Appendix E interlocks" (at 372). He says nothing about the fact that several of the large petroleum companies are audited by the same firm. 10 It is certainly not self-evident that, if one firm is the independent auditor for several large petroleum companies, there will be an impact upon competition in the petroleum industry. The Staff Study fails to identify the basis for its novel insinuation. There is no indication that the Staff studied the relationship between the petroleum industry's accounting practices and its competitive performance, and not a single incident is reported to support the suggestion that anticompetitive practices may be occurring, or how they might occur. The suspicion which the Staff Study evinces towards the independent accountant who audits several competing industrial corporations apparently stems from a basic misconception of the audit function. Every large corporation has its own accounting system, manned by corporate employees many of whom are professional accountants and CPAs. It is this accounting staff-not the independent auditor—that collects and analyzes operating data for the use of management in controlling costs, setting prices and making investment decisions. The independent auditing firm deals with the financial statements that are filed with government agencies and issued to investors and creditors. It determines whether these published reports comply with government rules and whether they are prepared in accordance with appropriate accounting principles; it also utilizes sampling and inspection procedures to verify reported assets and financial transactions. These operations are not related to the process of competition in the 10 John M. Blair, in The Control of Oil (Pantheon Books, New York, 1976), criticizes the financial statements of the petroleum companies and their accounting techniques (Preface, at viii), but does not charge that any lack of competition results from the alleged deficiencies. The Seven Sisters by Anthony Sampson (Bantam Ed., 1976), similarly criticizes the accounting techniques of the oil companies (at 243-44), but complains mostly about the diversity of accounting practices and the difficulty this creates for those who would compare the companies' financial positions—hardly a basis for concluding that the companies utilize accounting firms to lessen competition between them. Professor Blair also refers (at 45) to a 1955 memorandum from a Justice Department staff member complaining about the fact that the State Department had chosen Price Waterhouse to "pass upon the eligibility" of U.S. independents desirous of joining in a set-aside from the Iranian "consortium," because Price Waterhouse often served as the petroleum companies' auditor to verify the accounting of joint ventures and as arbitrator of disputes arising from them. This criticism of 22 years ago never resulted in any antitrust charges by the Department of Justice itself, and the selection of Price Waterhouse for the indicated responsibility is clearly a reflection of faith in the firm's integrity-hardly a basis for claiming it was a participant in any violation of law. Appendix E market place, nor to the decisions of management with respect to competitive activities. Even changes in these financial statements as a result of the criticism of an independent auditor would have no bearing upon the practices used in the client's internal cost accounting system or procedures. There have been trade association cases where accounting firms have participated in cost accounting and price reporting programs that were held to soften competition," but such activities are a far cry from auditing financial statements that are to be made public. Merely listing competitors for whom an accounting firm provides the audit function is no support for suggestions that it was employed to perform tasks that might contribute to a lessening of competition. Our own review of the accounting engagements performed by Price Waterhouse reveals nothing that would indicate it engaged in common activities for petroleum companies that could have anticompetitive effects: no cost analyses or comparisons; no appraisals of whether to expand or contract production, or product or geographic markets; no appraisals of exploration, drilling, refining, transporting or marketing prospects or decisions. The Staff Study cites no detail or incident to be answered or explained. It is fundamentally unfair to seek to place upon Price Waterhouse the burden of proving a negative-that it has not been a vehicle for conspiracies to restrain trade. Certainly, condemnation of the independent accounting profession on this score cannot be based upon a "record" so devoid of fact as that set forth in the Staff Study. 11 American Column & Lumber Co. v. United States, 257 U.S. 377 (1921); United States v. American Linseed Oil Company, 262 U.S. 371 (1923); compare Maple Flooring Manufacturers Assn. v. United States, 268 U.S. 563 (1925). Appendir F POLICY FORUM Accounting Standards And Business Ethics A Personal Perspective In spite of all the talk about deregulation, there is a continuing stream of proposals to increase government control over the private sector. This year's regulatory fashion has a new twist. It has been seriously proposed that the government take over the development of accounting standards. Government would be put in charge of reshaping the very language of business. The prospect concerns me deeply. This proposed government takeover of the accounting standards-setting function is presented as a cure for improper payments. Its proponents contend that such payments were made because accounting standards were somehow inadequate. This is fanciful. Improper payments were unmistakable violations of existing ethical and legal standards-not accounting standards. Who shall set accounting standards and how to restore public trust in American business are two separate issues; each must be examined on its own terms. Improper payments are a serious problem that demands a prompt all-out response by business and accountants. But it should not be confused with the establishment of accounting standards. Let's take a closer look at each issue. Lest my comments appear merely self-serving, should first point out that independent auditors will be affected last and least if government takes over the development of accounting standards. Firms like mine can audit to whatever standards prevail and regardless of who developed them. Certain myths associated with the proposed government takeover of accounting standards have seriously clouded an issue that we must all see most clearly. MYTH: Accounting standards developed by the government will be better than privately developed standards. The staff report of a Congressional subcommittee released in January said flatly that government agencies can develop standards more efficiently than private organizations. This proposition is at best, not proven. In fact, if there is any single lesson in the last four decades of everexpanding federal regulatory activity, it is that the government, with the best of intentions, cannot perform ably any task it puts its mind to. Ours is an era of a gathering recognition of the severe limitations of centralized decision-making Government standards-setting has several manifest disadvantages. Firstly, government takeover could expose standards to political pressures irrelevant to their technical function. Privately developed accounting standards must respond only to the practical requirements of those who use financial statements in economic decision-making. Secondly, accounting standards serve a purpose that reaches far byond the SEC's disclosure requirements. Literally tens of thousands of business entities outside SEC jurisdiction use those standards. To hand this function to the SEC would arbitrarily enlarge that agency's reach and either unnecessarily duplicate private standard-setting or, by diverging from it, cause American businesses to speak different, incompatible economic languages depending on their size and method of organization. Finally, why should taxpayers shoulder the cost of a function which is now self-financing and working well? MYTH: The SEC is improperly delegating its authority by adopting privately-developed accounting standards. The Federal Securities Acts gave the SEC power to prescribe the form and content of financial statements filed with it and the standards to be followed in ther preparation. From the beginning, the SEC has looked to the accounting profession for the development of standards and confined itself to oversight, administration and enforcement. Accounting standards are now developed in the private sector by the Financial Accounting Standards Board (FASB). When, in December 1973. the SEC agreed to accept and, in effect, enforce FASB pronouncements, it simply affirmed and formalized a division of responsibility that has prevailed for more than 40 years The SEC has not surrendered responsibility It has prudently chosen to exercise a part of its responsibility through the private sector. It oversees the process and can, at its discretion, intervene if it finds the private response inadequate. This, it seems to me, is a sensible and far-sighted approach to regulation. It activates and accelerates onvate responsibility. It frees government resources for the enforcement function which it cannot so readily delegate MYTH: The Financial Accounting Standards Board has been slow and ineffective and not fully representative of the public interests. The FASB is three-and-a-half years old. It began with a staggering initial assignment to establish a conceptual framework for accounting and to establish pn. orities. Meanwhile, it had to act on some issues that just couldn't wait. Already the FASB has established its priorities It has resolved many of the most pressing issues and it is mov ing ahead on the very complex task of developing a conceptual framework for accounting Has the FASB really moved so slowly? It has promul gated 14 Standards and 17 Interpretations and made solid headway in a dozen other areas in less than four years. Some people say it has moved too quickly The FASB has made a solid beginning and will do even better. As President of the Financial Accounting Appendir F Foundation, the body responsible for financing and overseeing the FASB. Ive urged a searching review of the Board's operations to find ways we can improve it I believe the private sector is doing a creditable job in developing accounting standards Its record does not suggest that standard-setting responsibility should be federalized. But business must bring the evidence forcefully to the attention of policy-makers At the same time we must move to rebuild public trust in business As one inevitable result of too many disclosures of improper corporate behavior-reinforced by uneasy conditions- public confidence in American business has plunged to its lowest level since the Great Depression We have no choice but to rebuild public confidence in the legitimacy of enterprise and the integrity of the business people who make it go We have to acknowledge that the public will not be much moved by what we say but almost entirely by what we do and how persuasively we explain the meaning and effectiveness of what we do Let me be much more specific There are some things bus nesses must do. there are some things auditors must do i believe an effective program must involve. at a minimum these six elements • Corporations should promptly adopt realistic codes of business ethics. Uncertainty is the enemy of ethics. I think many corporate employees perhaps against the grain of their inclinat ons. have behaved improperly in the misguided be ief that the front office wanted them to Every corporations business is conducted by some standard if it is not formulated systematically at the top. it will be formulated haphazardly and impulsively in the field • Corporations should strengthen internal and administrative control systems. The independent auditor s external review is an .n. dispensable supplement to a corporate system of internal controls but it is no substitute for Auditors can evaluate their clients internal contro s but management must take the major responsibility for implementing and improving them • Corporations should enlarge the internal audit function and give it a higher place in the management hierarchy. We ve tended to think of the internal auditor as some sort of interna' po ceman called in when some sign of trouble was spotted Now our conception of the internal auditors role is enlarging His turction should extend beyond the detection of deviations from established controls He should determine how well these controls work and design improvements And his work should have the attention of the highest level of management including the audit committee of the board of directors. • Corporations should set up audit committees with a majority of outside directors, including the chairman. The audit comm tee should nominate the independent au dors 1+ ther 'unction with them and moni tor and evaluate their work It should study and evaluate the independent auditor s conclusions about the effectiveness of internal control systems The audit committee should review annual and interim financial statements before they are submitted to the full board These measures should help deflate the ascendant notion that auditors are inclined to go easy on managers because they are hired by management • Independent auditors should include in the scope of their work a report on management's internal accounting and policy controls. Currently, an independent auditor studies and evaluates a company s system of internal accounting controls to decide how much he can rely on their effectiveness in defining the scope of his own audit But he is not now required to report to anyone on the results of his study and evaluation I believe that a written report of any material weakness in the system of internal accounting controls should be submitted to senior corporate management and the audit committee or the board of directors The public interest may also require that the report go to the company's stockholders, after management has considered whether or to what extent it can take corrective action • Independent auditors should carefully increase their sensitivity to improper or illegal transactions. The independent auditor must plan his examinations with a heightened awareness that material improprieties may exist and also ensure that an appropriate disclosure is made when he detects material improper acts The times may require a lowering of the threshold of materiality in certain types of transactions We have traditionally defined as material any weakness that could cause losses that are significant in relation to the Corporation s total assets In my judgment that s no longer good enough Recent disclosures reveal that the concept of materiality is much more complex and subjective Clearly, our best defense against over-regulation is to act responsibly decisively and convincingly No one in business can pretend to be uninvolved any more We've all tended to think wishfully that somebody else should take the responsibility for corrective action The buck has stopped all right-but it has stopped with al of us We are a nvolved We must all take a fair share of the respons bity for corrective action c. Trigle JOHN C BIEGLER SEN OR PARTNER Paterhouse 3.5 "aterhouse 2), *** ་ ་ KNA 449 Appendix G MEMORANDUM To: John C. Biegler, Price Waterhouse & Co. From: Arnold & Porter Re: Analysis of the Staff Study's Proposal for Legislative Reversal of the Hochfelder Decision The Staff Study suggests that the Supreme Court's recent decision in Ernst & Ernst v. Hochfelder, 425 U.S. 185(1976), be overturned by legislation to "restore" the right of individual investors to sue independent auditors of public companies and others for negligence under a provision of the Securities Exchange Act of 1934 which prohibits fraud in connection with the purchase or sale of securities, namely Rule 10b-5 adopted under Section 10(b) of that Act. As we shall discuss below, a legislative reversal of Hochfelder would not, in fact, "restore" any such right. The courts, even before the Hochfelder decision, never generally recognized a private cause of action for negligence under those provisions. The proposal of the Staff Study in this regard would impose a new, open-ended ' liability for negligence on accountants and others to broad classes of persons trading in the Nation's securities markets. It should be noted at the outset that the Hochfelder decision deals with the limited question whether an independent accountant or others may be subject to claims for damages based solely on negligence under the provisions of Rule 10b-5 in suits brought by persons who purchased or sold securities. Hochfelder does not limit the generally accepted right under common law of a client company, and through it the investors in the company, to recover from its accountants any damages caused the company by the accountants' negligence. Nor does Hochfelder affect the liability of accountants to investors expressly provided for in the federal securities laws. In the case of a public offering of securities registered under the Securities Act of 1933, that Act makes accountants liable to the purchasers of the securities for negligence in auditing or reporting on the company's financial statements used in connection with the offering. Furthermore, if a company's financial statements (which are required to be filed annually with the Securities and Exchange Commission under the Securities Exchange Act of 1934) are materially false or misleading, Section 18 of that Act, 15 U.S.C. § 78r, provides that persons trading in the company's securities may recover their damages from the accountant or other person who made the false or misleading statement unless he acted in good faith and with no knowledge that the statement was false or misleading. |