
The analysts, for example, cited concerns with revenue recognition and a lack of disclosure on reserves and changes in assumptions used to determine them.
CPAJ: It is a wonder that the standard setters have not dealt to a larger extent with revenue recognition accounting.
Turner: Here we have a situation where the single largest number in the financial statements has the least amount of accounting and auditing guidance. It is about time that the issue is addressed.
I heard from those in the profession that they felt more guidance is also needed on establishing loss reserves and accounting for restructurings. We also dug into some of the enforcement cases and identified the need for auditing standards to provide more guidance.
We heard from analysts about some very good disclosure ideas. The CFOs also thought some of the analysts' recommendations for items they could do made sense.
I also went back to some of the audit failures of the past--ZZZ Best and the like--and to the work of some of the study groups the profession set up, such as the Treadway and Cohen commissions. Some of the problems have not been effectively dealt with. They still exist.
In any event, my meetings were designed to get us up to speed on the issues. The fact that the groups we regulate raised a number of the issues encouraged us to attempt to work with them and the self-regulatory system to deal with solutions. Chairman Levitt's speech clearly has that tone. What can the profession and other affected groups do? We are giving them the chance to respond.
CPAJ: The Independence Standards Board was established about a year ago as a self-regulatory response to concerns of the SEC. What is your appraisal of the board's efforts to date? We have heard that the SEC was not fully satisfied with the board's first attempt at rule making--the endorsement of a proposed requirement of the SECPS Executive Committee.
Turner: It takes time for the members of a new board such as the ISB to get sufficient background and knowledge on the issues so that they can make informed decisions. Its public members have learned a lot about the very nature of auditor independence, not an easy subject. I think there are some unrealistic expectations in some places that the board could do something within a year's time. What I like about the ISB is that it has decided to work on the conceptual framework and use a top-notch academic to work on the project. I think the board is now at the point where we will begin to see the benefits of a self-regulatory agency.
I also like the idea that Chairman Allen has asked the accounting firms for information to help the board understand what the firms are presently doing. I have told representatives of the Big Five that the public members need this kind of information so that they can make informed decisions on the issues. The information should include a description of the services they perform, the revenues from those services, and the systems that the firms use to protect the audit function and auditor independence. I would hope that the firms will share their experiences openly and completely.
We often hear that the knowledge gained by consultants can help the audit; we need to know to what extent this transfer is actually happening. I will be following the responses the firms give and seeing that the "right" questions are asked of the firms.
The independence issue comes down to a very simple equation. If you are the engagement partner at a large client with substantial fees from either audit or non-audit services and are asked by the client if you are going to withhold your opinion if an adjustment you think must be made is not, what are you going to say? Many thoughts about what would happen if the client were lost will enter the partner's mind. We need a system so that when the engagement partner is placed in that position, he or she knows the right decision can be made without any adverse impact to the partner, either economically or professionally, within the firm. The pressure should be to make the right decision professionally, not the business-driven one. I strongly believe that good professional decisions are sound business decisions. However, not all business decisions are necessarily good for us as a profession.
I would oppose changes to the process that will make it more difficult for the engagement partner to make the right decision.
CPAJ: Are there lessons to be learned from reviewing court cases dealing with alleged audit failure? It is possible in such cases to see where an audit partner may have succumbed to pressures.
Turner: A problem with studying the court cases is you only see situations where the company went bust. There are many audits out there where the auditor may not have done what was best for the investor and yet the company went on.
Court cases are typically fraud cases. It does not matter what rules we write, we are always going to have fraud. That's why we have laws, and that's why we have to take enforcement actions leading to criminal convictions. Yes, we need to look at the court cases. But I believe the public also needs to be aware of and consider the many restatements of financial statements that are not made public by the accounting firms and that may not lead to a legal action. Most audits are done properly--but there are a number that are not, and we need to look at the whole population. The ISB would be well served if it could look at all of these cases and better understand what pressures resulted in the decisions being made that later had to be reversed.
CPAJ: Can you spot potential problems here at the SEC?
Turner: One particular problem I see I call the "lone wolf" syndrome. Wolves that hunt in packs do well. The wolf that travels alone may get eaten alive! I get concerned when I deal with an engagement partner that has obviously not consulted with his technical people, the national office. The partner may be in the gray area and being pushed by the client. The partner has not consulted because of the risk of getting an answer the client may not like. The national consulting partners of most firms are not tied to an office's profitability; that's why the firms have those resources.
If I encounter a lone wolf, that partner and I are going to have a personal conversation about the lack of using the firm's technical resources. I have told the national offices of the firms of my intention to do so.
CPAJ: Can we wait for the conceptual framework to be finished before the board starts to deal substantively with issues?
Turner: There will be things the board must do in the interim to deal with immediate problems. A directive on communications with audit committees on independence will take some pressure off the system. It may be that some of the board's early decisions will have to be revisited after the conceptual framework is completed.
In the meantime, we will be referring independence questions to the ISB. I encourage auditors to use the ISB staff to resolve concerns about independence that they may have. We are working closely with the ISB staff.
CPAJ: At the first meeting of the board, the AICPA presented a white paper "Serving the Public Interest: A New Conceptual Framework for Auditor Independence." The SEC's response to that white paper was somewhat critical.
Turner: I was disappointed with that paper. I thought it came across as an attack on the SEC rather than as a reasoned approach directed toward investor protection. It addresses the issue in terms of what the auditing firms are presently doing. It neglects investor protection. The right decisions for the profession and for investors in the long run will be the right decisions for accounting firms as successful business enterprises. The business purposes alone can not drive the process. I have told everyone I met with that the white paper was a low mark for the profession on independence issues.
CPAJ: The white paper seems to suggest that lack of auditor independence rarely, if at all, is an issue in the court cases where audit failure is alleged.
Turner: I don't think we are in a position to say whether audit failures were or were not as a result of independence issues. The heart of the matter is were there pressures on the engagement partner that caused him or her not to make the tough call that needed to be made. The presence or absence of fees from consulting issues is not solely the issue.
CPAJ: A practice issue that the ISB staff is now researching has to do with employees and partners of an audit firm who worked on the audit becoming employees of the registrant. There are many cases where audits have been challenged and that was the situation. What do you think about that?
Turner: The answer somehow lies in the procedures audit firms can and should employ where former partners and employees are now in key financial positions at the client. It may mean bringing in new engagement and concurring partners who have not worked with the former partner or staff. We need to ensure that the audit team will exercise the right level of professional skepticism, and there are ways of doing that.
CPAJ: Is having the chief executive officers of firms and the AICPA on the ISB the right makeup to help get at the problems and the right solutions?
Turner: I was not there for the negotiations as to the makeup of the board, and others have raised that same question. But in my mind, who can better speak out for the profession and make what may be tough decisions than the CEOs? They won't be able to duck issues by saying they have to consult with others back at the firms. I think they will do fine. The choice to put AICPA President Barry Melancon on the board I think came from the profession's side. The process will be subject to review by us within the next few years as it proceeds through its agenda. The mix of public and profession representation is relatively new to the self-regulatory process. We need to give it a chance, and there will be pressure on all of the players to try and make it work.
CPAJ: While not identified as independence related, Chairman Levitt's recent speech about earnings smoothing and questionable practices that are used to achieve it does come back to auditor backbone. But his speech did not address the problem of quarterly information, information which the auditor, even if he or she performed a timely review, would not have done enough to uncover some of the practices of which the chairman was critical.
Turner: When I was first here at the commission, the SEC became aware of a situation where an auditor knew of errors in quarterly information but, because the financial statements were unaudited, we did not do anything about it. This ultimately led to a provision in auditing standards that says the auditor can not stand by and permit this to happen. All of the large firms have informed us that they will be requiring that reviews of quarterly information must be made on a timely basis for all their public clients.
CPAJ: The report to the audit committee on the problems at Cendant indicated that there were topside adjustments made to the quarterly information of the kind the chairman criticized that were not effectively dealt with by the auditors, and their review was timely.
Turner: I can't comment on specific registrant problems. But I just saw an 8K filing announcing the resignation of an auditor because the firm could not resolve some quarterly reporting issues. This means that the current process can work.
CPAJ: But are the firms doing enough work to get at the problems during the timely reviews of quarterly information?
Turner: The investment analysts would not like to see any delays in the issuance of the quarterly information and would fight any increase in auditor involvement that might lead to delays. In light of that, I think we have a reasonable balance between timeliness and the level of auditor involvement.
CPAJ: Chairman Levitt announced the appointment of a blue-ribbon panel to make recommendations to strengthen the makeup and procedures of audit committees. This is clearly a move to strengthen auditor independence. The Kirk panel formed by the POB a few years ago made recommendations to strengthen procedures in this area, but on a voluntary basis. Do you expect the blue-ribbon recommendations to have more teeth in them?
Turner: My sense is there is a change in attitude, and companies are interested in improving the effectiveness of audit committees. This blue-ribbon panel, with its representation from the securities markets, corporate America, and the accounting firms has the potential to develop a very workable and effective structure in which audit committees would operate. The 90-day time period given to the panel for its deliberations will be up soon, and we will see where the panel is headed. We don't know whether the recommendations will suggest a rule that would require written reports of audit committees setting forth the procedures they have followed in monitoring the independent audit. The SEC staff would probably support such a recommendation.
I have asked the Auditing Standards Board to see if it has a role in strengthening this process as well. What is done, however, should not take the chief financial officer out of the loop with the auditor. One of the problems with the Kirk panel recommendations was that it seemed to do an end run around the CFO, with the auditor reporting directly to the audit committee or the board of directors. That did not go over very well. The audit committee should be asking both the CFO and the auditor the tough questions.
CPAJ: Chairman Levitt's speech said that the Public Oversight Board of the SECPS would be examining the audit risk model to see if improvements were needed there. What is the thought here?
Turner: We have asked that the POB put together a study panel of representatives from various groups that are involved in the process--investors, auditors, former regulators--to look at the audit risk model. Technology, an understanding of complex business issues, involvement in the audit of the right people at the right time are the kind of things the study group needs to consider.
CPAJ: The GAO, whenever it looks at the audit profession and the financial reporting system, recommends mandatory reporting on internal control. In the Cendant report to the audit committee, the investigators noted that internal controls at Cendant were a problem. The chairman's corrective plan did not mention the place of internal controls.
Turner: The underlying issue is whether a mandatory requirement for an auditor's report on internal control would motivate companies to strengthen their controls beyond what is already required. In some of the fraud cases we have seen, I don't think the report would make any difference.
CPAJ: The challenge by Chairman Levitt to the way materiality is used in audit decisions will cause a lot of anguish and gnashing of teeth. He talked about the need to look at materiality relative to earnings projections and analysts' forecasts. What's the background?
Turner: This is a great place for the use of auditor judgment. The answer lies in not hiding behind materiality rules of thumb and instead dealing forthrightly with the issues. The Corporate Finance Division of the SEC was seeing non-GAAP entries being made to financials in order to meet target earnings. There is just no room for that, regardless of any quantitative evaluation.
CPAJ: Who among the various players is dealing with this issue?
Turner: We are considering writing a staff accounting bulletin. I think the profession is working on this as well. A white paper is under development by some interested professionals. Materiality was never intended to be a means of justifying fictitious adjustments.
CPAJ: The Business Week cover story of October 5, 1998, which came out the same day as the chairman's speech, talks about the very same issues. Were the two somehow tied together?
Turner: The author of the article simply did a very good job of investigating the issues and talking to the same people we were talking to. The article was quite well done.
CPAJ: The Business Week article stressed a new area to us in the equation. That would be the pressure on companies to meet the projections of financial analysts.
Turner: I was in a meeting with 40 CFOs who pleaded with us to address the issue with the analysts. One CFO recalled a discussion he had with an analyst in which the CFO told the analyst that meeting the projections would be very close. The analyst responded by saying the CFO should be smart enough to find a way to meet the projection. The CFOs are under tremendous pressure from the analysts, especially during the recent bull market. This is another piece to the puzzle.
Requiring more detailed disclosure of changes in reserves will help to highlight some of these kinds of shenanigans.
CPAJ: Thank you, Lynn, for meeting with us. We now know firsthand why you were chosen to be chief accountant.
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