SECURITIES ANDEXCHANGE COMMISSION

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

THE ACCOUNTING PROFESSION AND THE SEC:A PARTNERSHIP UNDER ATTACK

Address byJohn R. EvansCommissioner

Securities and Exchange CommissionWashington, D.C.

Cincinnati ChapterOhio Society of Certified

Public AccountantsCincinnati, OhioApril 12, 1977

Four years ago, Sandy Burton, the SEC's most recentChief Accountant, described the relationship between the SECand the accounting profession by stating that:

For nearly forty years the Securitiesand Exchange Commission and theaccounting profession have constituteda highly effective partnership forprogress in improving the quality ofpublic information about the economicactivities of corporations who cameto the capital markets of the UnitedStates for financial resources.

The events of the intervening years, particularly some whichhave transpired during the past twelve months, have raisedserious questions regarding the effectiveness and stabilityof this partnership and the prospects for its continuation.

During the past year, one major accounting firminstituted legal action against the Commission because of theway the Commission had "injected itself into the area ofaccounting principles." Equally dramatic, two reports, oneissued by Congressman Mossl Subcommittee on Oversight andInvestigations, and the other by the staff of Senator Metcalf'sSubcommittee on Reports, Accounting and Management, have beencritical of the accounting profession, the various privateaccounting organizations and the Commission's policy withrespect to the standard setting processes for both accountingand auditing. Senator Metcalf's Subcommittee staff stated:

The Securities and Exchange Commission, as a matter of policy,disclaims responsibility for speeches by any of its Commissioners.The views expressed herein are those of the speaker and do notnecessarily reflect the views of the Commission.

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To an astounding degree, the SEC haspermitted, and even insisted upon,establishment of accounting standardswhich have substantial impact on theFederal Government and the public byself interested private accountingorganizations. The result has beenan extraordinary delegation of publicauthority and responsibility to narrowprivate interests.

* * *A review of the SEC's record onaccounting and reporting matters showsclearly that it has seriously failedto protect the public interest andfulfill its Congressional mandate.Published responses to this unusually strong

indictment of the relationship that has been maintainedbetween the SEC and the accounting profession have includedsuch epithets as "pure junk," "nonsense," and "incompetentlyresearched and grossly biased." While such responses mightaccurately describe one's opinion of the report, they arenot very helpful in re-examining the important, fundamentalquestion of whether the relationship between the SEC andthe accounting profession is appropriate and in the publicinterest. I believe the stature of professions andgovernment agencies, like that of individuals, can bemeasured by how they respond to criticism. If the relationshipof the SEC and the accounting profession cannot be strengthenedand tempered by the heat of criticism, then perhaps basicstructural changes are warranted.

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Before the Securities Act was enacted in 1933,there was an intense debate in the halls of Congress andelsewhere about the appropriate degree of governmentalintervention in the capital formation process. Someindividuals urged that the proposed legislation embody anapproach whereby an issuer of securities would be requiredto disclose relevant data to investors who would fend forthemselves in making their investment decisions. Othersadvocated an approach, similar to some llblue sky" laws, wherebya governmental agency would evaluate the fairness of anissuer's proposed offering. Indeed, the original billintroduced into Congress specifically provided for revocationof an issuer's securities registration upon an administrativefinding that "the enterprise or business of the issuer or thesecurity is not based upon sound principles, and that therevocation is in the interest of public welfare." Quiteobviously, the disclosure philosophy, with its genesis inthe English Companies Act, was adopted.

As a facet of the basic philosophical debate,consideration was given to the advisability and feasibilityof a statutory requirement that companies proposing to sellsecurities be audited by a corps of Federal auditors. Thatapproach was rejected, apparently in response to testimonyfrom the accounting profession that adequate protectionswould be provided to the investing public by requiring that

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financial statements be audited and reported on by independentaccountants.

As enacted, the Securities Act of 1933 necessitatesthe joint involvement of both the Commission and the accountingprofession by requiring the inclusion in prospectuses ofbalance sheets and profit and loss data "certified by anindependent public or certified accountant" and presented"in such detail and such form as the Commission shall prescribe."In addition, the Act authorizes the Commission to prescribe:

the items or details to be shown in thebalance sheet and earnings statement,and the methods to be followed in thepreparation of accounts, the appraisalor evaluation of assets and liabilities,in the determination of depreciation anddepletion, in the differentiation ofrecurring and nonrecurring income, inthe differentiation of investment andoperating income, and in the preparation,where the Commission deems it necessaryor desirable, of consolidated balancesheets or income accounts of any persondirectly or indirectly controlling orcontrolled by the issuer, or any personwith a direct or indirect common controlwith the issuer.

Similar authority was granted to the Commission in theSecurities Exchange Act of 1934.

In my opinion, the Congress did not mandate theSEC's adoption of accounting principles, nor did it directthe SEC to defer to accepted principles of the accountingprofession. Unlike the various Companies Acts, whichgenerally define required financial statements in considerable

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detail, the Securities Act granted the SEC extensivediscretionary authority to establish accounting requirementsand deal with evolving accounting issues.

Having been granted this broad discretionaryauthority, one of the threshold questions was the Commission'sproper role with respect to accounting standards. Seriousconsideration was given to the establishment of a uniformsystem of accounting standards by the Commission. On thebasis of staff studies, the Commission was advised that such

an approach was impracticable.The first Chief Accountant of the SEC, Carman

Blough, argued that the development of accounting principlesshould be left to the accounting profession. He recognized

that practicing accountants faced accounting and auditingproblems on a daily basis and thus should be responsible fortheir resolution. At the 50th Anniversary of the American

Institute of Accountants in 1937, he stated the following:As a matter of fact I think I haveemphasized at numerous times that thepolicy of the Securities and ExchangeCommission was to encourage theaccountants to develop uniformity ofprocedure themselves, in which casewe would follow. We expected to beable to follow the better thought inthe profession and only as a lastresort would the Commission feel thenecessity to step in.In April of 1938, the Commission publicly endorsed

the views of its Chief Accountant. By a vote of three to

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two, Acco~~ting Series Release No. 4 announced theCommission's policy that financial statements which wereprepared in accordance with accounting principles for whichthere was no substantial authoritative support would bepresumed to be misleading notwithstanding disclosure. Ifthere was a difference between the registrant and theCommission regarding the proper accounting, the Commissionwould accept disclosure in lieu of a change in the financialstatements only when there was substantial authoritativesupport for the proposed accounting principle and theCommission had not expressed a contrary view in an officialrelease.

This important decision was not made lightly, buton the basis of several year's experience. The evolution ofthe Commission's position was outlined in its Annual Reportfor 1939 which stated:

Until recently, the Commission's interestin accounting has been directed towardthe improvement of corporate reporting offinancial data and the standardization ofaccounting principles. At the time whenthe Securities Act of 1933 and theSecurities Exchange Act of 1934 becamelaw, accounting had developed to such apoint that it was believed feasible toprescribe forms that in large part askedonly for disclosure of some of the moresignificant principles upon which thefinancial statements were based and fordisclosure of a certain amount ofinformation believed to be of particular

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importance to investors. The form ofpresentation, the method of description,the inclusion of information beyond theminimum, and the fundamental responsibilityfor the quality of the statements wereproblems left on the shoulders of theissuer and its officers. In addition, itwas required that independent accountantsmake a review and express their opinionof the accounting principles followed andthe statements presented. However, at thesame time the Commission established apolicy of administrative review of financialstatements filed which led to discussionsof accounting problems with issuers andtheir accountants, to the preparation ofmemoranda of deficiencies observed, and insome cases to the issuance of stop order,delisting, or accounting opinions. Experiencegained in this way has demonstrated aconsiderable diversity of views on mattersof accounting principle. The Commissionfirst endeavored to overcome this situationby enlisting the cooperation of numerousorganizations interested in accounting, byconducting research, and by consultingwith registrants. In addition, on someaccounting matters the Commission has takena positive position in published opinionsor its rules governing financial statementsrequired to be filed. More recently, stepshave been taken to enforce the observanceof generally accepted accounting principlesby adopting a policy of presuming financialstatements to be misleading in cases inwhich such statements are prepared inaccordance with accounting principles forwhich there is no substantial authoritativesupport despite disclosure of the mattersinvolved in the accountant's certificate orin footnotes to the statements.The establishment and improvement of accounting

principles within the accounting profession has been theresponsibility of a single body within the profession since1939. From 1939 until 1953, the Commission on Accounting

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Procedure, appointed by the American Institute of CertifiedPublic Accountants, issued 51 accounting research bulletins.The focus in these documents was the identification ofaccepted practices, including alternatives. From 1959 until1973, the AICPA's Accounting Principles Board, whose membersserved on a part-time basis and without compensation, hadthe responsibility of establishing and approving accountingprinciples.

The increasingly complex business transactions ofthe late 1960's, particularly problems associated with theconglomerate movement, placed a severe strain on theaccounting profession and the principles board. In 1971,partially in response to mounting criticism, the AICPAauthorized a study of how accounting principles should beestablished. A committee chaired by former SEC CommissionerFrank Wheat recommended the establishment of a FinancialAccounting Standards Board. The committee's report was wellreceived and, at the urging of many, including the SEC, theFASB was established as the first full-time standard settingbody for accounting principles and began operation in Aprilof 1973.

With the establishment of the FASB, the Commissionbelieved that it should publicly reaffirm its historic policyof relying on the private sector to develop generally acceptedaccounting principles. In December of 1973, the Commission

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issued Accounting Series Release No. 150 in which it recognizedthe FASB as the private accounting sector's standard settingbody by stating that standards promulgated by the FASB wouldbe presumed to have substantial authoritative support, andthose which had been considered by the FASB and rejectedwould be presumed to have no such substantial authoritativesupport.

The Commission's administrative posture should notbe misunderstood. As one who participated in the approval ofAccounting Series Release No. 150, I can assure you that itwas not an abdication of Commission responsibilities or adelegation of its powers. We stated that: "the Commissionintends to continue its policy of looking to the privatesector for leadership in establishing and improving accountingprinciples and standards through the FASB with the expectationthat the body's conclusions will promote the interests ofinvestors." We also clearly stated that "the Corrnnissionhasthe responsibility to assure that investors are providedadequate information" and that the "Commission will continueto identify areas where investor information needs exist andwill determine the appropriate methods of disclosure to meet

these needs." Moreover, the Connnission noted that if it werenecessary to depart from statements specified in the releaseas those presumed to have substantial authoritative support

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in order to prevent misleading financial statements, theCommission might require the use of other principles.

It is this Commission policy--looking to the privatesector for leadership in the establishment of accountingprinciples--about which the Moss Report and the MetcalfReport are so critical. The Moss Committee Report statesthat "the results of the Commission's 1938 decision, by athree-to-two vote, to rely primarily on the private accountingprofession to establish accounting principles has beendisappointing at best." As I previously mentioned. theMetcalf Report is more blunt in concluding that the SEC has"failed" by deferring to the private sector. With respectto the FASB itself. the Moss Report concludes that it "hasaccomplished virtually nothing toward resolving fundamentalaccounting problems."

In my opinion, these criticisms are not supportedby the facts. Without debating the achievements of the paststandard setting bodies. and realizing that there have beenproblems since its formation in 1973, the FASB has issued13 discussion memoranda. conducted 14 public hearings, andadopted 14 new statements of accounting principles, a numberof which, such as leasing, business segments, translation offoreign currency, and research and development costs, deal withcontroversial and complex issues. In addition, eighteeninterpretations of accounting principles have been issued.

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Currently under consideration are such matters as theconceptual framework of financial statements, mergers andacquisitions, and accounting in the extractive industries, allof which are projects of enormous breadth.

In any event, the implicit assumption or explicitstatement in a report that the SEC has delegated its publicauthority or always deferred to the FASB or its predecessorsin the establishment of accounting principles cannot besupported. One need only examine the background of matterssuch as the SEC's' Regulation S-X amendments relating to thedisclosure of financial leases and their impact on income,or the FASB's Statement No.4 on Reporting Gains and Lossesfrom Extinguishment of Debt--issued only after the Commissionindicated that it was prepared to take action--to realizethat the Commission has not abdicated either its authority orresponsibility.

Another recent example of the SEC's action,reflecting a divergence of views between the SEC and the FASB,is in the area of replacement cost accounting. In late 1974,because of the distortive effect inflation was having uponfinancial statements prepared on the basis of historical cost,the Commission's staff was requested to recommend anappropriate method for the disclosure of inflation's impactupon such financial statements.

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About that same time, the FASB issued an exposuredraft calling for the supplemental disclosure of general pricelevel adjusted financial statements. Under the general pricelevel approach, historical cost financial statements would beprepared using an index which reflected the decline in thegeneral purchasing power of the dollar from period to period.This is certainly not an invalid concept, but it would failto portray the impact of inflation on an individual companybecause all companies would use the same index, and there ispersuasive evidence that inflation does not impact allcompanies equally.

The Commission was of the opinion that investorsshould have information which would indicate the impact ofchanging prices upon particular companies. Therefore, in1975 we issued a proposal for the disclosure of certainreplacement cost information. After considerable study andevaluation of the numerous comment letters, this proposal wasadopted. Without attempting to debate the merits of thereplacement cost regulation vis-a-vis the general price levelproposal, I would suggest that the SEC's adoption of thereplacement cost regulation does represent an important exampleof an SEC accounting initiative substantially different thanthat proposed by the private sector. We are just now seeingthe first wave of replacement cost disclosures and arecarefully monitoring the results. Incidentally, I was pleased

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that in his confirmation hearings last Wednesday, HaroldWilliams, the incoming Chairman of the SEC characterized theConnnission1s efforts in inflation accounting as a liveryimportant move. II

While the SEC and FASB have had disagreements, wehave generally worked together in close cooperation andcoordination in dealing with many complex accounting issues.This relationship has worked well in the past and I am hopefulit will continue to work in the future. In 1975, the Congressadopted the Energy Policy Conservation Act. Section 503 ofthat Act required that the SEC take such steps as may benecessary to assure the development of accounting practicesto be followed by all persons engaged in the production ofcrude oil or natural gas. Recognizing the Connnission'shistoric policy of allowing the private sector to take thelead in establishing accounting practices, Congressspecifically provided that the SEC could meet its responsibilitiesby relying on standards adopted by the FASB if the Commissionbelieves that such practices will be observed as if theywere adopted by the SEC as rules. The FASB has issued alengthy discussion memorandum, conducted public hearings,and expects to meet the December deadline. Unquestionablythe Congress has imposed a tight time schedule. However. Iam confident that the FASB will complete its work withinthe prescribed time frame and that the combined efforts

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of the SEC and the FASB will demonstrate the vitality of thepartnership between the accounting profession and theCommission.

Another accounting topic with which the SEC iscurrently concerned is betterment accounting. Historically,the SEC has had very limited jurisdiction over the reportingof financial results to shareholders by railroads and certainother regulated enterprises. In 1976, the Congress grantedthe Commission considerable responsibilities for the reportingof these enterprises. For many years railroads have recordedthe initial cost of track structures (usually ties, railsand ballast) as a nondepreciable asset and have subsequentlyexpensed replacements except to the extent they constitutea betterment, such as an increase in the size of the rails.Many believe that this method of accounting, which is quiteunlike the method of depreciation accounting used by mostcommercial enterprises for their fixed properties, can leadto significantly distorted financial reSUlts, particularlywhen a railroad allows the physical condition of its trackto deteriorate. I expect the Commission to issue a releasein the near future requesting comments from interested personson whether the Commission should continue to accept financialstatements prepared employing betterment accounting. Althoughthis is a relatively narrow accounting subject, it does impacta significant industry. Before concluding that we should

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undertake this study, we asked if the FASB would be preparedto complete such a project by the end of 1977. We wereadvised that the Board would not be able to meet this scheduleand that if the Commission believed the project should becompleted by the end of 1977, the Board understood the needfor the Commission to initiate its own rulemaking proceedings.To me, this response indicates the strength and flexibilityof the partnership between the SEC and the FASB.

Along with the criticism with respect to theformulation of accounting standards, the process for establishingauditing standards has also been under severe attack. I wouldbe less than candid if I did not tell you that I am concernedover the auditing profession's failure to be responsive topublic demands because of its fear of potential litigation. In1975, the Commission adopted a regulation requiring thatauditors perform a limited review, but not an audit, of thequarterly information that companies provide shareholders.Auditors have been somewhat reluctant to undertake suchreviews as a result of their anxiety over liabilities thatmight attach to their failure to detect errors in theunaudited quarterly information. The reports auditors arewilling to render on such reviews are guarded, technical and,in my opinion, fail to communicate the degree of effort theauditor has employed in conducting the reviews. In fact,Clarence Sampson, our Acting Chief Accountant, was told

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recently that companies are not publishing these reports onlimited reviews because they are negative and meaningless. Ifind that to be most unfortunate.

As another example, in 1975 we adopted a regulationwhich requires that in order for a company to change from onegenerally accepted accounting principle to another, the changemust be accompanied by a letter from the registrant's auditorsstating whether or not in the auditor's opinion the change isto a preferable accounting principle in the circumstances.If a change does not result in an improvement in financialreporting, it is not to a preferable method and, therefore,will not be allowed by the Commission. The Commission believesthat generally accepted accounting principles require consistencyunless a change results in improved financial reporting. Aboutthis there is no debate. The debate is over how to determinewhether the change results in improved financial reporting.

Some auditors claim that they are incapable ofarriving at an opinion as to whether changes in accountingprinciples are or are not preferable in the circumstances.Only management can make this decision. If a company'smanagement is required to justify a change in an accountingprinciple on the basis that the change will result inimproved financial reporting, its justification should besufficiently persuasive to bring the auditor to the sameconclusion. In other words, if a company can make this

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judgmen~, so can its auditors, and only when the auditorscan do so, from their independent vantage point, should thecompany be allowed to make a change. I might note that inits tentative conclusions, the Commission on Auditor'sResponsibilities, the so-called Cohen Commission, has gonebeyond the SEC's position which is limited to changes inaccounting principles. Its Report stated that, except incertain limited circumstances, an auditor should be requiredto satisfy himself in all instances that all principlesutilized are the most appropriate.

Auditing standards are presently set by the Auditing

Standards Executive Committee, the senior technical committeeof the AICPA. In the last few years, I have noticed adefensive trend in the publications of this body, a trendwhich seems to be designed to demonstrate to the courts thatauditors have only limited responsibility. In some instancesonly the threat of SEC action has resulted in the adoptionof adequate standards. These rather defensive documents maywell be playing into the hands of the auditing profession'scritics. It is not uncommon to hear the view expressed thatif the auditing profession continues to issue such negativedocuments then the SEC should not continue to rely upon theauditing profession to establish auditing standards.

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The Metcalf staff report raised a number of othervery important issues for the auditing profession, such asauditors performing management consulting services for theirclients, and whether auditors should be engaged in managementrecruiting or offer expert testimony on their client'sbehalf. Those who think auditors should not be performingsuch services believe that they can impair the auditor'sindependence from his client. Auditors argue that suchproblems are perceived and are not substantive. Nonetheless,even if the problems are only perceived, it is my view thatthey should be fully explored and deb.ated.

Because of the many unanswered questions regardingthe role and responsibilities of auditors, in October 1974the AICPA established the Commission on Auditor's Responsibilitiesto which I have already referred. In its recent Report ofTentative Conclusions, that Commission made forty recommendationswhich are intended, among other things, to:

--improve reporting on significant uncertaintiesin financial presentation;

--clarify an auditor's responsibility for thedetection of fraud by adopting a standard of"due professional care";

--establish a framework for auditor participationin the cvrporate accountability system withrespect to the detection and cessation of illegal

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or questionable acts regardless of theirmateriality;

--expand the audit function from being oriented toperiodic financial statements to include suchthings as a more comprehensive study andevaluation of the controls over the accountingsystem;

--reform the auditor's method of communicating withusers of financial information to clarify theauditor's role vis-a-vis management's role;

--improve the education, training and developmentof auditors;

--require internal re-examination and publicdisclosure of management advisory services byauditors for their clients to assure theauditors' complete independence;

--create a full-time auditing standards board; and--remove secrecy from professional disciplinary

proceedings.Although it would be premature for me to have any final viewson these broad ranging recommendations. it is clear that theReport is a professional and responsible work product.

I believe the auditing profession must bridge thegap between the performance of auditors and the expectations

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of the users of financial statements by being responsive tothe challenges of the Cohen Commission. I suspect that almosteveryone will agree with the general approach and philosophyof the Report as well as with such conclusions as improvingthe education, training and development of auditors. Themeasure of the auditing profession will be taken, however, bythe way it responds to the tentative conclusions relating tosuch topics as preferability and internal controls.

Members of the SEC, including myself, have not beencompletely satisfied with the performance of the accountingprofession and private standard setting bodies. There havealso been instances in which, I believe, the Commission hasnot responded as quickly as we should have. We know ourjudgments have not been perfect and that there have been andare problems that need to be resolved, but that doesn't meanthat the partnership between the accounting profession andthe SEC should be dissolved or that the government has theability and should dictate all accounting principles andauditing standards.

There were and are tmportant policy reasons forthe SEC to look to the private accounting profession for

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leadership in establishing and improving accounting principlesand auditing standards. I believe that the enviable reputationthe SEC has gained is in part a result of our regulatoryphilosophy of looking to those on the firing line in the

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private sector, whether they be broker-dealers, securitiesexchanges, accountants or other professionals, for se1f-discipline and appropriate professional ,standards. Wesupplement those efforts through rules, regulations andenforcement actions which are intended to encourage or induceprivate organizations to seek to fulfill the investorprotection and public interest purposes of the securitiesacts which we administer.

How the accounting profession responds to ourinitiatives, the recommendations of the Cohen Commission, andresponsible criticism and recommendations from other sourceswill determine whether the partnership is strengthened ordestroyed. While no system can provide a guarantee againstfraud and misrepresentation, investors and the public musthave confidence that all reasonable steps are being taken toassure that financial information on public corporations isfair, accurate, and meaningful. We can continue to rely onthe private sector only as long as it fulfills its part ofthat responsibility. I urge you to rededicate your effortsto meet this challenge because if you do not, both the publicand the accounting profession will be the losers.