MEMORANDUM PRIVATE TO: Jonathan G. Katz, Secretary Securities and Exchange Commission 450 Fifth Street N.W. Washington, D.C. 20549-6009 E-mail: rule-comments@sec.gov FROM: H. S. Hendrickson School of Accounting Florida International University Miami, FL 33199 SUBJECT: File No. S7-16-98 DATE: August 14, 1998 I commend the Commission and its staff for proposing an amendment to Rule 102(e) to address the Court's concerns in the articulation of the Rule's "improper professional conduct" elements. After a year (1980-81) as an Academic Fellow in the Office of Chief Accountant, and many years of studying financial accounting, reporting, and auditing, I have become increasingly concerned with what appears to be a continuing decline in the auditor's ability and/or willingness to say "No" to ridiculous interpretations and applications of GAAP. The extent of the decline has reached the point where I assert to my students that while the U.S. had no GAAP until the 1930's, it still has none because of the many ridiculous interpretations of reporting standards and principles that are implemented in the financial statements of public companies. The accounting/auditing profession and its organization, the AICPA, seem to be more concerned with business consulting and profit-making than with professional/ethical conduct and responsibilities to the public. Just having "Public" as a middle name does not give the Certified Public Accountant the right to assume or claim that anything s/he does is in the public interest. Further, my interpretation of the headline in the current issue (July/August 1998) of the AICPA'S The CPA Letter is that members may be undergoing conditioning to a new meaning of CPA: Consulting, Planning, & Assurance services. In bringing forth this proposal, establishing the Independence Standards Board, and taking many other initiatives, the SEC seems to be attempting to fill the vacuum created by the failure of the accounting/auditing profession to regulate itself. I laud these attempts of the Commission. We need to recognize that no small part of that vacuum relates to the central and most serious flaw in the structure of accounting regulation. That structure requires the CPA to be independent in fact and appearance vis-a-vis the client, the registrant (who hires, pays, and can fire the CPA). This structure was adopted in 1933 at the urging of Colonel Carter and the accounting profession. It was flawed then, and the flaws have become increasingly obvious and troublesome as a result of substantial changes that have occurred in the environment. I have questioned this on many occasions, most recently in a manuscript that has been accepted and is scheduled for publication in the October issue of Critical Perspectives on Accounting. The essence of my conclusion is as follows: How long can the accounting/auditing profession claim to be dedicated to providing credible, relevant, and reliable financial information, and also continue to adhere to the fantasy that auditors are independent of their clients, both in fact and appearance, when in fact they are neither? Won't society soon learn of the fantasy and clamor for action? Should we not face up to the reality of the situation: auditors are not independent of their clients and, thus, are not what they purport to be? In doing so, we must recognize that the solutions may be radical, but that re-establishing truthfulness and credibility is a worthy goal. Continuing to adhere to the fantasy surely will lead to self-destruction not only of accounting self-regulation--which already may have happened--but also of the accounting/auditing profession ("Relevant Financial Reporting Questions Not Asked by the Accounting Profession," p. 16). Other authors (e.g., Bazerman, Morgan, and Loewenstein, "The Impossibility of Auditor Independence," Sloan Management Review, Summer 1997) report on psychological research and state that "auditors may find it psychologically impossible to remain impartial and objective" (p. 89). Since my background does not give me competence to respond to many of the questions in the proposal, I will focus on my main concern which is that the definitions as given in the proposal still may need further clarification. They do not seem to be "overly aggressive" as suggested in Commissioner Johnson's separate statement. What separates competent from incompetent? A CPA may be competent technically and have an unintentional or unconscious bias. Or, s/he may be competent technically but under substantial pressure from the client to accept a desired GAAP interpretation and from his superiors to retain the client that s/he is not able to act in the public interest. Whether the bias is unintentional or due largely to the conflict between the CPA's private and public interests may impair her/his perceived impartiality and objectivity and keep her/him from applying objective professional judgment. In both cases her/his ensuing actions then may be considered to be incompetent and/or unethical. But, the two cases are not the same. The thresholds for incompetence need to be high enough so that actions are not initiated for unintentional or unconscious biases. How can an accountant's motives/intentions be determined? Can motive/intent be confused with competence? The use of intent as a consideration in accounting standards (e.g., in SFAS 115 [para. 7] in the classification of held-to-maturity securities) has been roundly criticized because of the impossibility verifying intent. What is the level or degree at which misconduct becomes reckless? At what level does a violation become unreasonable? Blatant? My concerns may be unfounded, because the Commission's purpose may be to get more precise terminology into the rules and then to add parameters and enhance specificity by inference from specific cases and comments in its deliberations and those of the courts. In summary, I commend the Commission for pursuing enforcement actions for improper professional conduct and for attempting to clarify the definitions of Rule 102(e) so that its actions will succeed in the future. I think that on the whole your proposal is a good. But we must also recognize that in a real sense these are stop-gap measures because the present accounting regulatory structure is so badly flawed that I claim it is "broke." As stated above, it is based the fallacy that the auditor is and can be independent.