Reclaiming the Profession’s Heritage:

The remarks that follow were delivered by former SEC Chairman Arthur Levitt, Jr., at the Americas Partners Meeting of KPMG LLP in Orlando, Fla., Thursday, November 20, 2003. While at the SEC, Levitt was openly critical of accounting practices, and urged reform. His September 28, 1998, speech “The Numbers Game” criticized the earnings management practices of companies during the last bull market (the speech was adapted in the December 1998 CPA Journal). The concerns Levitt expressed in that speech have proved to be prescient, as corporate scandals have exposed the downside of the practices Levitt warned against. Since leaving the SEC in February 2001, Levitt has continued to be an outspoken critic of corporate America’s behavior and an advocate for the individual investor. His book, Take on the Street: What Wall Street and Corporate America Don’t Want You to Know (reviewed in the December 2002 CPA Journal), recollected his time at the SEC and advised small investors how to invest intelligently.

His speech to the KPMG partners, adapted below, reiterates many of Levitt’s long-standing positions—the need to expense stock options, for one. But he also highlights the vital role that auditors play in keeping the financial markets running smoothly. Levitt is critical of the role accountants have played in the recent spate of corporate scandals, while retaining the belief that the accounting profession occupies a unique position in society. He offers a number of things accountants can do to help restore trust in the markets, from putting investors first to improving accounting education. Throughout his remarks, one sees Levitt’s unshakable desire to restore ordinary investors’ confidence in corporate America, a vital mission in which he sees the accounting profession as an indispensable partner.

When I left the SEC almost three years ago, I expected to speak to a lot of different groups. But I must admit that I never thought I ever would be invited to speak to a Big Four firm. It says a lot about the leadership here at KPMG that you would include me in your program today. There are a lot in the profession who wouldn’t. I am so heartened by the invitation because it represents—to me—the start of a meaningful dialogue among those inside and outside the accounting world about how to restore the noble profession and precious franchise of the public accountant.

The last time I spoke to an accounting group was three years ago in Las Vegas at the AICPA’s Governing Council. Then, I told the thousands of accountants gathered there that my intention was to work with the profession to “craft rules that, five years from now, we will be able to look back on and honestly say: ‘Our efforts, our patience, and our vision resulted in a consensus solution that will both nourish public confidence and lay a foundation for public trust in years and decades to come.’”

Unfortunately, we did not move quickly or resolutely enough. The bankruptcy of Enron and the implosion of Arthur Andersen opened the public’s eyes to a widespread erosion of ethical values and a dereliction of duty by accountants on both sides of the table—a lack of moral and ethical judgment on the part of management, compounded by the failure of the auditors to blow the whistle. As a result, investor confidence was undermined. Deep skepticism and fear have replaced trust.

The challenge before you, the auditing profession, policymakers, and all those who seek fair markets and a robust economy, is the same as it was three years ago. What has changed is the urgency of the task. We cannot delay nourishing public confidence and rebuilding public trust in the accounting profession and in our private sector.

Of course, this is not just a lack of trust in the accounting profession. It’s a systemic lack of confidence in the market as a whole. The year I became Chairman of the SEC, 1993, the Dow Jones Industrial Average hit 3,700. The year I left the SEC, 2001, it had hit 10,600. That incredible bull market built up a huge amount of wealth, but it also tore down a lot of ethical standards. The symptoms first arose in the executive suites. Enron, WorldCom, and the rest brought to the public’s attention the sad truth: CEOs were managing the numbers, not necessarily managing their companies.

Were auditors complicit? Yes, too many of them were. But accounting standards—especially as they relate to expensing of stock options—were a catalyst. Corporate boards were catatonic.

This erosion of independence and professional responsibility infected investment banking and stock research as well. Analysts shilled stocks to win lucrative investment banking business. The Chinese walls that were supposed to block conflicts of interest were breached. And more individual investors realized that they had been taken along for a ride.

This past year—after the Sarbanes-Oxley Act, the most expansive and transformative reforms to be legislated in the past 60 years, went into effect—many hoped that corporate malfeasance was behind us. Then, New York State Attorney General Eliot Spitzer’s and the SEC’s investigations revealed that the rights to market-time trades in mutual funds were effectively sold to the highest bidder and that big hedge funds were able to late-trade, while the rest of us thought we were all playing by the same rules.

As this is going on, one of the places where all these players interact, the New York Stock Exchange, has been weakened by ineffective oversight. Questions fundamental to its very being have been raised: How should the “big board” be governed, and by whom? How should it be regulated? How should it function?

While the revelations of the past year have spurred new regulations and rules, they also have planted the seeds of mistrust; seeds that will take root if we do not act. All the players in our market system—analysts, executives, brokers, mutual fund directors and managers, institutional investors, board of directors, and regulators—have an obligation to win back the people’s trust. But all of these efforts will be for naught if the public does not trust auditors.

The accounting profession is a profession like no other, and, in my mind, one of the most noble in our marketplace. You are private-sector actors with a public role to play.

With that precious franchise come some unique pressures and challenges. In most businesses, the watchword is “The customer is always right.” Accountants, however, are charged with telling the customer when he’s wrong. What other profession has that responsibility? What other profession is enshrined in our nation’s securities laws to serve no interest but the public’s? What other profession so directly holds the keys to public confidence–-the lifeblood of our markets?

At one point, the accounting profession was keenly aware of the importance of its stewardship of this trust. Integrity, honesty, and decency were a firm’s lodestars. How successful they were in keeping these high standards lay at the foundation of its reputation, which, in turn, lay at the heart of whatever marketing strategy the firm had. The thinking was that a client wanted a firm that was tough on accounting standards, unafraid of its customers, and unrelenting in upholding its reputation.
Arthur Wyatt, a former member of FASB and a long-time partner of Arthur Andersen, recounted how in the 1970s, his firm resigned from a large railroad engagement because the firm disagreed with a particular accounting principle being used. Later, Arthur Andersen resigned all of its savings-and-loan clients, again because it disagreed with an accounting principle acceptable in the industry.

After both decisions, Arthur Andersen saw an uptick in audit revenues. Compare that to how Arthur Andersen behaved with Enron and WorldCom, and you see how far the profession has come. Or consider what Weiss Ratings found in a study it released last summer: Auditing firms gave a clean bill of health to 94% of the public companies subsequently cited for accounting irregularities in 2002. This is astounding.

While it would be unfair to impugn the integrity of every Arthur Andersen partner or every accounting firm, it is fair to say that over the past 15 years, the business of accounting changed, and with it, the corporate culture of these firms. In the process, firms grew–-as did their profits. But what was lost was a focus on the profession’s public responsibility, on the ethical demands of the job, and on the unique role auditors play in keeping our markets vibrant.

New rules should help. New regulations will curb many abuses. But I believe strongly that the way back for the accounting profession rests with the accounting profession itself. Only you can make the reforms that will change the public’s mind. Only you can restore your reputation and regain the public trust. Only you can take the steps necessary to work as a partner with regulators, investors, and reformers toward our common goals.

This will involve some tough decisions—I am certain of that. It will take making some choices that may hurt your business in the short run, but that will be vital to its health in the long term.

That is why I applaud KPMG for being the first of the Big Four to drop legal services as one of its consulting services. Your decision to stop offering this service will undoubtedly increase investors’ faith in the profession. I have no doubt that this is good for your business and the profession.

But it would be easy for me to tell you today that the future health of accounting and of our markets rests in your hands, scold you for past misdeeds, and then take a car back to the airport. Instead, I want to offer some advice about what items should be at the top of your reform agenda and what you can do to start rebuilding investor confidence.

First and foremost, auditors must put investors first. For too long, auditors have put management first. Even though management pays auditors’ fees, they are not your ultimate customers; investors are.

When there is a tough call as to whether to disclose certain information or not to, decisions must be made based on what serves the interests of the investing public who will rely on and use that report. After all, nothing is more important than restoring the public’s confidence in the integrity of the product, the honesty of the auditors, and the fairness of the system. One of the questions to be answered is whether audit committees have been strengthened enough to be a real proxy for shareholders.

Second, regulators need to work with accountants, and accountants need to work with regulators. This is the only way that we will be able to craft accounting standards that make sense. Right now, billions of dollars of lease financing fail to show up on balance sheets; pension accounting fails to reflect the swings in funding and costs on a timely basis as a result of “smoothing” techniques written into the rules; and the battle over whether or not to expense stock options continues, more than 30 years after this debate first started.

You’ve all heard the saying that good disclosure is not a cure for bad accounting. However, it’s become an “easy out” when we’re engaged in difficult debates over accounting standards. All too often the response of the profession has been to ignore the compromised standards and argue for increased disclosure from these faulty rules. This ignores the central fact that if rules are passed that lack reality, then the reality is that there can be no trust.

The profession—and each of the firms—needs to reaffirm its leadership in standards setting, even when “the right answer” runs counter to the short-term interests of client management. You need to ensure that there is robust debate, even open disagreements, as standards are discussed. That’s the only way to ensure that the product represents not just a finely negotiated compromise, but the best thinking in the field.

I know you can prompt this debate in the future, because I know you have in the past. One of the great accounting leaders produced by KPMG is Walter Schuetze, who taught me what little I know about accounting when he served as the chief accountant at the SEC. While I didn’t always agree with Walter—for example, I’m not ready to fair value everything on the balance sheet, or write off all goodwill—I always admired his integrity, independent thoughts, and willingness to challenge conventional wisdom. That’s the kind of leadership I challenge you to provide, as individuals and as a firm.

I further urge you to strongly support FASB in its efforts to improve transparency and the quality of the numbers. To do this, be forthright in your letters to FASB. Tell them what is good and bad about a standard based on what investors will think, not on what your clients will think. Play an active role in FASB’s Emerging Issues Task Force, and take a lead role in pushing to get more investor representation on the task force. This will go far in setting better standards and in regaining investor trust. Also, passionately defend FASB from attacks on its independence. FASB’s independence buttresses your independence.

Third, help lay down good rules of the road. Instead of getting mired in the false choice between “rules-based” and “principles-based” accounting, help us craft “objectives-based” accounting, rules which would ensure that the underlying economics are reflected in the balance sheet. This may require expensing stock options; showing leases as financings; and taking out the smoothing mechanisms in pension accounting that fail to reflect the swings in the market.

These are tough things to sell, perhaps even to yourselves, because they represent a change from the way things have been done in the past. But change is important when it produces better information. Consistency and comparability are hallmarks of our financial disclosure system, and both principles must be upheld.

Fourth, show investors that you are on their side by showing them what you know. We can’t write a rule for every possible business transaction, nor should we have to. Yet too many in the accounting profession and standards setters resort to the old defense of “Where does it say in the standard that I have to do that?”

FASB should consider—and the accounting profession should support—adopting a rule similar to one the SEC has on its books which says: “In addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.”

And even if this rule is not passed, auditors, in carrying out their obligations and duties to investors, should ensure that if there is material information that is not required by a rule—but they themselves would want to know if they were investing in the company—that that information is clearly and transparently disclosed.

This brings me to my fifth point: Consider what other key performance indicators [KPI] investors need to know. In each company and in each industry, there is a set of statistics that provide great predictive capability with respect to the future earning power and cash-flow-generating capability of a business. In some businesses, it’s the number of patents issued. In others, it’s how many units of a product have been sold and where they were purchased.

As someone who was once a regulator, and is now an investor, I can say from personal experience that accounting hasn’t kept up with the real KPIs. I encourage KPMG to join with other firms to send a written proposal to the SEC as to how greater disclosure of KPIs can be achieved. This will not only improve the quality of financial reporting, but also begin to show investors that auditors are looking out for them.

Sixth, declare, and assert, your independence. When assessing your own independence, your standard should be whether an investor would consider you to be independent or not.

In February of 2001, I sent out a letter to the chairs of the audit committees of 5,000 public companies urging them to play an active role in this issue. That letter set forth nine basic criteria that audit committees should consider in determining whether auditors should perform a nonaudit service. I urge auditors to look at those criteria and consider adopting them as your own guidelines.

I also urge auditors to continue to take proactive steps to prove your independence and to win back investor trust. I know that KPMG has received a fair amount of criticism regarding its work in promoting tax shelters. But I also know that you’ve discontinued a number of tax strategies and that you’ve walked away from a lot of revenue as a result. I commend you for those actions, and I hope that the accounting profession, when considering the type of tax shelter work it does in the future, will ask itself whether the economics driving firms to provide these tax shelters is worth the stain on your image and reputation. And what will refusing to do tax shelter work do to increase the firm’s standing in the eyes of critics, regulators, and, most of all, investors? I believe that the answer to that question will lead more companies to forgo more of this type of work.

Seventh, take corporate governance seriously, including at your own company. Public companies are beginning to make real strides in improving corporate governance. For instance, a recent survey of the Business Roundtable members found that 8 in 10 participants report that their boards of directors are at least 75% independent, and 9 in 10 report that at least two-thirds of their directors are independent. In the absence of a legal requirement, 55% of Roundtable companies have (or will have by the end of 2003) an independent chairman, independent lead director, or presiding outside director. This represents an increase of 122% from 2002.

The accounting profession has been a real supporter of improving corporate governance. For example, I was pleased to see that KPMG created an Audit Committee Institute to serve as a resource for audit committee members and senior management. That is an important step that will strengthen audit committees and, ultimately, public trust.

Yet the Big Four represent large multinational companies in which the investing public must place great trust. So instead of just advocating good corporate governance, I believe that the top accounting firms must practice it as well. The top accounting firms should take the lead in establishing independent governing boards. These should be boards that have a real voice in the governance and oversight of the accounting firm. And they should be boards empowered to ask tough questions and to demand real answers from management.

Finally, we need firms’ help in improving education and in recruiting a new generation of auditors and accountants. Now more than ever, we need professors who are current with what’s happening in the profession, and accounting programs that offer both theoretical and practical experience.

KPMG provides great help in bringing practical skills and applications into the academic setting, and in funding academic chairs at leading institutions. I ask you to use your influence to get men and women sitting in those chairs who can convey the importance of the career these students are embarking on, who can produce students who have a grasp of the full range of views on the key issues of the day and have a keen appreciation of the importance of ethical standards in performing their future job.

And there is something else that we must do to improve accounting education, something that goes to the heart of all these suggestions, and a challenge that some say is the biggest obstacle this profession faces: finding parents who want to raise their kids to be accountants.

In light of all that has happened to the reputation of the auditing profession, where are we going to get auditors from?

It’s a tough question and a daunting task, but I believe that if the profession makes a concerted, public effort, through words and deeds, to establish its independence, its commitment to investors, and its dedication to the public trust, then I believe that we will find that next generation of accountants and auditors. And it’s imperative that we do.

For too long, the profession has overemphasized nonaudit work and de-emphasized the audit. In the past, leaders in the profession spoke of the audit as a commodity. All too often, the accounting profession is seen as another Washington lobby, another interest looking out for itself, just another avenue for business advice. But, as you know, it’s more than that. The audit is your covenant with investors. By your signature, you tell them, “The numbers speak the truth.”

You make business work, from the storefront shops that give life to Main Streets and shopping malls across America to multinational corporations that employ thousands and power the global economy. You are leaders in your communities and in business. You are the keepers of the information upon whose integrity free markets rely.

And while regulators can write rules and FASB can set standards, only accountants can reclaim the great heritage of this profession and win back the public’s trust.

We need you to lead the way, and when you do, our markets will be robust, our economy will be strong, and America’s investors will have their faith and trust rewarded.

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