Research in Accounting Regulation, Vol. 16 (Research in Accounting Regulation) (Research in Accounting Regulation)

RESEARCH IN ACCOUNTING REGULATION RESEARCH IN ACCOUNTING REGULATION Series Editor: Gary J. Previts Recent volumes: Vo...

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RESEARCH IN ACCOUNTING REGULATION

RESEARCH IN ACCOUNTING REGULATION Series Editor: Gary J. Previts Recent volumes: Volumes 1–15: Research in Accounting Regulation Supplement 1: 10th Anniversary Special

RESEARCH IN ACCOUNTING REGULATION VOLUME 16

RESEARCH IN ACCOUNTING REGULATION EDITED BY GARY J. PREVITS Case Western Reserve University, Cleveland, USA

ASSOCIATE EDITOR THOMAS R. ROBINSON University of Miami, Coral Gables, USA

ASSISTANT EDITOR NANDINI CHANDAR Rutgers Business School, Newark and New Brunswick

BOOK REVIEW EDITOR LARRY M. PARKER Case Western Reserve University, Cleveland, USA

2003

JAI An imprint of Elsevier Science Amsterdam – Boston – London – New York – Oxford – Paris San Diego – San Francisco – Singapore – Sydney – Tokyo

ELSEVIER SCIENCE Ltd The Boulevard, Langford Lane Kidlington, Oxford OX5 1GB, UK © 2003 Elsevier Science Ltd. All rights reserved. This work is protected under copyright by Elsevier Science, and the following terms and conditions apply to its use: Photocopying Single photocopies of single chapters may be made for personal use as allowed by national copyright laws. Permission of the Publisher and payment of a fee is required for all other photocopying, including multiple or systematic copying, copying for advertising or promotional purposes, resale, and all forms of document delivery. Special rates are available for educational institutions that wish to make photocopies for non-profit educational classroom use. Permissions may be sought directly from Elsevier Science Global Rights Department, PO Box 800, Oxford OX5 1DX, UK; phone: (+44) 1865 843830, fax: (+44) 1865 853333, e-mail: [email protected]. You may also contact Global Rights directly through Elsevier’s home page (http://www.elsevier.com), by selecting ‘Obtaining Permissions’. In the USA, users may clear permissions and make payments through the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; phone: (+1) (978) 7508400, fax: (+1) (978) 7504744, and in the UK through the Copyright Licensing Agency Rapid Clearance Service (CLARCS), 90 Tottenham Court Road, London W1P 0LP, UK; phone: (+44) 207 631 5555; fax: (+44) 207 631 5500. Other countries may have a local reprographic rights agency for payments. Derivative Works Tables of contents may be reproduced for internal circulation, but permission of Elsevier Science is required for external resale or distribution of such material. Permission of the Publisher is required for all other derivative works, including compilations and translations. Electronic Storage or Usage Permission of the Publisher is required to store or use electronically any material contained in this work, including any chapter or part of a chapter. Except as outlined above, no part of this work may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the Publisher. Address permissions requests to: Elsevier Science Global Rights Department, at the mail, fax and e-mail addresses noted above. Notice No responsibility is assumed by the Publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made. First edition 2003 Library of Congress Cataloging in Publication Data A catalogue record from the British Library has been applied for. ISBN: 0-7623-1022-7 ISSN: 1052-0457 (Series) ∞ The paper used in this publication meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper). Printed in The Netherlands.

CONTENTS EDITORIAL BOARD

ix

LIST OF CONTRIBUTORS

xi

INVITED REFEREES

xv PART I: MAIN PAPERS

THE MARKET PERCEPTION OF CORPORATE CLAIMS Qiang Cheng, Peter Frischmann and Terry Warfield

3

AN ANALYSIS OF THE ACCOUNTING PROFESSION’S OLIGARCHY: THE AUDITING STANDARDS BOARD John E. McEnroe and Marshall K. Pitman

29

THE ORIGINS OF THE SEC’S POSITION ON AUDITOR INDEPENDENCE AND MANAGEMENT RESPONSIBILITY FOR FINANCIAL REPORTS Nathan Felker

45

AUDITOR LIABILITY: A REVIEW OF RECENT CASES INVOLVING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND GENERALLY ACCEPTED AUDITING STANDARDS Scot P. Gormley, Thomas M. Porcano and Wayne Staton

61

PROFESSIONAL REGULATION AND LABOR MARKET OUTCOMES FOR ACCOUNTANTS: EVIDENCE FROM THE CURRENT POPULATION SURVEY, 1984–2000 James Schaefer and Michael Zimmer

87

v

vi

THE ECONOMIC THEORY OF REGULATION AND SUNSET REVIEWS OF PUBLIC ACCOUNTANCY LAWS: THE ROLE OF POLITICAL IDEOLOGY Gary Colbert and Dennis Murray

105

THE IMPACT OF STATEMENT OF FINANCIAL ACCOUNTING STANDARD NUMBER 123 ON EQUITY PRICES OF COMPUTER SOFTWARE COMPANIES Mark Myring, Rebecca Toppe Shortridge and Robert Bloom

121

GAAP: A REGULATORY TOOL TO MANAGE HEALTHCARE Mark Holtzman and Olga Averin

145

PART II: RESEARCH REPORTS IMPROVING AUDITOR INDEPENDENCE – THE PRINCIPLES VS. STANDARDS DEBATE: SOME EVIDENCE ABOUT THE EFFECTS OF TYPE AND PROVIDER OF NON-AUDIT SERVICES ON PROFESSIONAL INVESTOR’S JUDGMENTS Elaine G. Mauldin

159

THE ASSOCIATION BETWEEN AUDITOR INDUSTRY SPECIALIZATION AND EARNINGS MANAGEMENT Uma Velury

171

CONCURRING PARTNER REVIEW: DOES INVOLVEMENT IN AUDIT PLANNING AFFECT OBJECTIVITY? Arnold Schneider, Bryan K. Church and Robert J. Ramsay

185

LOCAL GOVERNMENT AUDIT PROCUREMENT REQUIREMENTS, AUDIT EFFORT, AND AUDIT FEES Laurence E. Johnson, Robert J. Freeman and Stephen P. Davies

197

AN EXPERIMENTAL EXAMINATION OF THE PEER REVIEW PROCESS Jeff L. Payne

209

vii

DEREGULATION OF THE PRIVATE CORPORATION AUDIT IN CANADA: JUSTIFICATION, LOBBYING AND OUTCOMES Morina Rennie, David Senkow, Richard Rennie and Jonathan Wong

227

SFAS 95 CASH FLOW INFORMATION AND SECURITIES VALUATION Sulaiman A. Alaraini, Joanne P. Healy and Ray G. Stephens

243

PART III: PERSPECTIVES A LONG FALL FROM GRACE David Mosso

259

REMARKS OF DONALD J. KIRK: INDEPENDENCE, AUDIT EFFECTIVENESS AND FRAUDULENT FINANCIAL REPORTING Donald J. Kirk

265

THE “INFORMATION RIGHT” AND THE CPA PROFESSION Gary J. Previts

275

PART IV: BOOK REVIEWS PRO FORMA BEFORE AND AFTER THE SEC’S WARNING: A QUANTIFICATION OF REPORTING VARIANCES FROM GAAP By Wanda Wallace Reviewed by Julia Grant

281

THE VALUEREPORTINGTM REVOLUTION: MOVING BEYOND THE EARNINGS GAME By Robert G. Eccles, Robert H. Herz, E. Mary Keegan, and David M. H. Phillips Reviewed by Kevin Carduff

285

viii

CREATING SHAREHOLDER VALUE By Alfred Rappaport Reviewed by Garen Markarian

289

EXPECTATIONS INVESTING By Alfred Rappaport and Michael J. Mauboussin Reviewed by Evelyn A. McDowell

293

UNDERSTANDING AUDITOR-CLIENT RELATIONSHIPS: A MULTI-FACETED ANALYSIS By Gary Kleinman and Dan Palmon Reviewed by Reed A. Roig

297

EDITOR Gary John Previts Weatherhead School of Management Department of Accountancy Case Western Reserve University

Assistant Editor Nandini Chandar Rutgers University

Associate Editor Thomas R. Robinson University of Miami, Florida

Book Review Editor Larry M. Parker Case Western Reserve University

EDITORIAL BOARD Andrew Bailey University of Illinois – Urbana-Champaign

William Holder University of Southern California

Dennis R. Beresford University of Georgia

Daniel Jensen The Ohio State University

Peter Bible General Motors Corporation

David L. Lansittel, CPA Winnetka, Illinois

Jacob Birnberg University of Pittsburgh

Donald L. Neebes Ernst & Young, LLP

Michael P. Bohan Consultant, Cleveland, Ohio

Hiroshi F. Okano Osaka City University, Japan

Paul Brown New York University

Paul A. Pacter Deloitte Touche Tohmatsu, Hong Kong

Graeme W. Dean University of Sydney, Australia

James M. Patton Federal Accounting Standards Advisory Board

J. R. Edwards Cardiff University

William J. L. Swirsky Canadian Institute of Chartered Accountants

Timothy Fogarty Case Western Reserve University ix

x

Sir David P. Tweedie International Accounting Standards Board Wanda Wallace College of William and Mary

Yuksel Koc Yalkin University of Ankara Head, Commission of Accounting Standards, Turkey

LIST OF CONTRIBUTORS Sulariman A. Alaraini

King Saud University, Saudi Arabia

Olga Averin

Frank G. Zarb School of Business, Hofstra University, USA

Robert Bloom

Department of Accountancy, John Carroll University, USA

Kevin Carduff

Department of Accountancy, Case Western Reserve University, USA

Qiang Cheng

School of Business, University of Washington, USA

Bryan K. Church

DuPree College of Management, Georgia Institute of Technology, USA

Gary Colbert

University of Colorado at Denver, USA

Stephen P. Davies

College of Natural Sciences, Colorado State University, USA

Nathan Felker

School of Law, Case Western Reserve University, USA

Robert J. Freeman

College of Business Administration, Texas Tech University, USA

Peter Frischmann

College of Business, Idaho State University, USA

Scot P. Gormley

Department of Accountancy, Miami University, USA

Julia Grant


xi

xii

Joanne P. Healy

Department of Accounting, Kent State University, USA

Mark Holtzman

Frank G. Zarb School of Business, Hofstra University, USA

Laurence E. Johnson

College of Business, Colorado State University, USA

Donald J. Kirk

Former Vice-Chairman, Public Oversight Board, New York, USA

Garen Markarian


Elaine G. Mauldin

College of Business, University of Missouri-Columbia, USA

Evelyn A. McDowell


John E. McEnroe

School of Accountancy and Management, Information Systems, DePaul University, USA

David Mosso

Federal Accounting Standards Board, Washington, DC, USA

Dennis Murray

University of Colorado at Denver, USA

Mark Myring

Department of Accounting, Ball State University, USA

Jeff L. Payne

School of Accounting, University of Oklahoma, USA

Marshall K. Pitman

Department of Accounting, The University of Texas at San Antonio, USA

Thomas M. Porcano

Department of Accountancy, Miami University, USA

xiii

Gary J. Previts


Robert J. Ramsay

Carol Martin Gatton College of Business & Economics, University of Kentucky, USA

Morina Rennie

Faculty of Administration, University of Regina, USA

Richard Rennie


Reed Roig


James Schaefer

School of Business Administration, University of Evansville, USA

Arnold Schneider

DuPree College of Management, Georgia Institute of Technology, USA

David Senkow


Rebecca Toppe Shortridge

Department of Accounting, Ball State University, USA

Wayne Staton

Department of Finance, Miami University, USA

Ray G. Stephens

Department of Accounting, Kent State University, USA

Uma Velury

Department of Accounting & Management Information Systems, University of Delaware, USA

Terry Warfield

Graduate School of Business, University of Wisconsin, USA

Jonathan Wong

Vancouver, Canada

Michael Zimmer

School of Business Administration, University of Evansville, USA

This Page Intentionally Left Blank

INVITED REFEREES Aaron Ames Ernst & Young, LLP, Canada

Jimmy W. Martin University of Montevallo

Kristen L. Anderson Georgetown University

Yoshinao Matsumoto Kansai University

Lee Blazey Case Western Reserve University

Dwight W. Owsen Louisiana State University

Salvador Carmona Juan Carlos III University, Madrid

David Pearson Case Western Reserve University

Anthony Catanach Villanova University

Vaughan Radcliffe Case Western Reserve University

Edward Coffman Virginia Commonwealth University

Alan Richardson Queens University

John Cumming Miami University – Ohio

Arnold Schneider Georgia Institute of Technology

A. Rick Elam University of Mississippi

Joseph Schultz Arizona State University

Asim Erdilek Case Western Reserve University

Mark Segal University of South Alabama

Ross Fuerman Northeast University

Ray Stephens Ohio University

Jula E. S. Grant Case Western Reserve University

Paul Walker University of Virginia

Joseph Legoria Mississippi State University

Mark Wilder University of Mississippi

Garan Markarian Case Western Reserve University

Steve Young Salomon Smith Barney xv


PART I: MAIN PAPERS


THE MARKET PERCEPTION OF CORPORATE CLAIMS Qiang Cheng, Peter Frischmann and Terry Warfield ABSTRACT This paper examines the economic substance of a broad range of securities by investigating their association with systematic risk and prices. The analysis is motivated by continuing security innovation and its impact on hybrid security reporting. Based on a sample of 2,617 firms that reported minority interests or preferred stock during 1993–1997, the results indicate that redeemable preferred securities (including trust preferred stock) are not viewed by the market as either debt or equity, suggesting dichotomous security classification may lack representational faithfulness. Inconsistent with their treatment in the financial statements, non-redeemable preferred stock and minority interests are viewed as debt-like and equity-like respectively. Additional analyses document that the systematic risk and pricing results vary based on firm size, performance, and bond rating.

1. INTRODUCTION In this paper, we examine the economic substance of a broad range of securities issued by corporations. Using complementary approaches, we study the market pricing of claims represented by debt, minority interests, redeemable preferred stock, and non-redeemable preferred stock.

Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 3–28 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160012

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4

QIANG CHENG, PETER FRISCHMANN AND TERRY WARFIELD

Prior research has provided evidence concerning the economic substance of some hybrid securities. Kimmel and Warfield (1995, hereafter KW) examine the association between systematic risk measures and redeemable preferred stock (RPFD) and document that, despite mandatory redemption payments, RPFD does not have a debt-like impact on systematic risk. KW also provide evidence that the market perception of a hybrid security is conditioned on security attributes. Findings from KW indicate that the market’s perception of RPFD is not consistently similar to either debt or equity, thus questioning the dichotomous classification of hybrid securities as either debt or equity. This paper extends the analysis in KW to examine the economic substance of a broader range of securities, including those reported as minority interests, those in the mezzanine between debt and equity (such as redeemable preferred stock and trust preferred stock), and those reported in equity as preferred stock. This analysis is motivated by continuing deliberation of hybrid security reporting by standard setting boards such as the IASB and the FASB, as well as accelerated innovation in new securities, which may be contributing to a growing mezzanine section in corporate balance sheets (Frischmann et al., 1999). Furthermore, there is little or no research that examines some of the more recent innovative securities or other ownership claims, such as minority interests and non-redeemable preferred stock, which also exhibit hybrid features.1 We examine two indicators of the economic substance of securities – their association with the issuing firm’s systematic risk and with equity price. The tests are conducted on a sample of 2,617 firms that reported minority interests or preferred stock during 1993–1997. We examine variation in systematic risk and price relationships, controlling for the amount of these alternative securities in the subject firms’ capital structures. If investors believe that certain features of these securities make them similar to debt, then the observed relation between the securities and systematic risk (prices) should be similar to that between debt and systematic risk (prices). Consistent with prior research, our results indicate that redeemable preferred securities (including the recent innovation in the form of trust preferred stock) are viewed by the market as neither debt nor equity. Thus, the current mezzanine reporting treatment of these securities appears to coincide with their market treatment. In contrast, the associations exhibited by both non-redeemable preferred stock and minority interests are more consistent with these claims being viewed as debt-like and equity-like respectively, which is inconsistent with their treatment in the financial statements. These results, apparently driven by large firms (which are on average financially stronger than small firms), further document the context-specificity of financial instruments.

The Market Perception of Corporate Claims

5

These results have implications for assessing the usefulness of classification as a means of reporting hybrid securities. The findings in this study indicate that the market perception of these alternative claims depends on the context. That is, the economic substance of these securities, as reflected in associations with systematic risk and prices, varies depending on firm characteristics, such as size and the economic context in which the securities are issued, including financial performance and debt rating. For example, all preferred stock is currently classified as equity. However, relative to small firms, large firms are generally financially stronger, have higher debt ratings, and are more likely to issue preferred securities without characteristics such as convertibility. Hence, the preferred securities of large firms exhibit more debt-like characteristics. Since the usefulness of classification is reduced if the items within a category are not similar in their economic substance, the grouping of large and small firm preferred stock into the same dichotomous classification may result in financial reports that lack representational faithfulness to the economic substance of these securities, as measured by their effects on systematic risk and firm value. More generally, the evidence presented here questions the merits of the current dichotomous classification framework within financial statements as a means of conveying useful information about hybrid securities. Our results suggest that if a dichotomous framework is retained, the equity classification should be comprised of only common stock and minority interests, which are clearly more residual relative to other claims. Given the diversity of attributes that could be reflected in the securities classified as liabilities within this framework, disclosure may be more important for communicating the features relevant to the economic substance of these securities.

2. BACKGROUND AND MOTIVATION The usefulness of financial reporting depends in part on the representational faithfulness of the reporting treatment to the economic substance of the underlying phenomenon (FASB, 1980, SFAC 2, para. 63). The FASB has been working on a project to develop representationally faithful classifications of securities issued by firms. Classifications of securities issued by companies within the issuer’s financial statements exhibit this characteristic (are useful) when the distinctions between classifications are meaningful and when the securities summarized within a particular classification have similar economic substance. However, determining the most useful classification framework is difficult because financial statements are used by a diverse set of stakeholders. For

6


example, equity investors, as residual claimants, are interested in any information about corporate claims, regardless of classification, if that information is useful in predicting future cash flows to equity. Creditors, on the other hand, may rely on classifications to assess their relative claims on firm assets and to enforce contractual terms of debt agreements. Hybrid securities, such as redeemable preferred stock (RPFD), are non-divisible securities having both debt and equity characteristics and recent decisions by the FASB with respect to hybrid security reporting reflect adherence to the current dichotomous classification model based on the (revised) definitions of debt and equity. Under this proposed approach, securities will be classified according to how obligations associated with the securities can be settled. Thus, if an obligation can be settled by issuing additional equity shares, then the security claim could be reported in equity. Otherwise, when the claim must be settled through distribution of assets or by issuing debt claims to assets, the security will be reported in debt (FASB, 2000). Some prior research has used the current conceptual framework definitions by focusing on mandatory redemption features to argue that certain hybrid securities (e.g. RPFD) be classified as debt within the current dichotomous model (Nair et al., 1990). However, the economic substance of these hybrid securities is arguably a function of features that are not easily accommodated in the current model. For example, legal features of preferred stock preclude payments to holders of such securities when the payments threaten the solvency of the firm.2 In this regard, the evidence in KW indicates that redeemable preferred stock is not perceived by the market as either debt or equity. Furthermore, continuing security innovation in preferred stock has led to a growing mezzanine section in corporate balance sheets, thereby drawing attention to accounting standards for hybrid security reporting. For example, trust preferred stock (TPS), which was introduced in 1993, derives its popularity from receiving debt treatment for tax purposes while receiving non-debt treatment for financial reporting (Frischmann et al., 1999). Non-equity treatment for TPS arises from mandatory redemption features similar to RPFD, that is, TPS may not be reported in equity but does not have to be reported in debt either.3 However, TPS reporting currently varies across different issues (Frischmann et al., 1999). For TPS issued during 1993–1996, 13% are reported as debt in the balance sheet, 58% are reported in the mezzanine section, and only 3% are reported as equity (the balance being reported on unclassified balance sheets). As for income statement classification, TPS “dividends” are expensed as interest by 36% of all firms; 36% are reported as minority interest; and 7% are reported as dividends (the balance are unidentified). Thus, the reporting method varies within


7

and across industries. These heterogeneous reporting practices impose difficulties for investors valuing a firm and illustrate the importance of developing accounting and reporting standards for hybrid securities. In contrast to the accounting for redeemable preferred stock and TPS, the reporting practices for minority interest and other preferred stock are more widely accepted. Minority interest generally is reported in the liability section of the balance sheet, while non-redeemable preferred stock is reported in equity. However, minority interest has all the characteristics of equity from the point view of investors, from the dividend payment to rights in liquidation. On the other hand, non-redeemable preferred stock is reported in equity, although it is clearly different from common equity. In fact, Smith (1986) and Clark (1993) argue that in general, capital structure theory views preferred stock as a liability, considered to be a senior security just like a secured bond. Furthermore, it is conceivable that the economic substance of a security is context-specific. Because of industry membership, firm size, and risk, securities may be used as substitutes in one instance but not another. For example, Engel et al. (1999) document the replacement of debt with trust preferred securities and Frischmann and Warfield (1999) note that this activity is concentrated in financially strong firms. The conflicting implications of the features of various corporate claims suggest that a simple characterization of preferred stock or other hybrid securities as either debt or equity based on the conceptual framework definitions is unlikely to result in useful classification. If these conflicting debt and equity features are relevant to the economic substance and useful classification of these securities, then questions arise concerning adherence to the dichotomous classification for reporting hybrid securities. The tests described below provide evidence on the economic substance of these securities and other corporate claims (minority interest and non-redeemable preferred stock) based on an analysis of systematic risk and prices, conditional on the inclusion of these securities in the capital structure. While these tests may not be relied upon to definitively determine the appropriate classification model for corporate claims, they provide important information regarding indicators of a security’s economic substance – its relation to systematic risk and price. To the extent that a security’s relation to these market measures differs from that of securities classified as either debt or equity, classification within a dichotomous framework may result in misclassification of securities when compared to their economic substance.4 The next section develops the theoretical framework for the empirical tests of the market perception of the economic substance of corporate claims.

8


3. RELATION BETWEEN SYSTEMATIC RISK, MARKET VALUE AND CORPORATE CLAIMS We use two different methods to examine the economic substance of corporate claims: a systematic risk analysis and a valuation analysis.5 For the systematic risk analysis we examine the following relationship: Systematic Risk = f(Operating Risk, Debt, Other Claims)

(1)

Prior research has used a systematic risk framework to address the economic substance of redeemable preferred stock (KW) and that of unfunded pension obligations (Dhaliwal, 1986). The rationale for this method is that financial leverage (Debt) is a determinant of the systematic risk of the firm. In KW, this idea is extended to debt and equity having different effects on systemic risk of the firm. In the setting here, by decomposing the capital structure into debt and other corporate claims (e.g. preferred stock, minority interest), we can assess economic substance based on the association between the claim and systematic risk. Consistent with the theoretical relationship between leverage and systematic risk, positive and significant coefficients are expected for securities that increase financial risk. Therefore, if a security affects the market assessment of systematic risk in a manner similar to debt, we expect the estimated coefficients on the debt variable and the other corporate claims to be positive. Alternatively, an insignificant or non-positive coefficient estimate for a non-debt claim is predicted if, conditional on the level of debt, the claim is perceived by the market to have both debt and equity features.6 Although the systematic risk analysis has an appealing theoretical foundation, it has two limitations. First, the risk measure (market beta) used in systematic risk analysis may not be a sufficient measure for risk (Fama & French, 1992). Second, the data requirements for estimating the variables in the systematic risk model reduce the sample significantly, possibly decreasing the generalizability of our results. In response to these limitations, we also use a valuation analysis based on the relationship between corporate claims and prices: Price = f(Assets, Debt, Other Claims)

(2)

Equation (2) is based on a valuation model that represents the market value of common equity of firm i at end of year t as a function of net assets – total assets minus all other financial claims. Similar to prior research (Barth, 1991, 1994; Barth & McNichols, 1994; Barth et al., 1991), we disaggregate net asset value into assets, debt, and other claims (minority interest, preferred stock, trust and


9

redeemable preferred stock) to examine their associations with the market value of equity. Because of potential measurement errors in accounting variables, omitted variables, and conservative accounting, the coefficients on assets and the debt may not be one and minus one respectively. Thus, we limit our tests to comparisons of the coefficient on debt to that on the other claims to see whether the financial instrument exhibits a price association similar to debt.

4. SAMPLE AND DATA 4.1. Sample We collected data on firms with minority interest, trust preferred stock, or other preferred stock outstanding in the 1993–1996 time period. The sample used in this paper comes from two sources: (1) 2,510 firms with preferred stock or minority interest outstanding during 1993–1996 on the 1996 Compustat Industrial Annual File; and (2) 256 firms issuing preferred stock from October 1993 to June 1997. A second sample, the TPS sample, was identified separately to discern the amount of TPS.7 As 149 firms are shown in both sub-samples, the whole sample consists of 2,617 firms or 10,468 firm-year observations.8 Missing data on firm capital structures from Compustat and the restriction that the book value of net assets (the deflator used in valuation analysis) should be at least 1 million dollars, reduce the sample to 6,727 firm-year observations used for the valuation analysis. Elimination of firms for lack of enough data in CRSP and Compustat to calculate systematic risk and accounting beta reduces the final sample to 1,770 firm-year observations, used for systematic risk analysis. The sample selection process is summarized in Table 1.

4.2. Variable Measurement Systematic Risk The systematic risk (Beta) measure for each firm-year was estimated with a one-factor market model using weekly returns on common stock and a market index (NYEX/AMEX weekly value-weighted market return).9 Operating Risk Similar to KW (1995) and Dhaliwal (1986), this paper uses accounting beta as the proxy for operating risk. Accounting beta for each firm was derived from the regression of accounting returns (accounting earnings before tax and

10


Table 1. Sample Selection Process. Number of Observations Firms with preferred stock or minority interests outstanding during 1993–1996 Plus: Firms issuing trust preferred securities from October 1993 to June 1997

2,510a 256

Total firms in sample Firm-year observations [2617 × 4] Less: With not enough financial data or net assets less than 1 million

2,617b 10,468 (3,741)

Firm-year observations used in valuation model Less: Not enough data on CRSP to calculate weekly beta Less: Not enough data to calculate accounting beta

6,727 (2,488) (2,469)

Number of firm-year observations used in systematic risk analysis

1,770

a These

firms also have liabilities outstanding, with no missing value on (redeemable) preferred stock and minority interest, and no change in fiscal year-end during 1993–1996 time period. b The double counting of 149 firms who are members of both sub-samples is eliminated. Data from four fiscal year periods (1993–1996) are used in this study.

interest expenses divided by beginning-of-period total assets) of a firm on the value-weighted average of accounting returns of S&P 500 firms. Capital Structure Variables Because our objective in this paper is to investigate the economic substance of a whole range of financial instruments, we decompose financial leverage into different parts according to capital structure items in financial statements. All capital structure variables, except for trust preferred stock, are measured based on data from the Compustat file as of the end of the fiscal year. Debt represents total liabilities (data item 181) minus minority interest (data item 38). Non-redeemable preferred stock is total preferred stock (data item 130), excluding redeemable preferred stock (data item 175). Due to its recent introduction, trust preferred stock is not a distinct item in the Compustat database and as mentioned earlier, we identified trust preferred stock from the Investment Dealer’s Digest and hand-collected data on these issues from company filings. Tax rate (tax expense/pretax income), ROA (income before extraordinary items/total assets), DA (debt/total assets), common shares outstanding, and market value (market price times number of outstanding shares) at the end of each year for each firm are also collected from the Compustat file. To reduce the impact of extreme values, all independent variables are winsorized at the 1 and 99% level in the following regression analysis.


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4.3. Descriptive Statistics Descriptive statistics for sample firms are presented in Table 2, which summarizes variables used in the analysis for the full sample and for sub-samples by firm size. The mean weekly beta for the whole sample is 0.996, close to 1. This indicates that the sample is representative of the overall population of firms with respect to systematic risk. Large firms have the lowest systematic risk (0.934), while the small firms have the highest beta (1.084). Overall, the debt-equity ratio (DEBT) is 1.760, while minority interest (MI) is 2.1% of the common equity (market value). The redeemable preferred stock (RPFD) and other preferred stock (PFD) are 1.2% and 3.4% of the common equity respectively. Trust preferred stock (TPS), likely because of its recent introduction and tendency to be issued by only large firms, represents only 0.1% of common equity. The mean market value is 4,523 million dollars for the systematic risk analysis sample, which is significantly greater than the mean market value of the valuation sample (2,470 million dollars). This reflects the impact of restricting the systematic risk analysis sample to only those firms for which we have data to estimate both weekly systematic risk measures and accounting betas. Analysis by firm size shows small firms having the highest weekly beta, but medium firms having the highest accounting beta. Large firms have the lowest risk measures, but the highest debt-equity ratio. Less than half the sample firms have minority interest or preferred securities.10

5. EMPIRICAL RESULTS In this section we present the results of systematic risk and valuation analyses. Consistent with prior research, we add industry, size, and year dummy variables to the basic models. Using this expanded specification, we also examine the relationships on sub-samples of the data partitioned by firm size and the type of corporate claims comprising the capital structure.11 The size partition is motivated both by findings that market pricing relationships vary by size (see e.g. Warfield et al., 1995) and by the evidence in Table 2 that capital structure varies by firm size. For example, note (in Table 2) that the small firm sub-sample has no TPS and a relatively smaller amount of minority interests. Examination of sub-samples in which only certain non-debt securities have been issued is motivated by recent research indicating that preferred stock and other hybrids can be issued as substitutes for either debt or equity depending on economic incentives faced by the firm (Frischmann & Warfield, 1999). Examining, in isolation, the market pricing of these alternative security claims relative to debt provides less ambiguous evidence on the economic substance of these securities.

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Table 2. Descriptive Statistics. (Descriptive Statistics of Variables used in Systematic Risk Analysis and Valuation Analysisa,b ) Full Sample Mean

Large Firms

Medium Firms

Small Firms

Median

Mean

Std.

Median

Mean

Std.

Median

Mean

Std.

Median

Mean

Std.

Median

12,396 0.623 4.538 2.675 0.064 0.006 0.027 0.078

1,131 0.905 1.234 0.714 0.000 0.000 0.000 0.000

602 11,466 0.934 1.133 3.165 0.026 0.003 0.013 0.045

18,923 0.454 1.539 3.690 0.057 0.008 0.025 0.078

5,304 0.878 0.876 1.108 0.002 0.000 0.000 0.001

584 1,675 0.973 1.860 1.091 0.029 0.001 0.011 0.026

2,506 0.546 4.153 1.663 0.068 0.006 0.027 0.066

1,131 0.849 1.377 0.668 0.000 0.000 0.000 0.000

584 214 1.084 1.194 0.980 0.028 0.000 0.013 0.031

327 0.816 6.644 1.534 0.068 0.000 0.031 0.090

118 1.064 1.854 0.402 0.000 0.000 0.000 0.000

588 2,401 0.913 0.839 2.116 0.000 0.002 0.027 0.083

9,607 0.604 4.089 2.832 0.000 0.008 0.038 0.113

993 0.807 0.730 1.025 0.000 0.000 0.000 0.031

Valuation Model Variables N 6,727 MVALUE 2,470 AT 2.806 DEBT 2.086 MI 0.035 TPS 0.001 RPFD 0.013 PFD 0.027

8,344 4.756 4.417 0.111 0.005 0.060 0.087

223 1.338 0.691 0.000 0.000 0.000 0.000

2,303 6,823 3.729 3.072 0.036 0.003 0.010 0.032

13,181 5.987 5.648 0.088 0.008 0.035 0.081

2,529 1.860 1.198 0.002 0.000 0.000 0.000

2,216 357 2.994 2.243 0.042 0.000 0.014 0.024

508 4.991 4.610 0.124 0.001 0.059 0.080

212 1.438 0.763 0.000 0.000 0.000 0.000

2,208 49 1.654 0.899 0.026 0.000 0.016 0.024

66 1.922 1.432 0.116 0.000 0.078 0.098

25 0.795 0.277 0.000 0.000 0.000 0.000

1,813 1,673 4.084 3.208 0.000 0.003 0.041 0.077

7,043 5.895 5.486 0.000 0.007 0.102 0.144

182 1.937 1.171 0.000 0.000 0.000 0.009

a Descriptive statistics are based on all firms-years with preferred stock or minority interest outstanding, or issuing trust preferred securities during 1993–1996. Size classification is based on the 33rd and 66th percentile of total assets. The PFD-Only sample includes firms with TPS, RPFD, or PFD, but not MI outstanding during 1993–1996. b N is the number of firm-year observations included in each sample. MVALUE is the market value of the common equity. BETA is the weekly beta, estimated with a one-factor market model using weekly returns on common stock and a market index (NYEX/AMEX value-weighted market return) for each firm-year. ABETA (accounting beta) for each firm is derived from the regression of the accounting returns of this firm on the value-weighted average of the accounting returns of S&P 500 firms. Accounting returns are calculated as accounting earnings before tax and interest expenses for one period divided by total assets at the beginning of that period (at least 10 observations are used). DEBT is total liabilities, excluding minority interests. MI is total minority interests excluding trust preferred stock for firms except utilities. TPS is the total amount of trust preferred stock. RPFD is the total amount of redeemable preferred stock excluding trust preferred stock for utilities. PFD is the total amount of preferred stock, excluding redeemable preferred stock. AT is total assets. All financial structure variables are scaled by market value. DEBT and TPS are adjusted for the tax shield for systematic risk analysis just as they appear in regressions.


Std.

Systematic Risk Variables N 1,770 MVALUE 4,523 BETA 0.996 ABETA 1.393 DEBT 1.760 MI 0.021 TPS 0.001 RPFD 0.012 PFD 0.034

PFD-Only


13

5.1. Systematic Risk Analysis The results for the systematic risk analysis are reported in Table 3.12 All regressions reflect estimations including industry, size, and year dummy variables (not tabled) to control for temporal and cross-sectional variation in the systematic risk relation Table 3. Systematic Risk Analysis. Betai,t = ␣1 OPi + ␣2 OPi +␣4 OPi

(1−T i,t )Debti,t MVi,t

(1−T i,t )TPSi,t MVi,t

+ ␣5 OPi

MI

+ ␣3 OPi MVi,ti,t RPFDi,t MVi,t

OP

Debt

MI

TPS

0.3590 (24.78) 0.2884 (19.55) 0.3401 (17.40) 0.3646 (13.85)

0.0100 (4.70) 0.0106 (4.24) 0.0065 (1.16) −0.0043 (−0.64)

−0.1612 (−1.84) −0.3436 (−4.22) −0.0267 (−0.21) 0.0047 (0.02)

0.2879 (0.60) −0.0889 (−0.16) 0.1385 (0.21)

Panel B: PFD-Only Sample All Firms 0.3820 (15.67) Large Firms 0.3304 (10.44) Medium Firms 0.3651 (16.02) Small Firms 0.3893 (7.75)

0.0071 (1.82) 0.0085 (2.16) −0.0070 (−1.34) 0.0079 (0.49)

Panel A: Full Sample All Firms Large Firms Medium Firms Small Firms

−0.3289 (−0.52) −0.5466 (−0.68) −0.5865 (−0.66)

+ ␣6 OPi

PFDi,t MVi,t

+ ␷i,t

PFD

N

Adj. R2

0.0200 (0.11) 0.4048 (1.90) 0.0754 (0.36) −0.1253 (−0.32)

0.1761 (2.35) 0.2051 (2.02) −0.0716 (−0.82) 0.2859 (1.93)

1755

0.76

612

0.87

591

0.80

552

0.67

0.1609 (0.89) 0.4199 (1.76) 0.1077 (0.46) 0.1293 (0.27)

0.1701 (1.79) 0.1981 (1.52) −0.0208 (−0.17) 0.1828 (1.13)

585

0.78

227

0.88

216

0.83

142

0.66

RPFD

Notes: The model used is an expanded model, containing financial instruments specified in each row, with controls for industry, firm size (not for size subgroups), and year. We use dummy variables to control for industries (utilities, financial companies, and other industries), firm size (large, medium, and small firm classified according to total assets at the fiscal end), and each year for the test period. The PFD-Only sample contains firms with no MI outstanding, but with TPS, RPFD, or PFD outstanding. White t-statistics in (·). N is the number of firm-year observations included in each sample. BETA is the weekly beta, estimated with a one-factor market model using weekly returns on common stock and a market index (NYEX/AMEX valueweighted market return) for each firm-year. OP is transformed accounting beta. Accounting beta is derived from the regression of the accounting returns of this firm on the value-weighted average of the accounting returns of S&P 500 firms. DEBT is total liabilities, excluding minority interests. MI is total minority interests excluding trust preferred stock for firms except utilities. TPS is the total amount of trust preferred stock. RPFD is the total amount of redeemable preferred stock excluding trust preferred stock for utilities. PFD is the total amount of preferred stock, excluding redeemable preferred stock. Independent variables are winsorized at the 1% and 99% levels to reduce the influence of extreme values. 15 observations are detected as outliners using the method described in Belsley et al. (1980) and are excluded from the full sample. Two-sided t-stat for 0.10, 0.05, 0.01 significance level are 1.65, 1.96, 2.58 respectively.

14


likely to exist in this sample, given the security innovation in recent years and the heterogeneous nature of the sample. Including industry dummy variables controls to some extent for variation in operating risk that is not captured in the accounting beta variable.13 In general, the results indicate that minority interest is priced to be equity-like, non-redeemable preferred stock is viewed similar to debt, and other claims to lie somewhere between these two. For the full sample, as reported in panel A of Table 3, the coefficient on debt is significantly positive (p < 0.001). The coefficient on MI is also significantly different from zero, but with a negative sign, suggesting that it is equity-like. The coefficients on TPS and RPFD are positive but insignificant. TPS and RPFD variables exhibit relations with systematic risk that are not consistent with their being priced as either debt or equity. These results on redeemable preferred stock are similar to the findings of KW. Surprisingly, given its reporting in financial statements, the coefficient on non-redeemable preferred stock is positive and significant, suggesting that it is debt-like. As discussed earlier, because the overall sample is fairly heterogeneous in terms of size, which may be related to security choice, we also estimate the regression conditional on firm size. The results for these partitions are reported in panel A and indicate that the preferred stock and minority interest results for the full sample appear strongest in large firms and that the RPFD of large firms exhibits a relation more consistent with it being viewed by the market as a leverage increasing claim.14 Panel B reports results based on sub-samples with only preferred stock but no minority interest (PFD-Only), also conducted on firm size partitions. Overall, the coefficient on debt is still positive and significant as is the preferred stock estimate. Neither the TPS nor the RPFD coefficients are significantly different from zero. However, the analysis conditional on firm size indicates that the coefficient estimates for RPFD exhibit a debt-like relation for large firms.

5.2. Valuation Analysis The valuation models were estimated on all firm-years with available data. The valuation test sample is not directly comparable to the sample used in the systematic risk analysis. The sample is much larger (N = 6,727), because this approach does not require systematic risk measures and accounting betas, which were estimated from a long time-series of data. In general, the results from the valuation model corroborate earlier findings based on systematic risk. The results for the full sample are shown in panel A of Table 4.15 As in the systematic risk analyses, we also control for intercept shifts for industry, size, and year.


15

Table 4. Valuation Model Analysis. MVi,t = ␣1 ATi,t + ␣2 Debti,t + ␣3 MIi,t + ␣4 TPSi,t + ␣5 RPFDi,t + ␣6 PFDi,t + ␣7 NIi,t + ␣8 NI × Posi,t + ␣9 NA1i,t + ␷i,t AT

Debt

MI

TPS

RPFD

PFD

N

Adj R2

1.5846 (9.06) 1.0125 (4.94) 1.3495 (5.46) 2.3122 (10.75)

−1.6263 (−9.27) −1.0355 (−5.00) −1.3958 (−5.65) −2.3619 (−10.23)

−1.5042 (−4.16) −0.1855a (−0.32) −1.1085 (−2.08) −3.7519 (−6.56)

1.3199 (0.36) 5.2345a (1.35) −3.0426 (−0.40)

−0.7945a (−1.24) 2.8815a (2.07) −1.3633 (−1.45) −2.5611 (−3.11)

−1.7894 (−4.32) −1.6958a (−3.08) −2.0421 (−3.59) −1.6271 (−6.63)

6727

0.65

2303

0.74

2216

0.67

2208

0.62

Panel B: PFD-Only Sample All Firms 1.3205 (6.21) Large Firms 1.1877 (5.49) Medium Firms 1.2727 (3.65) Small Firms 1.3093 (3.41)

−1.3797 (−6.27) −1.2466 (−5.75) −1.3464 (−3.78) −1.2500 (−2.88)

−0.0271a (−0.04) 3.7603a (2.51) −0.3868 (−0.49) −0.4198 (−0.41)

−0.4187a (−0.88) −1.2399 (−2.28) −0.8341 (−1.28) 1.0903a (1.20)

1813

0.67

718

0.78

473

0.73

622

0.64

Panel A: Full Sample All Firms Large Firms Medium Firms Small Firms

−2.7144 (−1.41) −3.2592 (−1.57) −3.9270 (−0.66)

Notes: The model used is an expanded model, containing financial instruments specified in each row, with control for industry, firm size (not for size sub-samples), and year. We use dummy variables to control for industries (utilities, financial companies, and other industries), firm size (large, medium, and small firm classified according to total assets at the fiscal end), and each year for the test period. The PFD-Only sample contains firms with no MI outstanding, but with TPS, RPFD, or PFD outstanding. White t-statistics in (·). N is the number of firm-year observations included in each sample. MV is market value and AT is total assets. DEBT is total liabilities, excluding minority interests. MI is total minority interests excluding trust preferred stock for firms except utilities. TPS is the total amount of trust preferred stock. RPFD is the total amount of redeemable preferred stock excluding trust preferred stock for utilities. PFD is the total amount of preferred stock, excluding redeemable preferred stock. NI is net income and Pos is dummy variable, defined as one if net income is positive. NA is book value of net assets. All financial instrument measures are scaled by book value of common equity at fiscal year end. We winsorized the independent variables at 1%, 99% levels to reduce the influence of extreme values. Two-sided t-statistics for 0.10, 0.05, 0.01 significance level are 1.65, 1.96, 2.58 respectively. a The

coefficient is significantly different from that on debt at 5% level.

Coefficients on total assets and debt excluding minority interest are significantly positive and significantly negative respectively. Similar to prior studies, the absolute values of coefficients are different from one because of omitted variables, potential measurement errors in the variables, and conservative accounting. The coefficient on non-redeemable preferred stock is also significantly negative, and the absolute value is greater than that of debt, although not significantly. This suggests that, as in the systematic risk analysis, preferred stock is priced similar to

16


debt. In the full sample, the coefficients on redeemable preferred stock (TPS and RPFD) are not significantly different from zero, thereby not exhibiting relations similar to debt or equity (although RPFD appears equity-like compared to the debt coefficient). The coefficient on minority interest is less negative than that on debt (appearing equity-like), although not significantly. These results are generally consistent with the systematic risk results reported above. As with the systematic risk analysis, we split the sample into three different sub-samples according to firm size. As expected, large firms have more minority interest than small firms and the size-partitioned results in panel A indicate that results on MI for large firms are stronger. The coefficient on MI is significantly less negative than that on debt for large firms, consistent with it being priced more like equity. As in our earlier analysis, the debt-like non-redeemable preferred stock relationships are strongest for the large firms. However, the difference between the coefficient on non-redeemable preferred stock and that on debt goes from significantly negative to marginally significantly positive from the large firm subsample to the small firm sub-sample in panel A of Table 4. The reverse situation applies to minority interest. This suggests that non-redeemable preferred stock is debt-like for large firms, but equity-like for small firms, while minority interest is equity-like for large firms but debt-like for small firms. The results for the preferred stock sub-sample and associated size partitions are reported in panel B of Table 4. Consistent with the full sample, the coefficients on the total assets and debt excluding minority interest are all significantly positive and significantly negative respectively. The results are similar to those reported for small firms in panel A. While on an overall basis, the coefficient on the non-redeemable preferred stock variable is significantly higher than the debt coefficient, the size analysis indicates that this is primarily due to the small firm sub-sample. This lends support to the discussion above that non-redeemable preferred stock is equity-like for small firms. Similar to results for the full sample, but inconsistent with the systematic risk analysis, conditioned on firm size, the results indicate that the coefficient estimates for RPFD exhibit an equity-like relation for large firms.16 In summary, the systematic risk and valuation analyses reveal the following results concerning the market pricing of alternative corporate claims. Confirming prior research, debt obligations exhibit an association with systematic risk and equity prices consistent with their treatment in the financial reporting framework. Also as in prior research, our results indicate that redeemable preferred securities (including the recent innovation in the form of TPS) are not viewed by the market as either debt or equity. Thus, the current reporting treatment of these securities (in the mezzanine) appears to be in line with their market associations.17 In contrast, the associations exhibited by both non-redeemable preferred stock


17

and minority interest are more consistent with these claims being viewed as debt-like and equity-like respectively (leverage increasing (decreasing)), especially for large firms, which is inconsistent with their treatment in financial statements.

5.3. Additional Analysis of Firm Characteristics The findings reported in the prior section indicate that the market perception of corporate claims varies according to firm size. For example, preferred stock is viewed like debt for large firms, but more similar to equity for small firms. There are two possible explanations for this phenomenon. First, as noted by Fama and French (1995) and Hayn (1995), smaller firms generally have lower accounting return and higher default risk. Debt holders of small firms are more likely to exercise their option to take over the firm than the debt-holders of large firms, so debt and preferred instruments are more equity-like for small firms (Warner, 1977a). Second, small firms tend to issue equity-like securities, and choose convertible preferred stock to attract investors, lower agency costs, and thereby reduce capital costs (Jensen & Meckling, 1976; Smith, 1986). To further examine the impact of firm characteristics on our results, we collected data on firms’ performance measures and convertible preferred stock. We chose ROA (income before extraordinary items/total assets), S&P senior debt rating, and the debt-to-asset ratio as measures of financial performance.18 To reduce the industry effect on ROA, we created a relative ROA variable, REROA, the difference between a firm’s ROA and the industry mean ROA, divided by the industry mean ROA. Consistent with the above analysis, we classified firms into three industry groups: utilities, financial companies, and other firms. We also collected the amount of convertible preferred stock for each firm-year, and calculated a convertible ratio (convertible preferred stock/total preferred stock), CNVPRE.19 One method to assess the impact of convertibility and firm performance on the market’s perception of preferred stock is to control for the convertibility of redeemable or non-redeemable preferred stock in the systematic risk and valuation analyses. However, Compustat data do not allow us to determine convertibility among various preferred stock issues (redeemable or not). Thus, to explore differential results on preferred stock conditional on size, we analyze: (1) the relation between the overall convertible ratio and firm performance, conditional on firm size; and (2) the market perception of convertible preferred stock, conditional on firm performance. The correlation among financial performance measures, convertible ratio, and firm size (total assets) are reported in panel A of Table 5. Consistent with our

18

Table 5. Evidence on the Relation Between Firms’ Characteristics, Convertibility and Differential Pricing of Preferred Stock. Panel A: Spearman Correlation Coefficientsa ROA 0.98981 −0.37984 −0.13597 −0.23427 0.3639

REROA −0.34408 −0.15021 −0.18738 0.35539

SP

0.34543 0.33728 −0.65418

DA

−0.1408 0.12198

CNVPRE

−0.32016

Full Sample

PFD-ONLY Sample

Panel B: Descriptive Statistics for the Performance Variables and Convertible Ratiob

ROA REROA SP DA CNVPRE

Full 2.5105 0.4738 9.5560 27.283 0.3842

Large 3.0540 0.7985 8.3112 27.9298 0.2951

Medium 3.8691 1.2380 10.4405 28.5907 0.3527

Small 0.5916 −0.6249 12.2857 25.4223 0.5836

Full 1.0161 −0.7555 9.8457 31.3132 0.3425

Large 2.0640 −0.0650 9.2833 31.9943 0.2137

Medium 3.0683 0.3880 10.2516 32.1543 0.2987

Small −3.3328 −3.3311 10.8378 29.1869 0.5433

Panel C: Systematic Risk Analysis of Convertible Preferred Stock Contingent on Firm Performance c (1 − T i,t )Debti,t MIi,t (1 − T i,t )TPSi,t NCPFDi,t + ␣3 OPi + ␣4 OPi + ␣5 OPi MVi,t MVi,t MVi,t MVi,t CPFDi,t +(␣6 + ␣7 ROA + ␣8 SP)OPi + ␷i,t MVi,t

Betai,t = ␣1 OPi + ␣2 OPi

OP 0.2993 (12.63)

Debt 0.0145 (5.74)

MI −0.1220 (−1.40)

TPS −0.4304 (−0.62)

NCPFD 0.1024 (1.20)

CPFD −0.1454 (−1.05)

CPFD × ROA 0.0019 (0.13)

CPFD × SP 0.0640 (2.33)

N 517

Adj. R2 0.84


REROA SP DA CNVPRE AT

Panel D: Valuation Analysis of Convertible Preferred Stock Contingent on Firm Performance c MVi,t = ␣1 ATi,t + ␣2 Debti,t + ␣3 MIi,t + ␣4 TPSi,t + ␣5 NCPFDi,t + (␣6 + ␣7 ROA + ␣8 SP)CPFDi,t + ␣7 NIi,t + ␣8 NI × Posi,t 1 +␣9 + ␷i,t NAi,t AT 1.6946 (8.66)

Debt −1.7266 (−8.28)

MI 1.2671* (2.20)

TPS 2.5910 (0.55)

NCPFD −1.2970 (−2.40)

CPFD CPFD × ROA 1.8257* 0.2200 (3.08) (5.10)

CPFD × SP −0.7076 (−5.16)

N 10,42

Adj. R2 0.70


Table 5. (Continued )

a Panel A is based on the whole sample, with no restriction on

weekly beta and accounting beta. ROA is return on assets (income before extraordinary items/total assets, in percentage), SP is S&P senior debt rating, and DA is debt-assets ratio. To reduce the industry effect on ROA, we create a relative ROA variable, REROA, which is the difference between a firm’s ROA and its industry mean divided by industry mean of ROA. CNVPRE is preferred stock convertible ratio (convertible preferred stock/total preferred stock). All correlation coefficients are significant at the 0.0001 level. b Panel B is based on the firms used in systematic risk analysis. A similar, but more significant pattern exists for the sample used in the valuation analysis. c CPFD is the total amount of convertible preferred stock and NCPFD is the total amount of non-convertible preferred stock. Other variables are defined as in Tables 3 and 4. In Panels C and D, we use mean-adjusted ROA and SP debt rating (based on sample means) in the interaction with convertible preferred stock, so that the intercept on convertible preferred stock (␣6 ) can be interpreted as coefficient on convertible preferred stock for an average firm. ∗ The coefficient is significantly different from that on debt at 5% level. White t-statistics are in (·).

19

20


conjecture, small firms are generally financially weak, with lower ROA and relative ROA, and higher SP value (lower rated debt).20 Also consistent with our conjecture, small firms tend to issue convertible preferred stock. The Spearman correlation coefficient between total assets and convertible ratio is −0.32016, significant at 0.0001 level. Panel B of Table 5 highlights the difference in financial performance measures and the convertible ratio across size-subgroups for the whole sample and the PFDOnly sample. There is no significant difference between medium firms and large firms in financial performance measures and convertible ratio. However, small firms have lower financial performance and a higher convertible ratio, compared to medium-size firms and large firms. Compared to large firms, the mean ROA for small firms is lower by 2.462% (t = 3.562), or 20% of the mean ROA for the large firms, for the full sample. Small firms have a higher SP code (by 3.975, t = 9.198), and therefore a lower debt rating. The small firms also have a higher proportion of convertible preferred stock (with t = 7.25). These results are similar for the PFDOnly sample. Overall, small firms generally exhibit weaker financial performance and a larger proportion of convertible preferred stock, which is consistent with the preferred stock being considered equity-like for small firms, but debt-like for large and medium-sized firms. To investigate the impact of conversion features and firm performance on the market’s perception of preferred stock, we replace redeemable and non-redeemable preferred stock with convertible preferred stock and nonconvertible preferred stock and we include interaction terms of convertible preferred stock with the return on assets and S&P debt ratings. These interaction terms are introduced to control for the effects of firm performance and other risk aspects on the market’s perception of convertible preferred stock. The results for the systematic risk (valuation) models are reported in panel C(D) of Table 5. After controlling for firm performance and other risk factors, convertible preferred stock is equity-like in both the systematic risk and valuation analyses. Moreover, the significant coefficient on the interaction of convertible preferred stock and return on assets suggests that the convertible preferred stock of more profitable firms is priced more similar to equity. The significant coefficient on the interaction of convertible preferred stock and S&P debt ratings suggest that convertible preferred stock of riskier firms is more debt-like. That is, investors are more likely to convert convertible preferred stock of more profitable firms to capture future growth opportunities and less likely to convert preferred stock of riskier firms in face of high default risk. The findings for non-convertible preferred indicate that, consistent with the earlier results, that these securities are priced more similar to debt.


21

6. CONCLUSION We examine the economic substance of a broad range of securities, including those reported in minority interest, those in the mezzanine between debt and equity (such as redeemable preferred stock), and those reported in equity as preferred stock. While prior research has provided evidence concerning the economic substance of some hybrid securities (e.g. KW), evidence on the broader range of corporate claims is limited. Our analyses are motivated by continuing security innovation, which is contributing to a growing mezzanine section in corporate balance sheets. Evidence on how the market views various corporate claims should be useful to standard setting boards such as the IASB and the FASB in their deliberations. Indeed, there is no study that we are aware of that has examined some of the more recently developed securities (trust preferred stock) or other corporate claims, such as minority interest and preferred stock, which also exhibit hybrid features. We employ two indicators of the economic substance of securities – their impact on the issuing firm’s systematic risk and their association with equity prices. If investors believe that certain features of the securities make them similar to debt, then the observed relation between the securities and systematic risk (and prices) should be similar to that between debt and systematic risk (and prices). Our evidence suggests that, consistent with prior research, debt obligations exhibit an association with systematic risk and prices consistent with their treatment in the financial reporting framework. Also consistent with prior research, our results indicate that redeemable preferred securities (including the recent innovation in the form of TPS) are not viewed by the market as either debt or equity. Thus, the current reporting treatment of these securities (in the mezzanine) appears consistent with their market treatment. In contrast, the associations exhibited by both non-redeemable preferred stock and minority interests are more consistent with these claims being viewed as debt-like and equity-like respectively (leverage increasing (decreasing)), which is inconsistent with their treatment in the financial statements. However, the fact that these results appear to be driven by large firms suggests the substance of such instruments are context specific. The contextual nature of these findings questions the merits of the current dichotomous classification framework within financial statements as a means of conveying useful information about hybrid securities and provides evidence relevant to the FASB’s deliberation on hybrid security reporting. These results indicate that the FASB project has merits, but that care must be exercised in choosing the demarcation between various corporate claims.

22


Specifically, the findings with respect to preferred stock and minority interest suggest that a less ambiguous line between liability and equity claims may be drawn based on a strict definition of equity. Consequently, the equity classification would contain only common equity (including minority interest) and the equity elements of compound securities. All other claims (including preferred stock) would be classified as liabilities. Under this approach, at least the elements reported within equity would exhibit similar economic substance. Given the diversity of attributes that could be reflected in the securities classified as liabilities within this framework, disclosure is arguably the most effective means of communicating the features relevant to the economic substance of these securities.21

NOTES 1. Linsmeier et al. (1999) use a single valuation approach (based on the residual income model) to examine the market pricing of debt and equity classifications. However, they do not examine the economic substance of minority interests and some of the more recent security innovations. Their results for preferred stock are consistent with the findings in this paper. 2. While RPFD payments are an obligation of the firm under normal operating conditions, RPFD investors cannot force a delinquent firm into bankruptcy (FASB, 1990; Manning & Hanks, 1990). This is important because financial theory suggests that a primary characteristic of debt is that creditors have the option of forcing a delinquent debtor into bankruptcy (Myers, 1977; Warner, 1977a, b). Prior research has examined the implications of bankruptcy costs for financial instrument innovations such as hybrid and compound securities (John, 1993). 3. Frischmann et al. (1999) provide evidence that these popular securities represent nearly two-thirds of new preferred stock issuance in the 1993–1996 time period. Frischmann and Warfield (1999) and Engel et al. (1999) provide evidence on the importance of tax and financial reporting motivations for issuing TPS. 4. Hopkins (1996) finds that the financial statement treatment of a security can affect how securities are treated by analysts in evaluating the company’s financial position. These results suggest that classification in financial statements matters. Furthermore, in collecting our data, we observed inconsistent treatment of hybrid securities in financial databases, which raises concerns about the lack of standards for the reporting of hybrid securities. At a minimum, when classifications lack representational faithfulness, users bear costs to adjust information reflected in financial statements to make the information more comparable. 5. These approaches take the perspective of investors, which is justified given the preeminence of this set of users within the FASB’s conceptual framework. A more complete development of the models and specifications are presented in the Appendix. 6. Insignificant coefficients for this test could also be caused by low variation in the distribution of the independent variable or high correlation in the measure of the security with another variable in the model. We address these issues by estimating the models on subsamples and by examining the distribution of the independent variables through the use of collinearity diagnostics.


23

7. From Investment Dealer’s Digest, we obtained a listing of all new preferred security issues in the October 1993 to June 1997 period, amounting to 471 issues of 272 different firms. This period spanned the beginning of TPS issues (with Texaco being the first in October 1993) up to the most recent year when new issue data, annual financial statements, and Compustat data were available. Our 1997 data end in June, which is the latest fiscal year end in the 1996 Compustat file. Financial information and attributes of each preferred security issue were obtained from the company’s annual report, 10-K, or prospectus as it appeared on Laser Disclosure or on the SEC EDGAR database. Data availability, chiefly the inability to identify or obtain a copy of the parent company annual report or lack of detailed disclosure to verify the details of the preferred issue, reduced this sample to 417 issues of 256 firms. 8. Not all firms issuing preferred stock are included in the preferred stock-minority interest sample for three reasons: (1) Some firms issued preferred stock after the fiscal year end of 1996 and did not have preferred stock or minority interests before; (2) Some firms’ TPS are included in other liabilities, rather than in minority interests or redeemable preferred stock; (3) Some firms issuing preferred stock have no data in Compustat (and are not used in the tests). 9. KW argue that estimates based on daily returns are downward biased for some inactive stocks, hence weekly beta is used for the main analysis. Firm-years with less than 30 weekly returns were dropped from the tests. Daily beta (estimated from the daily return of each common stock and market return) are calculated for sensitivity analysis. Long-term beta is also extracted from Compustat for sensitivity analysis. Results for these alternative measures are similar to those reported below. 10. Correlation statistics (not reported) indicate that multicollinearity is not an issue, based on the diagnostic suggested by Belsley et al. (1980). 11. We estimated the models below on industry sub-samples and observe similar but weaker results than those reported in the tables. To control for potential serial correlation in residuals caused by including up to five years data of individual firms, we also estimated a cross-sectional regression based on composite observations for each firm by averaging variables over years. Year-by-year regressions were estimated and the resulting coefficients were averaged over time. Both methods were implemented for the full sample and size partitions to check the sensitivity of results. The results based on both methods are qualitatively similar to those reported in the paper for both systematic risk and valuation analyses. 12. Fifteen observations are detected as outliers and excluded from the sample. The criterion is that the absolute value of the R-student measure is larger than three (Belsley et al., 1980). We also run the tests: (1) using truncated leverage ratios; and/or (2) with all financial instrument variables scaled by the total assets. The results are qualitatively similar. 13. KW use a similar specification. We repeated the systematic risk analysis by using the variability of earnings to proxy for operating risk, as in prior research (KW, 1995), and found similar results. 14. Similar results were obtained (not tabled) on a sample of firms with only minority interest. 15. For the full sample, coefficients on net income, its interaction term with a positive income dummy, and the inverse of net assets are −3.05, 9.06, 2.34 respectively, and are all significant. Consistent with theoretical predictions, similar coefficients are observed for sub-samples. As these coefficients are not of interest in this study, they are not reported in the table.

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16. In contrast to the systematic risk model, which excludes many smaller firms because of the lack of data, it is the small firms that are most influential in the valuation model. More firms in the PFD-Only sample are small firms because large firms are more likely to have minority interest. 17. The result on TPS could partly be driven by limited number of firms having trust preferred stock. While, the inconsistent results on redeemable preferred stock between the two analyses may reflect firm size differences between the two samples, results of the valuation analysis based on the systematic risk sample are qualitatively similar to those reported in Table 4. 18. We included the debt-to-asset ratio as a measure of firm performance as it is an indicator of the risk of a firm not meeting its maturing obligations. 19. Some firms issue ESOPs (Employee Stock Ownership plans), which are included in convertible preferred stock and current liabilities, but not in total preferred stock. This will bias the convertible ratio upward. To reduce the bias, we set the ratio to be one if the convertible preferred stock (including the ESOP) is greater than net preferred stock (not including the ESOP). 20. The S&P senior debt rating code is low for higher rated debt, and high for lower rated debt. For example, the code for AAA rated debt is 2, 17 for B rated debt, and 27 for D rated debt. 21. Kimmel and Warfield (1993) make a similar recommendation in their analysis of potential approaches for reporting RPFD. Some decisions by the FASB within the liability and equity project are consistent with this approach. As mentioned earlier, based on current deliberations, TPS and other RPFD will be classified as debt while minority interests and the equity elements of compound securities will be reported in equity. 22. See Brealey and Myers (1984), chapter 17, for further discussion of this model. This formulation is similar to those in Hamada (1972) and Bowman (1979), with the approach here incorporating alternative claims (besides debt) with potentially different risks. 23. This regression does not include an intercept term because it is not theoretically motivated and the inclusion of an intercept potentially causes multicollinearity problems. The coefficients on corporate claims in Eq. (2) are interpreted as the difference between 1 and the ratio of the beta of corporate claims to operating risk. An alternative regression format, theoretically and empirically identical to Eq. (2), is one replacing those interaction terms between operating risk and corporate claims with corporate claims alone. The coefficients from this latter specification are interpreted as the difference between operating risk and the beta of corporate claims. The results based on this specification are qualitatively similar. 24. See, for example, Barth and McNichols (1994), Barth (1991, 1994), Barth et al. (1991), Collins et al. (1999). This model is consistent with Ohlson (1995) (see Eq. (7) on p. 670). 25. We chose the levels specification because of two significant shortcomings of the changes specification. First, the misspecification of a return regression is more severe as manifested by the low adjusted R-square (Lev, 1989) and may affect the coefficients on independent variables (Kothari, 2000). Second, to implement the return regression, we need to take first differences of corporate claims, which reduces the sample size unnecessarily. While the levels regression is subject to a scale effect (Brown, Lo & Lys, 1999; Easton, 1998), we use net assets as the deflator to control for this. The results are not sensitive to the use of alternative deflators, such as beginning-of-period net assets or net sales.


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ACKNOWLEDGMENTS Qiang Cheng gratefully acknowledges the financial support of the Graduate School of University of Wisconsin and the Department of Accounting and Information Systems at the University of Wisconsin. P. Frischmann gratefully acknowledges the financial support of the College of Business of Idaho State University and the Department of Accounting and Information Systems at the University of Wisconsin. T. Warfield gratefully acknowledges the financial support of the PricewaterhouseCoopers Foundation. We thank our anonymous referees, Joe Anthony, Mike Lacina, Tom Linsmeier, Peter Pope, Steve Ryan, workshop participants at Lancaster University, The London Business School, Tilburg University, the University of Wisconsin-Madison, and conference participants at the 1999 AAA Annual Meeting in San Diego for helpful comments on earlier versions of this paper.

REFERENCES Barth, M. E. (1991). Relative measurement errors among alternative pension asset and liability measures. The Accounting Review (July), 433–463. Barth, M. E. (1994). Fair value accounting: Evidence from investment securities and the market valuation of banks. The Accounting Review (January), 1–25. Barth, M. E., Beaver, W. H., & Stinson, C. H. (1991). Supplemental data and the structure of thrift share prices. The Accounting Review (January), 56–66. Barth, M. E., & McNichols, M. F. (1994). Estimation and market valuation of environmental liabilities relating to superfund sites. Journal of Accounting Research (Supplement), 177–209. Belsley, D. A., Kuh, E., & Welsch, R. E. (1980). Regression diagnostics. New York: John Wiley & Sons, Inc. Bowman, R. G. (1979). The theoretical relationship between systematic risk and financial (accounting) variables. Journal of Finance (June), 617–629. Brealey, R., & Myers, S. (1984). Principles of Corporate Finance. New York: McGraw-Hill. Brown, S., Lo, K., & Lys, T. (1999). Use of R2 in accounting research: Measuring changes in value relevance over the last four decades. Journal of Accounting and Economics (December), 83–116. Clark, M. W. (1993). Entity theory, modern capital structure theory, and the distinction between debt and equity. Accounting Horizons (September), 14–31. Collins, D., Pincus, W., & Xie, H. (1999). Equity valuation and negative earnings: The role of book value of equity. The Accounting Review, 74(January), 29–61. Dhaliwal, D. S. (1986). Measurement of financial leverage in the presence of unfunded pension obligations. The Accounting Review, 61(October), 651–661. Easton, P. D. (1998). Discussion of revalued financial, tangible and intangible assets: Association with share prices and non-market-based value estimates. Journal of Accounting Research, 36(Supplement), 235–247.

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Engel, E., Erickson, M., & Maydew, E. (1999). Debt-equity hybrid securities. Journal of Accounting Research, 37(Autumn), 249–274. Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance (June), 427–465. Fama, E. F., & French, K. R. (1995). Size and book-to market factors in earnings and returns. The Journal of Finance (March), 131–155. FASB (1980). Statement of financial accounting concepts No. 2. Qualitative Characteristics of Accounting Information. Stamford, CT: FASB. FASB (1990). Discussion memorandum. Distinguishing between liability and equity instruments and accounting for instruments with characteristics of both. Norwalk, CN. FASB (August). FASB (2000). Proposed statement of financial accounting standards: Accounting for financial instruments with characteristics of liabilities, equity, or both. Financial accounting series – No. 213-B (October 27). Frischmann, P., & Warfield, T. D. (1999). Innovation in preferred stock: The impact of tax, financial reporting, and industry factors (Working Paper). University of Wisconsin. Frischmann, P., Kimmel, P., & Warfield, T. D. (1999). Innovation in preferred stock: Current developments and implications for financial reporting. Accounting Horizons, 13(September), 201–218. Hamada, R. (1969). Portfolio analysis, market equilibrium and corporation finance. Journal of Finance (March), 13–31. Hamada, R. S. (1972). The effect of the firm’s capital structure on the systematic risk of common stocks. The Journal of Finance (May), 435–452. Hayn, C. (1995). The information content of losses. Journal of Accounting and Economics (September), 125–153. Hopkins, P. (1996). The effect of financial statement classification of hybrid securities on financial analysts’ stock price adjustments. Journal of Accounting Research (Supplement), 33–50. Jensen, M. C., & Meckling, W. H. (1976). Theory of the firms: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 4(October), 305–360. John, K. (1993). Managing financial distress and valuing distressed securities: A survey and a research agenda. Financial Management (Autumn), 60–78. Kimmel, P., & Warfield, T. (1993). Variation in attributes of redeemable preferred stock: Implications for accounting standards. Accounting Horizons (June), 30–40. Kimmel, P., & Warfield, T. (1995). The usefulness of hybrid security classifications: Evidence from redeemable preferred stock. The Accounting Review (January), 151–167. Kothari, S. P. (2000). Capital market research in accounting. Journal of Accounting and Economics (forthcoming). Lev, B. (1989). On the usefulness of earnings: Lessons and directions from two decades of empirical research. Journal of Accounting Research (Supplement), 153–201. Linsmeier, T., Shakespeare, C., & Sougiannis, T. (1999). Liability/equity classifications decisions and shareholder valuation (Working Paper). University of Illinois. Manning, B., & Hanks, J. J. (1990). Legal capital (3rd ed.). Westbury, NY: Foundation Press. Myers, S. C. (1977). Determinants of corporate borrowing. Journal of Financial Economics (November), 147–175. Nair, R. D., Rittenberg, L. E., & Weygandt, J. J. (1990). Accounting for redeemable preferred stock: Unresolved issues. Accounting Horizons, 4(2), 33–41. Ohlson, J. (1995). Earnings, book values and dividends in security valuation. Contemporary Accounting Research, 11(Spring), 661–687.


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Smith, C. W., Jr. (1986). Investment banking and the capital acquisition process. Journal of Financial Economics, 1/2 (January/February), 3–29. Warfield, T. D., Wild, J. J., & Wild, K. L. (1995). Managerial ownership, accounting choices and informativeness of earnings. Journal of Accounting and Economics, 20(July), 61–91. Warner, J. B. (1977a). Bankruptcy, absolute priority and the pricing of risky debt claims. Journal of Financial Economics, 4(May), 239–276. Warner, J. B. (1977b). Bankruptcy costs: Some evidence. Journal of Finance (May), 337–347.

APPENDIX Systematic Risk Analysis The systematic risk model used in this paper is based on Hamada (1969, 1972).22 If the correlation between the interest on debt, the dividend rate on preferred stock, and the market return is not negligible, it can be shown that: (1 − T)Debt PFD + (␤U − ␤PFD ) (1) MV MV where: ␤S is the systematic risk of the firm as measured by the beta of its common stock. Similarly, ␤D , ␤PFD are betas of the debt and the preferred stock of this firm. Debt, PFD, MV represent the debt, preferred stock and equity of the firm respectively. ␤U is the operating risk of the firm (the systematic risk of an unlevered firm). T represents the tax rate faced by the firm. Extending this equation to a situation with minority interest, TPS, and redeemable preferred stock, the following regression Eq. (for all firm-year observations) can be constructed as:23 ␤S = ␤U + (␤U − ␤D )

Betai,t = ␣1 OPi + ␣2 OPi + ␣4 OPi

(1 − T i,t )Debti,t MIi,t + ␣3 OPi MVi,t MVi,t

(1 − T i,t )TPSi,t RPFDi,t PFDi,t + ␣5 OPi + ␣6 OPi + ␷i,t MVi,t MVi,t MVi,t (2)

where: Beta = an estimate of the systematic risk of the firm’s common stock, ␤S ; OP = measure of operating risk, ␤U ; Debt = total debt; MI = minority interest; TPS = total trust preferred stock; RPFD = total redeemable preferred stock; PFD = total preferred stock (excluding redeemable preferred stock); MV = market value of common equity.

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Valuation Analysis The following valuation model is based on prior research and is used to examine the market pricing of book value components.24 We use this model as a second methodology for assessing the economic substance of alternative corporate claims. The valuation model is constructed as follows: MVi,t = ␣1 ATi,t + ␣2 Debti,t + ␣3 MIi,t + ␣4 TPSi,t + ␣5 RPFDi,t 1 + ␣6 PFDi,t + ␣7 NIi,t + ␣8 NI × Posi,t + ␣9 + ␷i,t NAi,t (3) where: AT is total assets; NI is net income; Pos is one if the net income is positive; NA is book value of common equity; other variables are defined as in Eq. (2). All variables are scaled by book value of equity to reduce heteroscedasticity and to eliminate scale effects (Easton, 1998).25 If the coefficient on one instrument is significantly different from that of debt, we infer that the market perception of this instrument is different from that of debt.

AN ANALYSIS OF THE ACCOUNTING PROFESSION’S OLIGARCHY: THE AUDITING STANDARDS BOARD John E. McEnroe and Marshall K. Pitman ABSTRACT The Auditing Standards Board (ASB), a committee of the American Institute of Certified Public Accountants (AICPA) has been granted the authority to promulgate auditing standards in the United States. Unlike the members of the Financial Accounting Standards Board (FASB), ASB members are all AICPA volunteers and are not required to sever ties with their employers. In its present mode of operation, the ASB brings in revenue for the exclusive benefit of members of the profession as well as creating a legal defense in the case of a lawsuit arising from an audit. Abbott (1988) refers to this as a jurisdictional claim. Over the past quarter of a century, there have been many critics of the ASB, but the accounting profession resisted making any significant changes in either the Board’s composition or its operations. Given this background, this paper involves the following sections: a review of the auditing standardsetting process, criticisms and recommendations for a change in the ASB’s operations, benefits to the profession of the current structure, and a call for a restructuring of the ASB in light of the recently signed Sarbanes-Oxley Act of 2002.


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JOHN E. McENROE AND MARSHALL K. PITMAN

INTRODUCTION If a profession were allowed to select two privileges involving its operations, those chosen might very well be those same ones accorded to the accounting profession in the United States: a monopoly over its services, and the right to promulgate the specific procedures that define these services. The first benefit was conferred in 1933 and represents a monopoly regarding the audits of publicly traded companies. The second was bestowed in 1939 and is the ability to determine the official rules and procedures that constitute an audit. While the former prerogative brings in revenue for the exclusive benefit of members of the profession, the latter is especially propitious, for it is capable of not only generating revenue, but also, creating a legal defense in the case of a lawsuit arising from an audit. Abbott (1988), in his acclaimed work, The System of Professions,1 refers to the above phenomenon as a jurisdictional claim, which is the claim before the public for the legitimate control of a particular work (p. 59). However, as will be discussed in this paper, Congressional critics and others claim that the accounting profession has not lived up to society’s needs in performing its public service, especially given the recent collapses of Enron and WorldCom. Accordingly, they have called for reforms in the manner in which auditing standards are promulgated. Yet the accounting profession, except for some minor modifications that will be addressed later, continues to resist the calls for any significant modification of its oligarchical agent, the Auditing Standards Board (ASB). Given this background, the focus of this paper involves an examination of the ASB, the official body that creates these rules that govern the audits of companies – publicly traded and non-public. Abbott’s work, in large part, is used to explain the accounting profession’s behavior towards the resistance of change in the auditing standard-setting process in the U.S. The paper consists of the following sections: a review of the auditing standard setting process, criticisms and recommendations for a change in operations, benefits to the profession of the current structure, and a call for a restructuring of the ASB. The recent events involving Arthur Andersen LLP and its association with the Enron and WorldCom collapses, which have engendered calls for increased oversight and reforms in the accounting profession, help serve to make our research timely.

THE AUDITING STANDARD-SETTING PROCESS The accounting profession retained its authority over audit standard setting in the wake of the McKesson-Robbins fraud of the 1930s by prompt response to concerns for more effective processes, and despite a lengthy inquiry by the SEC into the issues of the event (Previts & Merino, 1998, pp. 294–296). In 1939,

An Analysis of the Accounting Profession’s Oligarchy

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the Committee on Auditing Procedure (CAuP) was established by the American Institute of Accountants, predecessor to the American Institute of Certified Public Accountants (AICPA). The Auditing Standards Executive Committee (AudSEC) replaced the CAuP in 1972, and evolved into the present organization, the Auditing Standards Board (ASB) in 1978. At the present time, the ASB is a senior technical committee of the AICPA. The Board consists of 15 members, representing individuals from each of the four largest audit firms,2 another three from other national firms, and five from small and regional audit firms, a person from a local, state, or federal governmental unit (currently from a state auditor’s department), one accounting academic, and a vacant position created by the resignation of the Arthur Andersen representative. A critical point to note is that unlike the Financial Accounting Standards Board (FASB), ASB members are AICPA volunteers and are not required to sever ties with their employers (parent organizations). The stated objective of the ASB is, “To develop and communicate performance and reporting standards and practice guidance that enable the public auditing profession to provide high quality objective attestation services at a reasonable cost and in the best interests of the profession and the beneficiaries of those services, with the ultimate purpose of serving the public interest” (AICPA, 2002a). The importance and power of the ASB is immense, since these standards and procedures must be adhered to in conducting audits, and the ASB is the exclusive promulgator of these auditing rules, called Statements on Auditing Standards (SASs).3 The AICPA states that the evaluation of a SAS (as well as SSAE) is the result of a due process procedure (AICPA, 1992, p. 13). A proposed pronouncement is developed by a task force composed of members of the ASB and other individuals who possess technical expertise in the subject matter of the project, after which an exposure draft (ED) is placed on the ASB’s website for comment.4 Comments are then collected for at least a 60-day period (normally 90 days) and reviewed by the ASB. Other matters that are contained in the comment letters that the Board did not consider previously are then evaluated. The ASB then usually issues the ED as a final standard. A member may cast either vote in one of these manners: assent, assent with qualification and dissent. If a member casts an assent with qualification or a dissent vote, the reason for the objection must be included in the SAS.

CRITICISMS AND RECOMMENDATIONS FOR CHANGE IN OPERATIONS OF THE ASB Although the ASB has not received either the same degree of attention in the media and the criticism by the financial community that the FASB has engendered, the ASB’s operations have been scrutinized on occasion, especially over the past

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twenty-five years. This scrutiny has come from various parties, including one U.S. Senate and two U.S. House of Representatives investigations. Perhaps the most exhaustive study was conducted in 1976, by the late Senator Lee Metcalf (D-Montana) who chaired a U.S. Senate committee that examined the U.S. accounting profession and released a 1,700-page diatribe titled The Accounting Establishment (U.S. Senate, 1976). Table 1 list a summary of the major criticisms and recommendations of the Metcalf and other committees pertaining to the ASB: the Cohen Commission, (CAR, 1978); the Oliphant Committee (Oliphant, 1978); the Treadway Commission (Treadway, 1987); the General Accounting Office (GAO, 1996); and the panel on Audit Effectiveness, 2000 (PAE, 2000). At about the same time, another government official, Representative John Moss (D-California), also investigated the accounting profession and recommended that the SEC prescribe the auditing standards that public accountants follow in certifying financial statements that are filed with the SEC (GAO, 1996, p. 112). These recommendations should not have taken the accounting profession by surprise, for Davidson and Anderson (1987, p. 126) state that by 1974 congressional critics of the accounting profession began to ask “whether independent auditors were living up to the expectations of the investing public.” In response to the criticisms of Metcalf and Moss, the AICPA formed a task force (the Cohen Commission) which issued a report The Commission on Auditors’ Responsibilities: Report, Conclusions and Recommendations (CAR, 1978). Representative John Dingell (D-Michigan), chairman of the Energy and Commerce Subcommittee on Oversights and Investigations, followed the lead of Metcalf and Moss by conducting hearings involving the accounting profession in the 1980s and 1990s, oftentimes focusing on well publicized audit failures. The committee was very outspoken. One member, Rep. Ronald Wyden (D-Oregon), on two occasions, warned SEC Chairman John Shad that the SEC was “. . . inviting Congress to step in and write a whole new set of rules” (Ingersoll, 1991, p. 50). Furthermore, he labeled Ernst & Whinney as “essentially a three time loser” for its involvement in three audit failures (p. 50). He also categorized the accounting profession’s Public Oversight Board as the “Private Oversight Board,” arguing that the self regulation of the public accounting profession is inherently flawed, since, “This is an industry where the same people write the rules, interpret the rules, and enforce the rules” (p. 50). Chairman Dingell even once compared his committee’s investigation of the accounting profession to a quail hunt, using the metaphor to emphasize his perception of the magnitude of the profession’s deficiencies. “You’re talking to a quail shooter. I always use good dogs, and I never go into a field where I don’t think there are quail” (Berton & Ingersoll, 1990, p. 47). In 1977, the AICPA appointed another group, the Oliphant Committee, to review the structure within the AICPA by which auditing standards are developed


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Table 1. Criticisms of the ASB by Various Committees. Source (Reference)

Primary Criticism(s)

Primary Recommendations(s)

Metcalf Committee, 1976 (U.S. Senate, 1976)

1. National firms dominate the establishment of auditing standards through membership on the AudSEC (predecessor to the ASB). 2. No mechanism for public participation in establishing auditing standards.

1. Federal government should establish auditing standards through the GAO, SEC, or by Federal Statute.

Cohen Commission, 1978 (CAR, 1978)

1. AudSEC too large, members work part time.

1. AudSEC should be reduced from 21 members to a smaller full time board compensated only by the AICPA.

Oliphant Committee, 1978 (Oliphant, 1978)

1. AudSEC too large, no representation from individuals outside the profession.

1. AudSEC be reconstituted as the ASB, allowing individuals with extensive audit training to serve on the Board, even if not a member of the AICPA.

Treadway Commission, 1987 (Treadway, 1987)

1. ASB promulgates auditing standards that are too narrow.

1. ASB be restructured to include knowledgeable person whose concern is with the use of auditing products. 2. ASB be composed of equal number of auditing practitioners and person not engaged in public accounting, selection based on expertise rather than constituencies.

2. No mechanism for public participation in establishing auditing standards.

General Accounting Office, 1996 (GAO, 1996)

1. No mechanism for public participation in establishing auditing standards.

1. Appoint knowledgeable non public accounting practitioners to the ASB.

Panel on Audit Effectiveness (PAE, 2000)

1. No mechanism for public participation on AICPA various self regulating bodies.

1. Public Oversight Board (POB) should oversee the ASB, including approval of all appointments to the ASB. 2. Majority of ASB members be from audit firms that provide attest services to SEC clients.

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and to recommend any changes deemed necessary to improve the process. The committee’s findings, are titled the Report of the Special Committee of the AICPA to Study the Structure of the Auditing Standards Executive Committee (Oliphant, 1978). A decade later, the National Commission on Fraudulent Financial Reporting (the Treadway Commission) issued a document, Report of the National Commission on Fraudulent Financial Reporting, which criticized both the ASB and the process by which it develops auditing standards for promulgating standards which were deemed to be too narrow. A notable recommendation of the Commission was that the ASB be reconstituted to include an equal number of auditing practitioners and persons not employed in public accounting (outside members). The resistance to this proposal was viewed with disdain by the accounting profession, who apparently regarded the potential outside ASB members as interlopers. For example, Hugh Marsh, a member of the Commission, stated that this recommendation was the most controversial of all the recommendations involving the public accounting sector and that the chairman of the AICPA was speaking against it in public forums. He added that the resistance came entirely from the upper levels of the accounting professions and was one of the key issues in the response by the chairmen of the (then) Big Eight accounting firms to the exposure draft report (p. 37). Marsh countered, protesting the accounting profession’s phalanx by stating: “We of the Commission felt strongly that this participation by non-practicing members would enhance the credibility of the standard-setting process significantly and take away some of the secrecy inherent in a standards setting group which is totally within the practicing profession” (Marsh, 1988, p. 36). The GAO released a report in 1996 that analyzed the extent to which recommendations made to the accounting profession by major study groups had been implemented (GAO, 1996). A large section of the report focused on those involving the ASB and the auditing standard setting process. It stated, in agreement with the SEC Chief Accountant, that if more knowledgeable non-public accounting practitioners were appointed to the ASB then the auditing standards would “better meet the public interest” (GAO, 1996, p. 123). Furthermore, in 1998 the chairman of the SEC requested the Public Oversight Board (POB) to appoint The Panel on Audit Effectiveness (PAE) to thoroughly examine the current audit model. In mid-2000, the PAE issued its document, titled Report and Recommendations (PAE, 2000). One recommendation was that the POB oversee the ASB and in that capacity would approve all appointments to the ASB. The ASB appointment oversight authority was granted to the POB in 2001, however the POB voted itself out of business in 2002 in response to SEC


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Commissioner Harvey Pitt’s recommendation (2002) to replace it with a new oversight Board. Pitt’s proposed Board, which was a result of the Enron collapse, would have been composed largely of individuals independent of the accounting profession. Lynn Turner, the former SEC chief accountant, stated that the proposed Board “falls way short.” Turner believes that all of the new Board members should be chosen from outside of the profession and also have the power to establish auditing standards (Smith & Schroeder, 2002, p. C15). In early 2002, Turner’s structure was endorsed by the GAO (2002a), who recommended that such a Board be formed. This recommendation to establish a new Board, whose functions would include the establishment of professional standards including auditing standards, was reaffirmed in a May 2002 letter to Senator Paul Sarbanes from David M. Walker, Comptroller General of the United States (GAO, 2002b, p. 77). On July 30, 2002, President George W. Bush signed the Sarbanes-Oxley Act of 2002 (P. L. No. 107–204) which involves corporate governance and oversight of the accounting profession. This legislation establishes a five member panel called the Public Company Accounting Oversight Board (PCAOB). Only two members may be CPAs and if the chairperson is a CPA, he or she may not have been a practicing CPA for at least five years prior to his or her appointment to the PCAOB (P. L. No. 107–204, Sec. 101). The PCAOB will, among other things, oversee the audits of companies that are subject to Securities Act of 1933 and 1934. At this point the SEC’s relationship with the ASB should be mentioned, especially since it will oversee the new PCAOB. Although the SEC has generally been supportive of the ASB, Lynn Turner, a former Chief Accountant, emphasized the SEC’s authority to write, modify, or supplement auditing standards in a comment letter to the ASB involving the ED of SAS No. 95, Generally Accepted Auditing Standards (AICPA, 2002b). In his letter, Turner suggested that this authority be disclosed in summary fashion in a footnote to SAS No. 95, and the ASB complied (Turner, 2001, pp. 1–2). Furthermore, an individual who is very knowledgeable regarding the auditing standard-setting process stated that the SEC often prods the ASB to place issues on its agenda. These actions underscore the SEC’s desire not to abrogate its authority in the establishment and oversight of auditing standards, and will, no doubt, continue to so through the PCAOB. Having reviewed several calls for a restructuring of the ASB, the question arises then, as to why the accounting profession has repeatedly assumed an immutable posture against change, especially in allowing outsiders to sit on the ASB.5 The answer is provided by analyzing the rewards accruing both to the profession and also to audit firms who have an employee serving on the ASB under the current structure.

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ADVANTAGES AWARDED TO THE PROFESSION AND MEMBER FIRMS BY THE ASB The primary benefits accruing to the accounting profession from the ASB’s current structure discussed in this section are those associated with the establishment of audit rules (standards). The Metcalf Committee, offered the following observation regarding the auditing standard-setting process: “The accounting profession and ultimately the public, depend on auditing standards to establish the reliability of financial statements, but the Auditing Standards Executive Committee operates autonomously on behalf of the AICPA. There are no provisions to guarantee public participation in the process” (p. 91). As Robson et al. (1994, p. 531) state, occupations seek to affirm their professional status as resulting from a social contract between itself and the public. In the case of the accounting profession this results from its monopoly status in attesting financial statements. As stated earlier, Abbott (1988, p. 60) refers to this as a “jurisdictional claim,” which is a claim before the public for the legitimate control for a particular kind of work. Abbott goes on to state that this assertion involves, first and foremost, a right to perform the work as the profession desires. It also includes the right to exclude other workers (non-CPAs), to create the public definitions of the tasks involved, as well as professional definitions of the tasks to competing professions (p. 60). Furthermore, a profession may further its agenda by controlling its abstract knowledge system which in turn generates the practical techniques of its workers. Such a knowledge system has the power to redefine its problems and tasks, defend them from interlopers, and seize new problems (p. 9). Applying Abbott’s framework to the ASB, the definition of the problems and tasks become the SASs, and the defense against interlopers is the resistance to the appointment of outsiders to the ASB. The above analysis partially explains the behavior of the accounting profession in resisting calls for restructuring of the ASB. However, besides these general benefits, the specific benefits accruing to the profession and/or individual firms from the current system should also be examined. These fall under the following categories: revenue production, ologarichal status of national firms, limitation of the legal liability for individual firms, and legitimizing the audit firm approach. Revenue Production The ASB’s ability to increase revenue for its members stems from its ability to prescribe the standards for attestation (i.e. SASs and SSAEs). The more


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complicated the promulgation of standards, the more revenue it generates for the large member firms that do audits. This overt strategy has also led to a protest by small practitioners, who feel that such esoteric SASs place a burden on their ability to compete in a system of increasingly complex rules. This schism was accelerated by the “conglomeration of industries” phenomenon cited by Abbott (1988, p. 25). Abbott states that when the accounting profession took a “divergent change” in the twentieth century, local accountants were replaced by “conglomerate accountants.” The end result was a few giant, transnational firms versus individuals and small partnerships doing a completely different type of local business. Martens and McEnroe (1998) provided empirical evidence of the revenue producing ability of the ASB, especially for the benefit of large audit firms. They found that after the ASB issued the ED for SAS 72, it subsequently modified the final SAS in order to protect the prices charged for comfort letters (p. 367).

Oligarchy Status of National Firms Over twenty-five years ago, the Metcalf Committee stated that the national firms dominated the auditing standard-setting process (U.S. Senate, 1976, p. 11) and chief financial officers believe this still to be the case (McEnroe, 2000, p. 30). The CFO’s also perceive that national audit firms maintain a greater advantage than other parties in achieving comment integration into the final SAS (p. 30). Although studies by McEnroe (1993) and McEnroe and Martens (1998) found no evidence of an advantage of national firms having their comments integrated into a final SAS versus other parties, the research of Kaplan and Pany (1992) found evidence that the large firms were more successful than others in lobbying before the ASB. McEnroe (1994, 2002) examined the voting behavior of members of the ASB involving the issuance of the expectation gap SASs (EGSASs), SAS Nos. 53–61, and post expectation gap SASs (PEGSASs), SAS Nos. 62–87. In the 1994 study, covering the EGSASs, he found that agency relationships existed in the voting patterns of certain ASB members and the firms that employ them. In addition, he found that there was often a strong correlation between an ASB member’s reason listed for an objection to a SAS and his/her parent organization’s position as expressed in a comment letter submitted to the ASB. In his 2002 study, covering the PEGSASs, he found that “agency” voting behavior is still evident. He also found that there is less participation, as measured by the submission of comment letters regarding a proposed SAS, on the part of organizations who have an employee serving on the ASB. Although the AICPA states that the development of a SAS is the result of a due process procedure, there is certain evidence to the contrary. For example, in the

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development of SAS 82, Considerations of Fraud in an Audit (AICPA, 1997), the AICPA apparently vetted the ED to the legal departments of the (then) Big Six audit firms before revealing it to the other parties for their input. In examining the comment letters responding to the ED, Martens and McEnroe (2001) found that three of the letters mentioned a meeting consisting of the National Accounting and Auditing Symposium where an AICPA representative reportedly declared that attorneys representing the (then) Big Six audit firms had already analyzed the proposed standard and had concluded that it would not increase auditors’ exposure to legal liability. As further evidence of a concentration of the national audit firms controlling the audit standard-setting process, consider the following. In an interview conducted by Carmichael and Craig (1994, p. 45) of five sitting ASB members, the following question was asked: Do members of the large firms dominate the process? The ASB member stated: “The large firms send their best talent, supported by the technical resources of their organizations. It is difficult for local practitioners to be as prepared for discussions as the large firm representatives. The present members respect the views of all members. The large firms by no means vote as a block or seem to demonstrate common interests or points of view. The task-force chairs tend to be members from the large firms. I think local practitioners should have more opportunity to provide leadership by serving as task-force chairs.” When asked if ASB members were voting on their own versus on their firm’s behalf, the member stated that he “only noticed it one or two times” when an individual was voting his/her position rather than “what he or she thought was right for the profession” (p. 45). This observation contrasts with the evidence of lobbying behavior in the McEnroe studies (1994, 2002) which will be discussed in a subsequent section. Further evidence of an oligarchy is revealed by a couple of observations by Arens (1993, p. 44) who stated that, the Vice President of Auditing of the AICPA and the ASB Chair “almost completely control” the issues the ASB addresses and that these same individuals select all of the ASB members except the (then) Big Six. As Arens states, “This puts them in a position to significantly influence auditing standards by who they select as members” (p. 44).

Limit the Exposure to Liability The ability to limit the liability of its members through the definition of the task is probably the second greatest privilege accruing to the ASB. A case in point is the issuance of SAS 82, Consideration of Fraud in a Financial Statement Audit.


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Martens and McEnroe (2001) analyzed the events leading up to and including the release of the SAS. The authors contended that although the stated purpose of the SAS was to clarify the auditors’ responsibilities in the area of fraud detection, the actual intent was an attempt by the AICPA to lower public expectations as to auditor’s responsibilities involving fraud detection. Indeed, an AICPA representative even characterized a series of panel presentations of ASB members and the Fraud Task Force as “road show” presentations (Landsittel & Bedard, 1997, p. 5). As further evidence of the professions ability and desire to limit the liability of auditor, consider the following observation of Arens: “It is obvious from being on the ASB that the driving force in setting auditing standards now is legal liability. Given that fourteen of the ASB members are practitioners, this is completely understandable. Many practitioners, including those on the ASB, believe that the extensive exposure to legal liability puts the existence of the profession at risk. Many members also believe that their life savings are jeopardized by the legal liability crisis. Given that environment, it is not surprising that potential legal liability is the driving force in any deliberation by the ASB. It may not be in the best long-term interest of the profession to have liability considerations dominate auditing standard-setting, but in the present environment, it is likely to remain the key factor” (1993, p. 43). This ability to limit the legal liability through the formation of a SAS awards the profession great power, for as Abbott (1998, p. 136) notes, if the public accepts an incumbent’s definitions of its problems, the incumbent requires an enormous power over opponents whose case depends on new definitions.

Legitimization of Audit Firm Approach Another benefit to the firms (parent organizations) who have employees serving on the ASB is the possible adoption of their audit approach as a SAS. Kinney (1986, p. 77), a former member of the ASB, has stated that audit firms may benefit from SASs in several ways, including a perception of increased quality of the audit, decreased training costs (given that SASs are taught in colleges and universities), reduced legal liability, and avoidance of government intervention in the regulation of auditing. However, Kinney argues that although the benefits of new SASs apply to all auditors, they may vary across firms. As an example, an SAS that would increase the structure of an audit would be less costly for a firm that maintains a structured audit appraisal and more exposure for those that employ an unstructured approach. Thus, structured firms would likely support SASs that require increased audit actions versus unstructured firms who would not be expected to support them.

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Thus, Kinney states that different firms have different economic interests in the adoption of certain SASs, and that to satisfy those interests may require a major commitment of the firm’s employees’ time to the auditing standard-setting process; including besides ASB membership, AICPA task forces and sub-committees. He concluded that “the auditing standards environment provides a direct link between standard-setting behavior and economic self interest.” But the question arises to what extent do ASB members engage in lobbying for their firms’ agendas? In a study of ASB voting behavior on the expectation gap SASs, McEnroe found that if no letter involving an ED was on file by the parent organization, or if the parent was in favor of the ED, there was about a 95% probability that ASB member will cast an assent with qualification or assent vote. If, however, the parent opposed the ED via a negative letter, the proability increased to 35% that he would dissent to the SAS (1994, p. 126). Similar results were found in the McEnroe (2002) study, involving the post expectation gap SASs. Another analysis combined the assent with qualification and the dissent votes in a “total protest category.” In this exercise, it was thought that if the parent organization objected to the ED, although the ASB member might not cast a dissent vote, he might cast a qualification to his assent. The results showed that if the parent organization was against the ED, there was a 50% chance that the ASB member would cast either an assent with qualification or dissent vote. If there was no letter on file, however, opposing the ED, the probability of voting a pure assent vote was about 85%. Lastly, McEnroe listed 12 examples of parent organization’s positions that closely resembled the ASB member’s objection in the final SAS for eight different firms (seven national firms). He concluded that his narrative analysis that the parent organization’s position is being voted on and recorded in the SAS through their ASB member’s objection (1994, p. 130). Subsequent research by McEnroe (2002) on the post expectation gap standards found such agency voting behavior to be the status quo. As a result, there is evidence that certain audit firms with ASB member/employees are using the ASB as a vehicle to further their interests.

CALL FOR REORGANIZATION OF THE ASB As previously mentioned, the PCAOB is the new body that will oversee and regulate accounting firms that audit public companies. Since the PCAOB will have no more than two CPAs, it is unlikely that they will directly establish auditing standards. Rather, it will probably subcontract that function to the ASB6 and “jawbone” the ASB when it deems appropriate to issue or strengthen certain standards. In


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addition, there will still be a need for auditing standards to be established for audits of non-public companies. Given these events and the deficiencies of the current auditing standard-setting process cited, it is our proposal that the ASB should be restructured. The authors believe that it is the opportune time for the ASB to establish its credibility and expertise in the audit standard-setting arena. Three issues need to be considered: funding, structure, and reporting. Currently, the ASB is funded solely by the AICPA. To improve the independence and authority of the ASB, an alternative funding source must be obtained. One possible funding source would be the PCAOB. Public accounting firms and audit partners who have filings with the SEC will now be required to register with the new board and pay annual registration fees. These registration fees, along with other fees for services such as peer reviews, would cover the full costs of the board; they could also be used to fund the ASB. As to the structure, several matters are recommended. First, it should be a full-time board structured in a similar manner to the FASB. Second, all members (with the exception of an academic member) would be required to sever their membership from their firms or employers and not be allowed to rejoin the organization when their tenures on the ASB end. Third, in accordance with the Treadway Commission’s recommendation, the ASB would be comprised of an equal number of former auditing practitioners and individuals not engaged in public accounting but are qualified and knowledgeable about auditing (outside or public members). Fourth, the ASB should consist of ten members. This size is within the range of 8 to 12 suggested by the Treadway Commission but is larger than the five members of the PCAOB. This size was chosen to be large enough to be representative of those who would use the ASB’s products, but small enough to be efficient in its standard-setting function. The five former auditing practitioners would be selected as follows: one from the Big Four firms, one from the other national firms, two from the Practice Group B firms (regional and large local firms), and one from a small (less than 10 professionals) firm. The five public members would be selected as follows: one from academia, one from internal auditing, one from a governmental unit or agency, and two other individuals who are qualified and knowledgeable about auditing including those with a background in international auditing standard setting. The third issue regarding the new board is its reporting responsibility. Besides reporting to the PCAOB, the new ASB should also report annually to the public, the SEC, and Congress. The report might include the results of audit standard setting and the coordination with other standard-setting bodies. The auditing profession maintains a position of public trust. It has enjoyed a state sanctioned monopoly over its services since 1933. However, the increasing

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number of audit failures and the inevitable question of “where were the auditors” might erode confidence in the profession to the extent that its monopoly status might be revoked. As a result, others (e.g. financial service companies) might be allowed to perform audits. The proposed structure and funding should address the problem of agency voting and the focus on limiting the liability of auditors. Finally, such an ASB could promulgate the auditing standards that as the GAO stated might “better meet the public interests” (1996, p. 123). In summary, it is too early to speculate how active the PCAOB will be in the auditing standard-setting arena. In any event, the ASB official subjugation to the PCAOB is a loss of power and prestige to the accounting profession, and is, in part, a consequence in some measure of the deficiencies of the current system that are discussed earlier in this paper. Future research should be undertaken to document the outcome of this power-sharing scheme and the “true” power in auditing standard setting. In the meantime, the implementation of the ASB model as proposed in this paper may serve to restore both the public trust and confidence in the profession.

NOTES 1. This work was the winner of the 1991 Distinguished Publication Award of the American Sociological Association. 2. Currently, the Chair of the ASB is from a Big Four firm. 3. Besides developing SASs, the ASB is responsible for: (1) Statements on Standards for Attestation Engagements (SSAEs); (2) being alert to new oportunities to serve th epublic; and (3) providing guidance in the implementation of its pronouncements (AICPA, 1992, p. 1). 4. A two-thirds majority approval by the ASB is necessary for the release of the ED, as well as the passage of the SAS. 5. However, in recent conversations with two individuals involved with the ASB, one individual revealed that as a concession as a result of the recent events, the ASB will probably appoint another academic member. The other individual stated that they believe that non-AICPA members are likely to be appointed to the ASB in the near future. 6. Sec. 3 of the Sarbanes-Oxley Act of 2002 states, “The Board shall, by rule, establish, including, to the extent it determines appropriate, through adoption of standards proposed by 1 or more professional groups of accountants designated pursuant to paragraph (3) (A) or advisory groups convened pursuant to paragraph (4), and amend or otherwise modify or alter, such auditing and related attestation standards, such quality control standards, and such ethics standards to be used by registered public accounting firms in the preparation and issuance of audit reports, as required by this Act or the rules of the Commission, or as may be necessary or appropriate in the public interest or for the protection of investors” (P. L. 107–204).


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REFERENCES Abbott, A. (1988). The system of professions. Chicago: The University of Chicago Press. American Institute of Certified Public Accountants (AICPA) (1992). Auditing standards board resume. In Our Opinion, 8(2), 1–2. American Institute of Certified Public Accountants (AICPA) (1997). Statement on auditing standards No. 82. Consideration of fraud in a financial statement audit. New York: AICPA. American Institute of Certified Public Accountants (AICPA) (2002a). http://volunteers.aicpa.org/ handbook/groupDetail.asp?271 American Institute of Certified Public Accountants (AICPA) (2002b). Statement on auditing standards No. 95. Generally accepted auditing standards. New York: AICPA. Arens, A. (1993). An academic’s perspective of setting auditing standards. In: M. Usry (Ed.), Mary Ball Washington Forum Series in Accounting Education (pp. 36–47). Pensacola, FL: University of West Florida. Berton, L., & Ingersoll, B. (1990). Rep. Dingell to take aim at accountants, SEC, in hearings on profession’s role as watchdog. In: L. Berton & J. Schiff (Eds), The Wall Street Journal on Accounting (pp. 45–48). Homewood, IL: Dow Jones-Irwin. Carmichael, D., & Craig, J. (1994). The Auditing Standards Board at work-interviews with selected members. The CPA Journal (March), 40–45. Commission on Auditors’ Responsibilities (CAR) (1978). Report conclusions and recommendations. New York, NY: AICPA. Davidson, I., & Anderson, G. (1987). The development of accounting and auditing standards. Journal of Accountancy (May), 110–127. General Accounting Office (GAO) (1996). The accounting profession: Major issues: Progress and concerns. Washington, DC: GAO. General Accounting Office (GAO) (2002a). Accounting profession: Oversight auditor independence and financial reporting issues. Washington DC: GAO. General Accounting Office (GAO) (2002b). The accounting profession: Status of panel on audit effectiveness recommendations to enhance the self-regulatory system. Washington, DC: GAO. Ingersoll, B. (1991). House democrats question SEC’s role in guarding against audit failures. In: L. Berton & J. Schiff (Eds), The Wall Street Journal on Accounting. Homewood, IL: Dow Jones-Irwin. Kaplan, S., & Pany, K. (1992). A study of public comment letters on the auditor’s consideration of the going concern issue (SAS 59). Research in Accounting Regulation, 6, 3–23. Kinney, W. (1986). Audit technology and preferences for auditing standards. Journal of Accounting and Economics (March), 73–89. Landsittel, D., & Bedard, J. (1997). Consideration of fraud in a financial statement audit: A new AICPA auditing standard. The Auditors Report, 4–5. Marsh, H. (1988). Interview. The Internal Auditor (April), 34–39. Martens, S., & McEnroe, J. (1998). Interprofessional conflict, accommodation and the flow of capital: The ASB vs. the securities industry and its lawyers. Accounting, Organizations and Society, 23(4), 361–376. Martens, S., & McEnroe, J. (2001). Strategies for maintaining professional legitimacy claims: The case of SAS 82 (Working Paper). McEnroe, J. (1993). An analysis of comment integration involving SAS No. 54. Abacus (September), 160–178.

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McEnroe, J. (1994). An examination of voting behavior of the ASB. Journal of Accounting, Auditing, and Finance, 9(1), 117–147. McEnroe, J. (2000). The auditing standards board and the auditing standard-setting process. Internal Auditing (July/August), 25–31. McEnroe, J. (2002). An analysis of post expectation gap voting behavior by the ASB. Abacus (forthcoming). McEnroe, J., & Martens, S. (1998). An examination of the auditing standards promulgation process involving SAS No. 69. Journal of Accounting and Public Policy (17), 1–26. National Commission on Fraudulent Financial Reporting (Treadway Commission) (1987). Report of the National Commission on Fraudulent Financial Reporting. Oliphant, W. (1978). Report of the Special Committee of the AICPA to study the structure of the Auditing Standards Executive. New York: AICPA. Pitt, H. L. (2002). Public statement by SEC chairman: Regulation of the accounting profession (January 17). Washington, DC: SEC. P. L. 107–204, Sarbanes-Oxley Act of 2002. Previts, G. J., & Merino, B. D. (1998). A history of accountancy in the United States: The cultural significance of accounting. Columbus: Ohio State University Press. Robson, K., Willmott, H., Copper, D., & Puxty, T. (1994). The ideology of professional regulation and the market for accounting labor: Three episodes in the recent history of the U.K. accounting profession. Accounting Organizations and Society (19), 527–533. Smith, R., & Schroeder, M. (2002). Pitt’s SEC Plan for self-regulation of accountants may have pitfalls. Wall Street Journal (January 18), C15. The Panel on Audit Effectiveness (PAE) (2000). Report and recommendations. Stamford, CT: Public Oversight Board. Turner, L. E. (2001). Comment letter No. 1 to the Auditing Standards Board (June 4). U.S. Senate (1976). The accounting establishment. A staff study prepared by the Subcommittee on Reports, Accounting and Management of the U.S. Senate Committee on Governmental Operations, 94th Congress, 2nd Session. Government Printing Office, Washington, DC.

THE ORIGINS OF THE SEC’S POSITION ON AUDITOR INDEPENDENCE AND MANAGEMENT RESPONSIBILITY FOR FINANCIAL REPORTS Nathan Felker ABSTRACT Contemporary legislation recently enacted by Congress seeks to reinforce the responsibility for financial statements with the financial officers and executives of SEC registrants. This paper reviews the development of SEC policy and case law regarding the established and traditional view of such responsibility as it affects auditors and financial officers and executives of these companies. The Cornucopia Gold Mines (1936) and Interstate Hosiery Mills (1939) actions reflect the origins of long standing views as to the role and responsibility of executives and auditors.

INTRODUCTION The notions of auditor independence and management responsibility for company financial records have become fundamental principles in the SEC’s regulation of financial disclosure by covered firms.1 The enforcement action against Cornucopia Gold Mines (1936) would establish, early in the SEC’s regulatory existence, its position on the necessity for independent outside auditors to review a disclosing Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 45–60 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S1052045702160036

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company’s accounting work. Three years later, the Commission’s action against Interstate Hosiery Mills (1939) would affix on a disclosing firm’s management the ultimate responsibility for the integrity of the company’s financial statements, even if problems in those statements result from the work of the audit firm. The precedents developed in these actions would be cited repeatedly as the SEC considered similar matters in subsequent proceedings. Included below are detailed summaries of both enforcement actions, stating the basis of the SEC’s action, the relevant factual background, the SEC’s opinion and the ruling based on that opinion. Following each summary is a brief assessment of the opinion offered by the SEC as well as a citation history of the treatment given to these decisions by the SEC in subsequent actions and Commission pronouncements.

IN THE MATTER OF CORNUCOPIA GOLD MINES File No. 2-1200; 1 SEC 364 (March 28, 1936) Issue The action against Cornucopia Gold Mines was brought by the SEC under Section 8(d) of the 1933 Securities Act, regarding the effectiveness of Cornucopia’s registration statement. Specifically, the SEC alleged that Items 50, 54, & 55 of the registration statement filed by Cornucopia, as well as the prospectus which contained the same information, were deficient. The crux of the SEC’s argument was that the dual role of David Hill as both comptroller of Cornucopia as well as independent auditor for the company (as an employee of White and Currie) caused a failure of the independence requirement contained in the registration’s certification statement. Factual Background Cornucopia Gold Mines, which was incorporated in 1930 in Washington State, filed a registration statement under Form A-1 in November of 1934. The registration became effective on April 5, 1935. Cornucopia contracted with White and Currie, a local accounting firm to perform the audit of its books. According to the contract, White and Currie were to be paid $5,000 per year plus 1% of the annual metal sales. The contract included that, in addition to auditing services, White and Currie was to put in place an accounting system for Cornucopia and provide the company with office space. Finally, under the arrangement, David Hill, an employee of White and Currie, was made the comptroller of Cornucopia in December 1934. David Hill’s entire salary was paid by White and Currie. The record further showed that David

The Origins of the SEC’s Position on Auditor Independence

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Hill had purchased 1,760 shares of Cornucopia prior to filing of the Registration statement with the SEC. As comptroller, David Hill supervised employees doing accounting work as well as signed checks and mailings. In preparation of the registration statement, David Hill signed the statement as Comptroller of Cornucopia, however, he also performed the audit of the company’s Balance Sheet and Profit & Loss statements on behalf of White and Currie. The auditing firm then issued a certificate, as required under Schedule A (26) of the 1993 Act, stating that the financial statements had been audited by an independent certified accountant. SEC Proceedings and Opinion The SEC claimed that David Hill’s status as comptroller of Cornucopia as well as employee of White and Currie caused the auditor’s certificate, filed in connection with Cornucopia’s registration statement, to be false and misleading, as White and Currie was in fact not independent. The SEC reasoned that David Hill could not have disassociated himself from his role as the chief financial and accounting officer as well as shareholder of Cornucopia in performing the independent audit. The audit would have required that he inspect the company’s books and accounting practices with objectivity and be willing to criticize or correct problems that were detected – problems that he himself would have taken part in creating. Consequently, White and Currie could not be considered independent since Hill’s audit work in connection with the issuance of the auditor’s certificate was performed on behalf of the auditing firm. The SEC found that White and Currie further failed to establish its status as an independent auditor due to its interest in 1% of Cornucopia’s annual sales. The contract was held to create a continuing pecuniary interest in the registrant. Although such an interest does not per se cause an auditor to lose its objectivity, the interest in this case was material and substantial enough to disqualify the auditor’s objectivity. The SEC stated that a claim of this sort would give the holder too close an association with the financial performance of the company and cause too much personal concern with the management of Cornucopia to allow the holder to exercise the “objectivity which is the essence of an independent accountant.” The SEC rejected Cornucopia’s argument that even if certification of the registration statement was not issued by an independent auditor, it is of no consequence since the certificate itself is not a material fact – it is merely a tag attached to the financial statements signifying the propriety of the information within the statements. It was the SEC’s position that certification by an independent auditor is material “for it gives meaning and reliability to financial data and makes less likely misleading or untrue financial statements.” The real function of the 1933 Act’s insistence on certification by an independent auditor is

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the submission of the registrant’s accounting practices and policies to an impartial independent mind. This review provides a level of protection for investors against falsehoods and half-truths which could find their way into financial statements without such scrutiny. The history of finance demonstrates the need for this check against unsound accounting practices and support it provides for the truth of the financial condition of the enterprise. The SEC found that Cornucopia’s answer to Item 50 in the registration statement was also deficient in that it failed to list the interest in Cornucopia held by White and Currie. The language of Item 50 requiring that any expert or person (legal definition including corporations as well) employed by the registrant that is to receive an interest or payment from the registrant must be fully disclosed. In the opinion of the SEC, use of the term “employed” did not only include master and servant relationships but also independent contractors and, thus, included White and Currie. Therefore, White and Currie’s interest should have been included in Item 50. Ruling Therefore, the certificate’s assertion that the financial statements had been reviewed by an independent public or certified accountant, and that the relationship between White and Currie and Cornucopia was that of the usual relationship of independent auditor to its accountant were untrue statements of material fact sufficient to justify the issuance of a stop order denying effectiveness of Cornucopia’s registration statement under Section 8 of the 1933 Act. These deficiencies rendered the Balance Sheet and Statement of Profit and Loss included in the Registration Statement to be similarly deficient. Items 54 and 55 of Form A-1 require the filing of a Balance Sheet and Profit and Loss Statement. Schedule A requires that these Items be certified by an independent auditor. Since White and Currie and were not in fact independent, the statements submitted to the SEC did not comply with Schedule A and were, therefore, deficient. In issuing its final ruling, the SEC determined that it is not limited to review of the registration statement at the time of initiation of the proceedings and, therefore, allowed consideration of amendments filed by Cornucopia subsequent to the effective date of the registration statement, which cured the deficiencies. In light of Cornucopia’s resolution of the deficient registration statement, the SEC exercised its discretionary power and decided to dismiss the stop order proceedings in favor of Cornucopia.

Assessment of Auditor Independence There are a number of concepts dealing with auditor independence that resulted from the SEC’s opinion in Cornucopia (1936). The foremost is the importance


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of submitting financial statements for review by independent auditors in order to provide assurance to investors of the reliability and veracity of the information. With this opinion, audit firms and disclosing companies were now expressly aware that the SEC considered the certification of financial statements a substantial element of the financial disclosure and that audit firms should take notice of the significance that is attached to their signing it. Accompanying this concept are two somewhat related issues. The first is that an auditor who is both the outside reviewer of the company books, as well as the person in charge of preparing those books, cannot possibly give the sort of unbiased critical assessment that is required of an independent auditor. The second is where employees of the audit firm hold a pecuniary interest in the audit client which could cause them to become too concerned with the financial performance and management of the company. While this does not per se defeat the independence of the auditing firm, an interest that is “substantial and material” can be deemed to cause the individual auditor(s) to lose their objectivity, “which is the essence of an independent accountant.” This opinion would serve as the basis for the degree of separation between the auditing firm and client necessary for the auditor to be considered “independent,” an issue that has become extremely relevant in recent times. These principles would be cited a number of times over the decades following the action against Cornucopia Gold Mines, typically in situations where the importance of independent review is coupled with one or both of the cases where the auditor has conflicting positions. Citation History – Review of Disclosure Documents by an Independent Auditor (In reverse chronological order) In the Matter of KPMG Peat Marwick LLP c/o Michael Carrol, Esq. Davis Polk & Wardell, 450 Lexington Ave., New York, New York 10017 (January 19, 2001), Admin. Proc. File No. 3-9500, SEC, Securities and Exchange Act of 1934 Release No. 43862; Accounting and Auditing Enforcement Release No. 1360, 2001 SEC LEXIS 98. Cited for precedent that an audit firm having a substantial pecuniary interest in an audit client defeats the independent nature of the auditor. The requirement that the financial statements be audited and certified by independent auditors signifies the real function of submitting the financial statements to an impartial mind. The continuous flow of reliable financial data is critically important to the efficient function of the securities markets.

In the Matter of Dixie Land and Timber Corporation (Section 8(d) of the Securities Act of 1933, as amended) (June 23, 1966), Admin. Proc. File No. 3-215; 2-2278, SEC, 1966 SEC LECIS 2371. Cited for notion that the lack of independence of the auditor causes the representations made to that fact as well as the financial data in the registration statement to be false and misleading.

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Precision Microwave Corporation, Main Street, Mills, Massachusetts (January 11, 1963), File Nos. 2-18720 & 1-4583, SEC, 1963 SEC LEXIS 2451. In a matter involving auditor independence, quoted SEC’s opinion that certification by an independent auditor signifies the real function of which certification should serve – submission of financial data for review by an impartial mind.

In the Matter of Bollt and Shapiro, Theodore Bollt, and Bernard L. Shapiro, Proceeding Pursuant to Rule ii(e), Rules of Practice (January 28, 1959), SEC, Accounting Series Release (ASR) No. 82, 1959 SEC Lexis 1096, 38 SEC 815. Issuance of a certification by an independent auditor reflects the importance to investors and the public that the information had been audited by an outside auditor and not management.

In the Matter of Touche, Niven, Bailey, & Smart, et al., Proceeding Pursuant to Rule ii(e), Rules of Practice. (March 25, 1957), File No. 4-77, SEC, Accounting Series Release (ASR) No. 78, 1957 SEC LEXIS 1014, 37 SEC 629. The insistence by the 1933 Act that the financial statements be audited and certified by Independent auditors signifies the real function of submitting the financial statements to an impartial mind.

In the Matter of Associated Gas and Electric Company, Common Stock, $1 Par Value, and Class A Stock, $1 Par Value (August 4, 1942), No. 1610, File No. 1-1810, SEC, Securities and Exchange Act of 1934 Section 19(a)(2), 1942 SEC LEXIS 3051; 11 SEC 975. Cited for support that an auditor cannot be independent if a number of the auditors employees hold an interest in the audit client which is a substantial part of the client or the employees personal wealth.

In the Matter of Proceeding under Rule ii(e) of the Rules of Practice, to determine whether the privilege of Kenneth N. Logan to practice as an accountant before the Securities and Exchange Commission should be denied, temporarily or permanently. (January 8, 1942), SEC, 1942 SEC LEXIS 1942. Cited for the proposition that an interest in the audit client by employees of an audit firm that is so substantial with respect to the accountants net worth is sufficient to defeat the independence of the audit firm.

In the Matter of Proceeding under Section 19(a)(2) of the Securities and Exchange Act of 1943, as amended, to determine whether the registration of A. Hollander & Son, Inc. Capital Stock $5 par value, should be suspended or withdrawn (February 6, 1941), File No. 1-627, SEC, Securities and Exchange Act of 1934, Release No. 2777, 1941 SEC LEXIS 1465; 8 SEC 586. An auditing firm is precluded from being considered independent (as part of the Certification requirement) where it owns a pecuniary interest in the gross proceeds of the audit client.


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In the Matter of Rickard Ramore Gold Mines, Ltd. (June 16, 1937), File No. 2-2592, SEC, Securities Act of 1933, Release No. 1476, 1937 SEC LEXIS 986; 2 SEC 377. Cited as precedent in comparison of the ownership interest in the audit client with the level of independence required by an independent auditor.

In the Matter of American Terminals and Transit Company (September 29, 1936), File No. 2-1289, SEC, 1 SEC 701; 1936 SEC LEXIS 1759. Used to find that the relationship of the auditor to the registrant did not fall short of the measure of independence established by the SEC in Cornucopia gold Mines.

Assessment of Other Concepts Developed in Cornucopia Gold Mines While not as significant as the SEC’s opinion on auditor independence, there are a number of other positions that the action has been cited for. These include: (i) the materiality of the auditor’s certificate; (ii) the auditor’s certificate being subject to consideration for deficiency under §19(a)(2); (iii) the SEC’s discretionary power to consider, in its review, amendments filed after initiation of the proceeding; (iv) the requirement for including under Item 50 of Form S-1 an attorney who issues an opinion on a firm in connection with a registration filing and also owns stock in that firm; and (v) perhaps the most important of the ancillary issues, the materiality, substance and specific areas to be included in the auditor’s certification. Citation History – Various Concepts In the Matter of Military Robot Corporation (April 15, 1986), File No. 3-6493, SEC, Securities Act of 1933, 1986 SEC LEXIS 2356; 48 SEC 473. Cited as support for proposition that the materiality of the Auditor’s Certification of financial data has long been recognized.

Qualifications and Reports of Accountants; Proposed Amendment of Rules Regarding Independence of Accountants (October 14, 1982), SEC, Securities Act of 1933 Release Nos. 33-6430; 34-19137; 35-22668; IC-12738; S7-947 17 CFR 210, 1982 SEC LEXIS 673. Cited as an example for SEC’s position that enforcement actions are used to assure the integrity of the concept of Auditor Independence.

In the Matter of Miami Window Corporation. (June 21, 1962), File No. 2-14766, SEC, Securities Act of 1933, Section 8(d), Release No. 4503, 1962 SEC LEXIS 644; 41 SEC 68.

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NATHAN FELKER Deficiencies in certification are considerable under a Section 19(a)(2) review.

In the Matter of the Registration Statement of Kiwago Gold Mines Limited (No Personal Liability), 1102 Central Building, 45 Richmond Street, West, Toronto, Canada (March 31, 1948), File No. 2-6852, SEC, Securities Act of 1933, Section 8(d), Release No. 3278, 1948 SEC LEXIS 7; 27 SEC 934. Cited for discretionary power of SEC to consider amendments filed after initiation of proceedings.

In the Matter of Mica Corporation of America (August 15, 1941), File No. 2–4675, SEC, Securities Act of 1933, Section 8(d), Release No. 2636, 1941 SEC LEXIS 225; 9 SEC 889. Cited for precedent that the attorney who issued an opinion on Mica Corporation also owned 100 shares of the company and should have therefore been listed in Item 50 of the Registration Statement.

Independence of Accountants; Indemnification by Registrant (March 14, 1941), SEC, Securities Act of 1933, Release No. 2498; Securities and Exchange Act of 1934, Release No. 2820; Accounting Series Release No. 22, 1941 SEC LEXIS 1413; 11 FR 10922. Cited for the review of auditor independence in a stop order proceeding.

In the Matter of National Electronic Signal Company (November 6, 1940), File No. 2-4381, SEC, Securities Act of 1933, Section 8(d), Release No. 2387, 1940 SEC LEXIS 358; 8 SEC 160. Cited as reference for Rule 651 of the 1933 Act requiring that the certificate be reasonably comprehensive as to the scope of the audit, clearly state the auditor’s opinion on the financial statements, and indicate the accounting principles upon which they are based. The certificate in this case lacked these features and was, therefore, substantially deficient.

In the Matter of Callahan Zinc-Lead Company (September 26, 1939), File No. 2-1039, SEC, Securities Act of 1933, Section 8(d), Release No. 2061, 1939 SEC LEXIS 565; 5 SEC 1009. Cited for discretionary power of SEC to consider amendments filed after initiation of proceedings.

In the Matter of Queensboro Gold Mines, LTD. (November 17, 1937), File No. 2-2922, SEC, Securities Act of 1933, Release No. 1617, 1937 SEC LEXIS 893; 2 SEC 860. Cited for position that the full certification is one of substance and not easily satisfied.


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In the Matter of Equity Corporation (August 24, 1937), File No. 2-684, SEC, Securities Act of 1933, Release No. 1535, 1937 SEC LEXIS 876; 2 SEC 675. Cited for discretionary power of SEC to consider amendments filed after initiation of proceedings.

In the Matter of Condor Pictures, Inc. (May 11, 1937), File No. 2-2763, SEC, Securities Act of 1933, Release No. 1433, 1937 SEC LEXIS 971; 2 SEC 292. Review under a stop order proceeding is discretionary and the Commission is not limited to consideration of the registration statement at the time of filing.

IN THE MATTER OF INTERSTATE HOSIERY MILLS, INC. File No. 1-300; 4 SEC 706 (March 18, 1939) Issue This matter was brought before the SEC for a determination under Section 19(a)(2) of the 1933 Act on whether the stock of Interstate Hosiery Mills, Inc. should be suspended or delisted from the New York Curb Exchange. The SEC charged that the financial statements submitted to it by Interstate Hosiery Mills for 1934 through 1936 were false and misleading due to gross misstatements of financial data as well as the failure of the auditor and Interstate’s management to properly supervise and review the audit process. Factual Background Homes & Davis was a certified public accounting firm organized in 1917. Beginning in 1929, Interstate Hosiery Mills employed Homes & Davis for audit services in relation to preparation of various financial reports (annual, monthly, etc. . . .). Raymond Marien of Homes & Davis was responsible for reviewing and auditing Interstate’s books. In February 2, 1938, employees of Interstate discovered that Raymond Marien had forged two checks from Interstate’s bank account. Upon this discovery, Mr. Greenwald, VP for Interstate, made arrangements with Homes & Davis management to review the work done by Marien. After review of Marien’s work on Interstate’s books and financial statements for 1937, it was determined that there were discrepancies between Interstate’s books and balance sheet in the cash and accounts receivable items. On February 12, Interstate management notified the SEC and the New York Curb Exchange of the problems with its financial statements. In response, on February 15, the Exchange suspended trading of Interstate’s stock. After further review of Interstate’s financial statements, it became evident that from 1934 through 1936, the financial statements

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submitted to the SEC contained overstatements in operating profits and, resultantly, in cash, accounts receivable, and inventory & surplus. There were no problems with the financial statements filed by Interstate prior to 1934. SEC Proceeding and Opinion The SEC determined that Marien had been acting on his own in misstating the financial performance of interstate, therefore, the issues to be decided on were: (1) whether Homes & Davis had exercised due care in employing Marien and reviewing his work;2 and (2) whether the misstatements should have been discovered by Interstate’s management. In reviewing the circumstances of Marien’s employment by Homes & Davis, the SEC concluded that even though the auditing firm missed a forgery conviction in 1924, Marien came highly recommended and had more than adequate advanced education, earning two degrees from the University of Montreal. This was sufficient to justify Homes & Davis hiring Marien in 1928. As for supervision by Homes & Davis, the audit firm’s management supervised Marien’s work from 1928 until 1931. These managers found Marien to be competent, accurate, and conscientious. In 1931, Homes & Davis quit its supervision of Marien, but still reviewed his reports. The SEC then turned its inquiry to Marien’s audit procedures and the efforts by his supervisor, Phillips, to review the work. It was revealed that Phillips review consisted of reading the draft reports and working papers, asking question on unusual items and making any necessary corrections. The figures included in the financial statements were checked against the schedules, but the schedules themselves were not checked in detail. Phillips testified that his main role was to make sure that the audit had been performed, which he accomplished through review of the working papers and asking questions on the accuracy and consistency of reported information with the corporate records. With this level of review, there was nothing in the financial statements that would notify Phillips of the falsified figures in the profit and loss statement. In addition, Marien had also falsified data that may have indicated that there were problems with the profit and loss statements. Ultimately, Phillips’ review did not involve recalculations of the data used to determine the final statements but rather relied on Marien’s ability for accuracy. Expert witness testimony was solicited from other audit firms who testified that the review performed by Homes & Davis was not outside of the usual practice and that it is typical to not question figures that do not appear unreasonable or unclear. The expert witness audit firms also disclosed that the results of the audit are usually accepted without independently verifying the data. The SEC concluded that the review by Homes & Davis was not any less extensive than that ordinarily made by accounting firms. However, the SEC chastised the audit review process that was


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revealed through the witness testimony. As part of its criticism, the SEC stated that an audit review should not be a mere series of questions on basic procedures of the audit and nor should the reviewer accept responses to unusual items without supporting evidence from the working papers. The purpose of the audit review is to, first, insure integration of the original working papers with the financial statements and, second, to perform a searching analysis of the data yielded by the audit process. It was the SEC’s opinion that had the review been conducted with these principles in mind, it would have revealed the misstatements. The SEC concluded that the monthly reports that Marien was preparing were merely unaudited summaries of Interstate’s corporate ledger and that this sort of data preparation is not in any sense of the word an audit. Therefore, the auditor’s certificates furnished on these reports were false. It was also determined that Marien in fact had some participation in the bookkeeping of Interstate, which was against Homes & Davis’ rules and procedures. Not only did this defeat the audit firm’s independence, but also placed much of the responsibility for Marien’s fraudulent reports on Interstate’s management. Despite the fact that Homes & Davis failed to adequately review Marien’s work, it was with Interstate’s almost complete abdication of responsibility to confirm the correctness of the information where the SEC found the ultimate blame to lie. Of all the parties involved, Interstate’s employees and management had the greater knowledge of the hosiery business and the record indicated that it would have been relatively easy for Interstate’s management to discover the problems through a routine comparison of the reports furnished by Homes & Davis against its own records. A check of Interstate’s operating schedules and cost sheets against Marien’s reports would have disclosed the huge discrepancies; however, it appeared that this was never done. The SEC found unpersuasive Interstate’s assertion that Homes & Davis’ reports were filed too late for them to be of any benefit in comparing with Interstate’s internal records because the information that the reports were based on was outdated by the time the report was released. Regardless of this, the comparison would still have yielded important information on the accuracy of the financial data. This level of review did not only flow from a duty to test the accuracy but also from the obligation of the management to “use all available means of assuring the correctness of its public financial statements.” From this, the SEC concluded that the “fundamental and primary responsibility for the accuracy of information filed with the Commission and disseminated among the investors rests upon management.” Interstate’s management had not discharged its duty by contracting with Homes & Davis to review the company’s accounting, and, in the opinion of the SEC, Interstate’s conduct associated with the preparation of the financial statements submitted to investors, the New York Curb Exchange

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and the Commission was a “complete abdication of responsibility.” Since the SEC determined that Interstate’s management had been at fault, the Commission disregarded the company’s defense that the SEC may not under Section 19(a)(2) of the 1933 Act, suspend or withdraw a registrant’s securities due to violations of the Act that it was not party to. Ruling Although Interstate’s failure to adequately review and ensure the accuracy of its financial reports would have justified the SEC in suspending the registration of Interstate’s stock, the SEC concluded that the actions taken by the company after discovering the problems with its financial statements had mitigated its culpability. These actions included (i) immediately informing the SEC and the New York Curb Exchange of the problems; (ii) reauditing and amending the financial statements; and (iii) requiring management to return the excess compensation given on the inflated earnings. Due to these mitigating factors as well as the New York Curb Exchange’s willingness to reinstate Interstate’s stock, which had already been suspended from trading for one year, the SEC ruled that Section 19(a)(2)’s function of protecting investors by bringing to their attention “the seriousness of the misstatements and the negligence of management” had already been served, and, therefore, suspension or withdrawal of Interstate’s stock registration was not necessary. Assessment of Auditor Independence The SEC’s opinion in Interstate Hosiery Mills developed the principle that the duty to verify information presented to investors in the form of financial statements rests with management and cannot be passed-off to an independent auditor. Although the Interstate Hosiery Mills matter has only been cited three times, holding management responsible for materially false and misleading information contained in documents filed with the SEC and disseminated to investors, even when actually caused or produced by the auditing firm, is a hallmark of the SEC’s regulatory framework. Through this opinion, the SEC warned management that in preparing for disclosure, the duty to ensure the accuracy of the firm’s information does not end when the company’s records are given to an outside auditor who then prepares the final document. The financial statements belong to the disclosing firm and, as such, management is ultimately responsible for their content. Citation History – Management Responsibility for Financial Statements Commission’s Guidelines on Independence of Certifying Accountants; Example Cases and Commission’s Conclusions, (July 19, 1972), SEC, Securities Act of 1933 Release No. 5270, Securities Act of 1934 Release No. 9662, Public Utility


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Holding Company Act of 1935 Release No. 17636; Investment Company Act of 1940 Release No. 7264, Accounting Series Release No. 126, 1972 SEC LEXIS 2107; 37 FR 14294. In the Matters of Babcock & Co., 136 South Main Street, Salt Lake City, Utah, Louis W. Babcock, Robert Stead (June 19, 1970), Admin. Proc. File Nos. 3-1512 & 8-11902, SEC, Securities and Exchange Act of 1934, Sections 15(b) and 15A, Release No. 8905, 1970 SEC LEXIS 406; 46 SEC 350. Circumstances under which independent public accountants may properly express an opinion, and the form of such an opinion with respect to summary earnings tables to be included in registration statements under the Securities Act of 1933 (June 27, 1947), SEC, Accounting Series Release No. 62, Securities Act of 1933 Release No. 3234, 1947 SEC LEXIS 1419; 15 FR 9104. The enforcement action and two SEC pronouncements above directly quoted the opinion in Interstate Hosiery Mills that a disclosing firm’s management bears the fundamental and primary responsibility for the accuracy of information filed with the Commission and disseminated among investors. This duty is not discharged by employing an independent auditor to review the accounting work. Assessment of the Audit Process and Review Somewhat related to management responsibility for information contained in the financial statements is the SEC’s expression of what it considered to be a sound audit review. Clearly troubled by the procedures being employed by audit firm supervisors and management, the SEC expressed that a cursory review of the work is insufficient and that a proper inspection must make efforts to verify the data produced by the audit work as well as ensure the integration of the audit work into the final statements. This opinion put audit firms on notice of what the SEC would expect in terms of supervisory level review in the performance of all future audits. Citation History – Supervisory or Management Level Review of Audit Work In the Matter of Proceeding under Rule ii(e) of the Rules of Practice, to determine whether the privilege of Barrow, Wade, Guthrie & Co., Henry H. Dalton and Everett L. Mangam to practice as accountant before the Securities and Exchange Commission should be denied, temporarily or permanently. (April 18, 1949), SEC, Accounting Series Release (ASR) No. 67, 1949 SEC LEXIS 1319. Cited to support long established position of SEC that an auditing firm should have upper level supervision and detailed review of the work done by employees performing the audit.

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In the Matter of Red Bank Oil Company (January 4, 1946), File No. 2–5754 &; File No. 1-342, SEC, Securities Act of 1933, Section 8(d), Release No. 3110, Securities and Exchange Act of 1934, Sections 19(a)(2), Release No. 3770, 1946 SEC LEXIS 162; 21 SEC 695. Cited as precedent for auditing firm’s failure to undertake management or supervisory level review necessary to conduct a sound audit program.

Assessment of other Concepts Covered in Interstate Hosiery Mills Although not original to Interstate Hosiery Mills, the SEC opinions on expert witness testimony and auditor independence have been cited fairly often in subsequent enforcement actions and SEC pronouncements. Citation History – Expert Witness Testimony In the Matter of Ernst & Young, Cleveland, Ohio; Clarence T. Isensee, John F. Maurer (May 31, 1978), Admin. Proc. File No. 3-2233, SEC, Accounting Series, Release No. 248, 1978 SEC LEXIS 1452; 46 SEC 1234. In the Matter of Ernst & Young, Clarence T. Isensee, John F. Maurer, Rule 2(e) of the Rules of Practice, (October 21, 1975), Admin. Proc. File No. 3-2233, SEC, 1975 SEC LEXIS 2561. In the Matter of Ernst & Young, Clarence T. Isensee, John F. Maurer, Rule 2(e) of the Rules of Practice, (October 21, 1975), Admin. Proc. File No. 3-2233, SEC, 1972 SEC LEXIS 4257. In the Matter of Haskins & Sells and Andrew Stewart, File No. 4-66, (Rules of Practice – Rule ii(e)). SEC (October 30, 1952), SEC, 1952 SEC LEXIS 1062. All cited Interstate as precedent for the notion that expert witness testimony by auditing or accounting firms may be helpful, yet it is the responsibility of the SEC to evaluate the merit of the service or practice in question.

Citation History – Auditor Independence: Dual Role as Auditor and Bookkeeper Qualifications and Reports of Accountants; Proposed Amendments of Rules Regarding Independence of Accountants; (October 14, 1982), SEC, Securities Act of 1933 Release Nos. 33-6430; 34-19137; 35-22668; IC-12738; S7-947 17 CFR Part 210, 1982 SEC LEXIS 673. Cited as support for the difference between the SEC and AICPA rules on independent auditors performing both auditing and bookkeeping services. The SEC’s position, stated in Interstate Hosiery Mills, is that independent auditors should not do bookkeeping for audit clients.


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In the Matter of Precision Microwave Corporation, Main Street, Mills, Massachusetts (May 22, 1964), File Nos. 2-18720 & 1-4583, SEC, Securities Act of 1933, Section 8(d), Release No. 4694, Securities and Exchange Act of 1934, Sections 19(a)(2), Release No. 7319, 1964 SEC LEXIS 506; 41 SEC 971. In a case involving an auditor who also served as comptroller of the audit client, Interstate cited for the notion that this sort of relationship is inconsistent with the objectivity required by independent auditors.

In the Matter of Christina Copper Mines, Inc., (May 1, 1952), File Nos. 2-8487, SEC, Securities Act of 1933, Section 8(d), Release No. 3439, 1952 SEC LEXIS 7; 33 SEC 397. In a case where an auditor helped maintain the audit client’s books and records, Interstate cited for the notion that this sort of relationship is inconsistent with the objectivity required by independent auditors.

Form of Accountants’ Certificate (February 20, 1940), SEC, Accounting Series Release No. 13, 1940 SEC LEXIS 1537; 11 FR 10916. Although not in issue in this matter, SEC referred to the independence of the auditor being jeopardized when employees of the Auditing Firm prepare the company ledger or perform accounting work which is treated as a substitute for management’s own accounting.

CONCLUDING COMMENTS Although citation of the precedents developed in Cornucopia and Interstate Hosiery has fallen off over the last several decades, it is perhaps the case that the more recent enforcement actions and SEC pronouncements that utilized Cornucopia and Interstate Hosiery have become the more recognized embodiments of the principles developed in these two hallmark cases. What is clear, however, is that the concepts of auditor independence and management bearing the ultimate responsibility for a company’s financial statements are as important and fundamental today as they were when first pronounced by the SEC, perhaps more so in light of the recent Enron and World Com debacles. It is no surprise, therefore, that when Congress proposed the Sarbanes-Oxley Act as a corrective measure in response to these significant accounting failures (along with others experienced throughout the later part of 2001 and the first half of 2002) it included provisions which would strongly reinforce the positions taken by the SEC nearly 70 years ago. The final Act as passed by Congress and signed into law by President Bush at the end of July, 2002, requires that the CEO’s and CFO’s of all Covered Companies certify to the SEC the accuracy of the company’s financial reports, while attaching enhanced criminal penalties for knowing or

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willful violations related to the reports. In terms of auditor independence, the Act imposes greater restrictions on the type of additional services that an audit firm can perform for a client “contemporaneously” with audit work, and creates the Public Company Accounting Oversight Board, organized as a non-profit entity under the supervision of the SEC to oversee firms that audit public companies. With the Act applying to companies who file registration statements under the 1933 Act and periodic reports under the 1934 Act, the SEC will serve as the oversight and enforcement agent for the Act’s regulatory provisions. Thus, it may be that the Sarbanes-Oxley Act will further supplant use of the Cornucopia Gold Mines and Interstate Hosiery Mills opinions, yet it is certain that the importance of the principles developed in these actions will continue to play a central role in ensuring the stability of the U.S. capital markets.

NOTES 1. “Covered firms” used to refer to companies under the reporting requirements of the Securities Act of 1933 and the Securities and Exchange Act of 1934. 2. The Auditor was a proper party in this hearing to determine whether its certificates filed with the statements were false.

AUDITOR LIABILITY: A REVIEW OF RECENT CASES INVOLVING GENERALLY ACCEPTED ACCOUNTING PRINCIPLES AND GENERALLY ACCEPTED AUDITING STANDARDS Scot P. Gormley, Thomas M. Porcano and Wayne Staton ABSTRACT The Securities and Exchange Commission (SEC), the primary regulatory body that oversees the operations of the financial markets, requires that publiclytraded companies be subject to an annual audit – a set of procedures designed to determine whether a firm’s financial statements fairly comply with generally accepted accounting principles (GAAP). When performing audits, auditors use generally accepted auditing standards (GAAS) as guidelines in determining the amount of evidence to gather and to what degree the client’s accounting system may be relied upon. Since investors and their advisors rely on audited financial statements to make investment decisions, auditors have a significant impact on the financial


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community and capital markets. Accordingly, auditors must be diligent in the execution of their duties. However, notwithstanding the high level of care exercised by most auditors, sometimes misleading or erroneous information is released to the investing public, and this article focuses on recent case law dealing with the auditor liability that attaches in such situations.

LIABILITY UNDER THE SECURITIES EXCHANGE ACT OF 1934 A survey of recent case law shows that most of the cases involving plaintiffs’ claims against auditors are based on the Securities Exchange Act of 1934 (the 1934 Act) and the regulations prescribed thereunder. Section 10(b) of the 1934 Act provides that it is unlawful “to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] . . . may prescribe.” Additionally, SEC Rule 10b-5 is the primary interpretive pronouncement that is cited in Section 10(b) claims. Similar to Section 10(b), Rule 10b-5 makes it unlawful for any person to do any of the following (either directly or indirectly): . . . employ any device, scheme, or artifice to defraud, . . . make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or . . . engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Basic Requirements for Section 10(b) and Rule 10b-5 Claims Although Section 10(b) and Rule 10b-5 were designed to protect investors from fraudulent activity on the part of investees, the provisions are not meant to be means of investor insurance whereby investors would be entitled to reimbursement for every instance of stock value decline. Instead, through common law a four-element test has emerged that plaintiffs generally must meet in order to sustain securities fraud claims under Section 10(b) and Rule 10b-5. In the majority of the Circuit Courts, plaintiffs must establish that: (1) the defendant made false statements or omitted material facts; (2) the defendant acted with scienter; (3) the plaintiffs justifiably relied upon the defendant’s false statements; and (4) the false statements proximately caused the plaintiffs’ injury. Discussed below are the elements of the test that generate the most debate – scienter and causation.

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Scienter As applied to Rule 10b-5, “scienter” refers to a mental state embracing intent to deceive, manipulate or defraud.1 For plaintiffs to establish a meritorious claim that defendants acted with scienter, the plaintiffs must show that the defendants’ conduct was so unreasonable that it lacked the care that ordinarily would be taken by a reasonable person in the defendant’s position.2 This type of conduct usually results in obvious fraud about which the defendant reasonably must have known.3 Additionally, the conduct must have been so grossly negligent as to be tantamount to actual intent to aid a client in perpetrating fraud.4 Causation Causation is present when it can be shown that an act was the cause of some event that happened later in time. To satisfy Section 10(b), plaintiffs must demonstrate both transaction causation and loss causation. Transaction causation. Transaction causation (also known as “but for” causation), is demonstrated when plaintiffs can show that, in making decisions to purchase a firm’s debt securities or equity securities, the plaintiffs relied on the firm’s erroneous financial statements and would not have purchased the securities if the firm had disclosed its true financial condition in its financial statements.5 When material errors exist in financial statements (and auditors nonetheless fail to issue qualified opinions) transaction causation automatically is established so long as the Supreme Court’s fraud-on-the-market theory applies.6 Under the fraud-on-the-market theory, there is a dual presumption that: (1) purchasers rely on an open, well-developed, and efficient market for purchasing stock; and (2) most publicly available information is reflected in the market price of debt and equity securities. For purposes of Section 10(b) and Rule 10b-5 actions, it is presumed that investors rely on material public misrepresentations when making decisions to purchase debt or equity securities. Thus, although under Section 10(b) transaction causation generally is easier to establish than loss causation, in order for the presumption of transaction causation to attach, plaintiffs must establish that the fraud-on-the-market theory validly applies. As shown in Zucker v. Sasaki,7 mere “fraud by hindsight” is insufficient to support Section 10(b) claims. Zucker involved Cygne Designs (Cygne), a designer and manufacturer of clothing that made ill-fated purchases of two other clothing manufacturers (FW&M and GJM). Prior to making the purchases, Cygne made public statements that the transactions would result in higher earnings and profits for Cygne, and Cygne made a secondary common stock offering of 2.3 million shares to raise cash for the purchases. Ultimately, the acquisitions of FW&M and GJM resulted in substantial losses for Cygne; consequently, the firm’s stock prices plummeted.

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As a result, a plaintiff class of Cygne’s shareholders filed a Section 10(b) complaint, asserting that Cygne and Ernst and Young (E&Y), Cygne’s independent auditor, had misled the investing public. Specifically, the plaintiffs claimed that, at the time that Cygne was considering purchasing FW&M, Cygne was aware that FW&M was in financial distress and that the purchase price and capitalized goodwill amounts were unrealistic. Additionally, the plaintiffs claimed that E&Y had taken affirmative steps to further Cygne’s fraud by: (1) failing to disclose the potentially adverse effects that the FW&M acquisition could have on Cygne’s earnings; and (2) intentionally choosing to treat Cygne’s later sale of an FW&M division as a subsequent event to avoid disclosing the negative financial impact of the transaction. In its discussion, the District Court found the plaintiffs’ complaint to be insufficient under Section 10(b). Noting that there was no indication that E&Y had attempted to deceive investors (the plaintiffs offered no facts to support an inference that E&Y had actual or constructive knowledge of the unreasonableness of the goodwill or its associated amortization period), the court determined that E&Y’s treatment of Cygne’s FW&M acquisition was appropriate. In its analysis, the court characterized the plaintiffs’ argument as “fraud by hindsight.”8 Second, consistent with the Second Circuit’s ruling in Denny v. Barber,9 the District Court disallowed the plaintiffs’ claim that E&Y intentionally had chosen to treat a fiscal year 1994 transaction as a subsequent event so as to avoid revealing the negative financial impact of the transaction. This was the case because the 1994 auditor’s report was issued after the plaintiffs’ final stock purchases. Therefore, the court reasoned that the plaintiffs could not possibly have relied on the allegedly false statements in making their stock purchases. Accordingly, the District Court found that the plaintiffs’ claims failed to meet the requirements of Section 10(b) because the plaintiffs could not rely on the presumption of reliance that accompanies the fraud-on-the-market theory. Loss causation. The second part of the causation requirement, loss causation, has a relatively high burden of proof in most courts. Historically, the Second,10 Fourth,11 Fifth,12 Sixth,13 Seventh,14 and Eleventh15 Circuits have required plaintiffs to allege facts demonstrating a causal connection between their loss and the material representation.16 For example, in a recent case, the Eleventh Circuit explicitly provided that the mere fact that a defendant’s representation led to artificial inflation of stock prices does not satisfy loss causation requirements.17 Accordingly, in most circuits plaintiffs must establish that their losses were proximately caused by material misrepresentations in a given firm’s financial statements. However, although the application of the loss causation standard generally requires plaintiffs to establish causation, this is not a uniform rule in all the Circuits.

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Instead, the Eighth18 and Ninth19 Circuits depart from the majority view and assume that loss causation exists when plaintiffs assert the fraud-on-the-market theory. Accordingly, to establish viable Section 10(b) claims in Eighth and Ninth Circuits, plaintiffs merely need to demonstrate that material misstatements were disseminated to the investing public, and on the date of their purchases the plaintiffs paid artificially inflated prices for the securities because of the defendant’s fraudulent misrepresentations.20 Although the majority of the Circuits requires a more explicit demonstration of proximate causation than that required by the Eighth and Ninth Circuits, that is not to say that the appellate court majority requires plaintiffs to show that the defendants’ actions solely were responsible for the plaintiffs’ losses. Instead, the majority viewpoint acknowledges that many factors affect the market values of debt and equity securities and that it would be virtually impossible for plaintiffs to isolate and identify all such factors. Accordingly, in cases where plaintiffs can show that a defendant’s actions substantially contributed to the plaintiff’s loss, the appellate court majority will consider the loss causation requirement as being met.21 Determining plaintiffs’ damages. When determining the monetary damages that plaintiffs may seek from Section 10(b) and Rule 10b-5 actions, 15 U.S. C. section 78bb(a) provides that plaintiffs may recover actual damages, and courts generally apply an “out-of-pocket rule”22 to determine such damages. Under the out-of-pocket rule, plaintiffs’ damages are measured as the difference between the price paid and the actual fair market value of the securities in question absent the fraudulent misrepresentation that compelled the investors to purchase the stock.23 However, when determining the damages that may be recovered by plaintiffs, all factors other than the defendant’s actions that contributed to the plaintiff’s loss must be removed from consideration.24 Additionally, it should be noted that in the majority of the Circuits, proof of damages under the out-of-pocket rule does not establish loss causation; instead, loss causation must be established independently.25 Applying the causation requirements to cases involving accounting firms. The establishment of causation is fact specific; therefore, it is difficult to define a common set of criteria that will establish causation for any particular group of defendants. However, common law does provide some guidance. For example, the Second Circuit has held that plaintiffs meet their burden of establishing both transaction causation and loss causation when the plaintiffs can show that an accounting firm helped to further a client’s fraud by willfully violating GAAP and GAAS by preparing false and misleading financial statements opinions and by failing to update those opinions.26 Nonetheless, recent case law indicates

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that there is still a significant burden that plaintiffs must meet in establishing causation. This was illustrated in two recent cases (Robbins v. Koger Properties27 and Ausa Life Insurance Co. v. Ernst & Young28 ) in which the plaintiffs failed to establish causation as required by Section 10(b) and Rule 10b-5. Robbins v. Koger Properties involved Koger Properties (KPI), a publicly-traded commercial real estate construction and management company and Koger Equity (KE), a company in which KPI had a 20% equity interest. In their complaint, the plaintiffs argued that they sustained losses in their investments in KPI’s stock due to KPI’s false and misleading accounting methods. Specifically, the plaintiffs alleged that KPI violated GAAP by improperly recognizing revenue and by improperly capitalizing several types of costs – thereby inflating earnings and creating the illusion that KPI’s operations generated sufficient cash to sustain the company’s steadily-increasing quarterly dividend payments. The plaintiffs alleged that they had relied on the company’s increasing trend of dividend payments when assessing the value of KPI’s stock. That is, the investors assumed that KPI’s operating revenues were sufficient to cover the dividend payments. Despite outward appearances, KPI’s financial condition was dire. KPI did not use operating revenues to finance its dividend payments; instead, KPI financed its dividend payments by liquidating non-inventory real estate.29 In late 1990, KPI management bowed to the inevitable and reduced quarterly dividends per share from $0.70 to $0.25. Consequently, KPI’s stock price dropped an average $10.05 per share, and its shareholders suffered significant losses. In the surviving portion of the plaintiffs’ complaint,30 the plaintiffs asserted the fraud-on-the-market theory and charged Deloitte & Touche (D&T) with violations of Section 10(b) and SEC Rule 10b-5. The plaintiffs asserted that, despite D&T’s knowledge of many of KPI’s GAAP violations, D&T nonetheless gave unqualified audit opinions for the years at issue and thereby proximately caused the plaintiffs’ losses. For example, D&T was aware that KPI had capitalized interest payments in contravention of GAAP. D&T initially insisted that KPI record the payments as interest; however, D&T eventually abandoned this tactic. Additionally, for the years 1989–1990, D&T informed KPI that its practice of capitalizing “lease up” costs was proscribed by GAAP. However, KPI refused to correct its accounting methods with respect to these costs, and D&T nonetheless issued unqualified audit reports. Finally, the plaintiffs presented testimony of an expert witness who identified other instances in which D&T had tacitly approved of improperly capitalized indirect property costs by KPI.31 Taken as a whole, the plaintiffs argued that, by allowing KPI to continue its non-GAAP accounting methods, D&T misled

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investors into believing that KPI’s cash flow was sufficient to support its increasing dividend payment level. In District Court, a jury held D&T liable for damages of $10.05 per share (a total of $81,338,647). In making this determination, the jury apparently was influenced by an expert witness who opined that KPI would have been forced to cut its dividends at a much earlier date if D&T had insisted that one of KPI’s primary financial statements, the statement of cash flows, had been restated to reflect reality. D&T appealed to the Eleventh Circuit, arguing that the plaintiffs had failed to meet the loss causation threshold for Section 10(b) actions because the plaintiffs failed to show that D&T’s conduct was the actual cause of the plaintiffs’ losses. The Eleventh Circuit agreed – thereby reversing the District Court’s ruling and rendering judgment for D&T. The Eleventh Circuit found that the plaintiffs had presented sufficient evidence that could lead a jury to conclude that D&T’s misrepresentations led to artificiallyinflated stock prices (the plaintiffs showed they were led to purchase KPI stock based on their reliance on KPI’s erroneous financial statements). However, the Eleventh Circuit ruled that such a showing was insufficient to meet the loss causation requirement for a Section 10(b) claim. Additionally, the Eleventh Circuit found that the plaintiffs had failed to present any other evidence suggesting that their loss was due to D&T’s misrepresentations. As factors in the determination, the court noted that in 1991 KPI corrected improper operating revenue amounts that were recorded in earlier periods and in 1992 charged an adjustment for amounts that were previous overcapitalized. The court reasoned that since these events occurred well after the $10.05 per share average drop in stock prices, the plaintiffs could not have been harmed by the existing errors in the financial statements. That is, the investing public was unaware of the errors; therefore, a drop in stock prices could not have been attributable to the errors. The court also noted that KPI’s board made the decision to reduce quarterly dividends based on concerns about future financing to support sales of properties – not because of any accounting errors that resulted in overstated cash flows. In a second recent causation case, Ausa Life Insurance Co. v. Ernst & Young,32 the District Court found that the plaintiffs had likely failed to establish transaction causation and definitely had failed to establish loss causation. The court also noted that there might be different reliance standards that should be applied for equity investors (stockholders) as compared to debt investors (note holders). In Ausa Life, a plaintiff group of insurance companies that purchased debt instruments from JWP (a regulated water utility) filed claims against E&Y – JWP’s independent auditor. In their complaint, the plaintiffs charged that E&Y had issued clean audit opinions for JWP financial statements which failed to disclose JWP’s

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true operating condition after JWP undertook an aggressive and ill-fated campaign of expansion through the purchase of diverse business interests. Ultimately, JWP was forced into bankruptcy. Accordingly, the value of the debt instruments (notes) held by the plaintiffs plummeted, and the plaintiffs suffered approximately $100 million in losses after selling their notes at heavy discounts. In the complaint against E&Y, the plaintiffs argued that when making their decisions to purchase the debt securities, they relied on JWP’s annual reports (which included unqualified audit opinions by E&Y) and on annual assurance letters prepared by E&Y and issued to debtholders. JWP’s financial statements were misstated because they included a variety of GAAP violations. E&Y was aware of JWP’s GAAP violations, but E&Y nevertheless issued clean audit opinions for 1987–1990 – the main years at issue. In certain instances, there was apparent justification for E&Y not requiring amounts to be restated. In other instances, E&Y erroneously concluded that JWP’s practices conformed to GAAP. In still other instances, E&Y was aware of GAAP violations and requested that JWP correct the erroneous accounting entries; however, in these cases JWP refused to make correcting entries, and E&Y nonetheless issued clean audit opinions. In its analysis, the District Court acknowledged that E&Y was aware of JWP’s misstatements. Furthermore, the court ruled that, although it would be virtually impossible to calculate the exact amount of the understatement caused by the GAAP violations, it was clear that the understatements were of a sufficient magnitude to be considered significant by reasonable investors. The court also found that the plaintiffs had relied on the financial statements and assurance letters when making their decisions to purchase the debt securities. Accordingly, the reliance criterion of the Section 10(b) test was satisfied. However, the District Court did not make a definitive ruling on the transaction causation issue because the plaintiffs’ claims clearly failed the loss causation test.33 In ruling on the loss causation requirement, the District Court found that JWP’s bankruptcy and corresponding inability to meet obligations due to the plaintiff noteholders was primarily due to JWP’s failed business activities – the most notable of which was the purchase of Businessland, a computer retailer which faced severe financial distress at the time at which JWP acquired it. Accordingly, the court found that JWP’s inability to pay amounts owed to the plaintiff noteholders was due to unforeseeable post-audit events and not due to any misstated amounts on JWP’s financial statements. Additionally, the court noted that virtually all of JWP’s GAAP violations affected JWP’s accounting income but had a negligible effect on JWP’s cash flow. Thus, the misstatements present in JWP’s financial statements did not affect JWP’s ability to meet its obligations to the plaintiff debtholders.

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Statute of Limitations on Section 10(b) Claims In accord with the Supreme Court’s 1991 ruling in Lampf, Pleva, Lipkind & Petigrow v. Gilbertson,34 plaintiffs who seek recovery under Section 10(b) must commence their actions within one year after discovery of the facts constituting a defendant’s Section 10(b) violation and within three years after such defendant’s violation. In interpreting these requirements, the Second Circuit has ruled that a plaintiff’s constructive notice must also be included when determining if an action properly falls within the limitation period.35 In determining the point at which constructive notice attaches to defendants, the Second Circuit applies a reasonable person standard: when circumstances would cause investors of ordinary intelligence to suspect they have been defrauded, the investors have the duty to inquire about the nature of their investments. Failure to make such inquiries will result in the court imputing notice of the fraud to the investors. However, based on the distinctly different needs of equity investors and debt investors, some courts make a distinction between equity investors (individuals mainly concerned with the earnings prospects of companies) and debt investors (creditors primarily concerned with investee companies’ ability to meet contractual interest payments) with respect to the point at which constructive notice attaches. That is, equity investors may be considered to have a duty of inquiry (and thus have constructive notice of potential problems) at times during which the investee’s stock value drops. By contrast, constructive notice does not necessarily attach to debt investors in similar situations. For example, the filing of a class-action lawsuit by corporate shareholders is not necessarily a triggering event that affects debtholders because debtholders may suffer no loss so long as the investee continues to make its periodic interest payments. Accordingly, in Ausa Life Insurance Co. v. Ernst & Young36 the District Court disallowed a defendant’s claim that the plaintiffs’ motion should be dismissed because it violated the statute of limitations. The court ruled in this manner because it considered the filing of a number of class-action Section 10(b) lawsuits against a debtor corporation and its independent auditors insufficient notice to trigger an inquiry duty on the part of the plaintiff debtholders.

Pleading Standards of Fed. R. Civ. P. 9(b) [Rule 9(b)] When analyzing the common law dealing with Section 10(b) and Rule 10b-5 actions, it becomes abundantly clear that procedural rules (especially the Federal Rules of Civil Procedure) often determine the ultimate disposition of individual

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cases. Of the cases surveyed, Rule 9(b) was the most dominant, as the following discussion illustrates. Because securities fraud claims under Section 10(b) require proof of scienter, the claims are subject to Rule 9(b)’s pleading requirements. Generally speaking, Rule 9(b) exists to provide defendants with fair notice of plaintiffs’ claims so the defendants may prepare an adequate defense, to protect defendants against harm to their reputation, and to reduce the potential number of strike suits that might be filed against defendants.37 Rule 9(b) sets forth a two-pronged pleading standard which plaintiffs must satisfy in order to sustain a Section 10(b) securities complaint: (1) the complaint must be stated with “particularity”; and (2) allegations of scienter must be established in the complaint. A description of the detailed requirements follows. Particularity of the Complaint Rule 9(b)’s first prong requires that “the circumstances constituting fraud or mistake shall be stated with particularity.” There has been some debate as to what constitutes “particularity,” but the Second Circuit has indicated that for plaintiffs to meet the particularity threshold, they must specify the allegedly fraudulent statements, identify the speaker, state where and when the statements were made, and explain why the statements were false or misleading.38 By contrast, there appears to be a lower threshold for meeting Rule 9(b) in the Seventh and Ninth Circuits. For example, in Cooper v. Pickett,39 the Ninth Circuit overturned the District Court’s earlier ruling that a plaintiff’s complaint failed to meet the Rule 9(b) particularity threshold. Cooper v. Pickett involved the Merisel corporation – a distributor of computer products and services. In late 1993, the trading value of Merisel’s stock was $14.50 per share. In February 1994, Merisel announced its purchase of a related business (Computerland). By March 24, 1994, the trading value of Merisel’s stock had risen to $22.50 per share, and this increase primarily was due to Merisel’s reported year-end results for 1993 combined with favorable securities analysts’ reports.40 Early in 1994, Merisel announced a planned secondary common stock offering to finance the debt associated with the Computerland acquisition. However, just prior to the planned date of the offering, Merisel announced that its profits had fallen; subsequently, the company’s stock prices fell, and the company canceled the planned stock offering. Merisel’s trend of decreasing profitability continued through the second quarter of 1994, and in June of 1994 the stock value declined from $17.50 per share to $8 per share. After the rapid decline of Merisel’s stock value, Merisel’s shareholders filed a class action lawsuit alleging that certain Merisel corporate officers, D&T (Merisel’s independent auditor), and certain securities analysts had colluded in a scheme to

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defraud Merisel’s shareholders. Specifically, the plaintiffs alleged that, for fiscal year 1993, Merisel had violated GAAP by recording sales revenue for shipments of merchandise that customers did not order as well as other merchandise for which customers had an unlimited right of return.41 Alleging that D&T deliberately or recklessly failed to follow GAAS in conducting the Merisel audits, the plaintiffs also directed Section 10(b) and Rule 10b-5 complaints against D&T because D&T issued unqualified audit opinions on Merisel’s financial statements for 1993 and the first quarter of 1994 even though D&T allegedly had reason to know of Merisel’s true business condition. In January of 1995, the defendants filed a motion to dismiss the plaintiffs’ complaint. Finding that the plaintiffs’ claims constituted broad allegations that lacked the particularity required by Rule 9(b), the District Court granted the defendants’ motion and accordingly dismissed the plaintiffs’ claims with prejudice.42 On appeal, the Ninth Circuit – while mindful of the Supreme Court’s Central Bank liability limitation rules with respect to aiding and abetting securities fraud43 – found that Merisel might be liable if it released false information to the securities analysts that ultimately misled investors. The Ninth Circuit found that Central Bank did not apply because the allegedly false statements were made directly by Merisel and were intended to be communicated to the stock market. In this case, the Ninth Circuit distinguished between a conspiracy, under which defendants are not liable for Rule 10b-5 violations per Central Bank, and a scheme, in which defendants may be liable for Rule 10b-5 violations. Since in this case the defendants were alleged to have directly participated in a scheme to defraud investors, the Ninth Circuit ruled that Central Bank did not apply. As for particularity, the Ninth Circuit overruled the District Court and found that the plaintiffs’ complaint was sufficient under Rule 9(b). In applying its GlenFed44 test, the Ninth Circuit noted that “Merisel’s financial house . . . was built on a landfill.” With respect to the alleged GAAP violations, the Ninth Circuit found that the plaintiffs’ complaint had sufficient particularity despite the plaintiffs’ inability to identify any single transaction that led to improper revenue recognition. In its ruling, the Ninth Circuit applied the following Seventh Circuit rule (see DiLeo v. Ernst & Young45 ): to show that fraud exists, details of specific fraudulent transactions need not be identified; instead, plaintiffs merely need to identify “who, what, where, when, and how”46 the alleged fraud was perpetrated. In the instant case, the plaintiffs identified specified customers who were overshipped merchandise, specific fiscal quarters of the alleged revenue overstatements, and specific overstatement amounts; thus, the plaintiffs were considered to have alleged the fraud with sufficient particularity so that the defendants could prepare an adequate answer. Accordingly, the Ninth Circuit allowed the plaintiffs’ claim to stand against Merisel, the securities analysts, and D&T, but the court refrained

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from ruling on the evidence because discovery had not yet occurred when the case was dismissed by the District Court at the trial level. With respect to D&T, the Ninth Circuit noted that the plaintiffs met the particularity requirements because their complaints named specific customers who were alleged to have received shipments for which improper revenue recognition techniques were employed and for which D&T knowingly “certified” financial statements including the false revenue figures.47

Establishing Knowledge and Intent Rule 9(b)’s second prong provides that “malice, intent, knowledge, and other condition of mind of a person may be averred generally.” Historically, this prong of the standard has been highly controversial. Through case law, a majority position (first established by the Second Circuit) emerged for determining the adequacy of plaintiffs’ complaints. Under the majority position, plaintiffs were required to allege facts that would give rise to a strong inference of scienter. Plaintiffs could create such an inference either: (1) by alleging facts demonstrating a motive for committing fraud and a clear opportunity to do so;48 or (2) by identifying circumstances indicating conscious or reckless behavior by the defendant.49 However, the Ninth Circuit rejected the Second Circuit’s “strong inference” test and instead concluded that fraud may be averred generally. Accordingly, in the Second Circuit plaintiffs were not required to identify specific facts that gave rise to an inference of scienter.50 Thus, a split of opinion among the appellate courts existed for some time. In response to this split, and to alleviate abuses in private securities lawsuits (Congress was concerned about the abuse of the discovery process in imposing costs so burdensome that it was often more economical for victimized parties to settle),51 Congress enacted the Private Securities Litigation Reform Act of 1995 (the PSLRA)52 to develop uniform pleading standards.53 (President Clinton initially vetoed PSLRA, but Congress subsequently overrode his veto.) However, the PSLRA may have failed to achieve its purpose. For example, in a recent District Court case, In re Health Management, Securities Litigation,54 the plaintiffs unsuccessfully argued that the PSLRA abrogated the Second Circuit’s alternative motive and opportunity or recklessness test. In denying the plaintiffs’ argument, the Health Management court noted that in the PSLRA, Congress essentially adopted the Second Circuit’s “strong inference” pleading standard in that the PSLRA explicitly requires that scienter claims under Section 10(b) must plead with sufficient particularity. However, the PSLRA does not clearly define what facts suffice to establish a strong inference of fraudulent intent. Thus, such a determination is still within the purview of the courts.

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The belief that PSLRA produced more restrictive discovery rules led plaintiffs to file parallel actions in federal and state courts because of the less-restrictive discovery rules at the state level. Concern about such actions was a major factor behind the passage of the Securities Litigation Uniform Standards Act of 1998 (SLUSA). SLUSA effectively precludes litigation of major securities class actions in state courts. Since its enactment, there have been at least 40 cases involving SLUSA (although none deal with alleged GAAP violations). In those cases, the courts generally have upheld the preclusion of a state court action when the allegations involved securities fraud violations. However, two exceptions remain, and, therefore, do not preempt a state court from hearing the case. An exclusively derivative action brought by one or more shareholders on behalf of a corporation is not preempted, and the availability of state court class actions is preserved where state law already provides that corporate directors have fiduciary disclosure obligations to shareholders. These two exceptions are known as “Delaware carve-outs.”55 Accordingly, despite the uniformity that Congress sought to achieve by enacting the PSLRA, case law illustrates that an on-going debate surrounds the proper interpretation of the PSLRA’s pleading requirements. Some District Courts have held that plaintiffs need only show circumstantial evidence that a defendant acted consciously to satisfy the PSLRA’s pleading requirements.56 Some assert that the muddled legislative history of PSLRA, with conflicting expressions of legislative intent, has contributed to disagreement in interpreting and applying PSLRA.57 Other District Courts have adopted an approach akin to the Second Circuit’s “strong inference” test for pleading fraudulent intent.58 Additionally, current case law illustrates that the debate regarding the interpretation of the PSLRA continues. In In re Health Management, Securities Litigation,59 the District Court ruled that allegations of recklessness on the part of a defendant or a showing that such defendant had the motive and opportunity to perpetrate fraud were sufficient to pled a strong inference of fraudulent intent as contemplated by the PSLRA.60 Accordingly, in In re Health Management, the District Court ruled that the PSLRA did not abrogate the Second Circuit’s pre-PSLRA pleading standard for fraudulent intent. However, despite the varying interpretations of the PSLRA, it remains clear that Section 9(b)’s two-pronged test is subjunctive. For example, the In re Health Management plaintiffs failed to establish motive and opportunity, but the District Court allowed the plaintiffs’ complaint to stand because it adequately pled recklessness (and therefore created an inference of scienter) on part of the auditor. In re Health Management involved a provider of health management services that was experiencing difficulty in collecting its accounts receivable. Due to its collection problems, Health Management (HM) had a high ratio of days’ sales

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outstanding (DSO) in accounts receivable – an indicator to potential investors and current shareholders that HM’s asset utilization was inefficient. To remedy the situation, HM devised and implemented a strategy whereby it sought to decrease its DSO by purchasing complementary health care companies with low DSO levels. HM issued new common stock to finance many of the acquisitions. In its complaint, a plaintiff class of HM’s shareholders alleged that HM’s independent auditor, BDO Seidman (BDO), and several of HM’s corporate officers participated in a fraudulent scheme solely designed to inflate the fair market value of HM’s stock. Since HM’s acquisitions of new companies were primarily funded through sales of common stock, the plaintiffs argued that HM had a clear motive for engaging in fraud. As for the specific components of the fraudulent scheme, the plaintiffs identified several GAAP violations, and as a result of these violations, HM’s net income was overstated by more than 116% for 1996. The investment community reacted favorably – thereby increasing the market value of HM’s stock. However, after HM’s GAAP violations later came to light, BDO withdrew its favorable audit opinion on HM’s 1995 financial statements, and HM restated its financial statements for 1995 and for the first two quarters of 1996. Ultimately, the value of HM’s stock collapsed. In attempting to establish BDO’s complicity, the plaintiffs argued that BDO had a clear motive for participating in the fraudulent scheme because HM was one of BDO’s largest clients, and BDO’s independence was impaired because the wife of HM’s chief financial officer was a BDO employee during the audit period. Furthermore, in attempting to establish BDO’s recklessness, the plaintiffs argued that BDO either had actual or constructive knowledge of HM’s malfeasance because, given the magnitude and frequency of HM’s GAAP violations, BDO apparently turned a blind eye to the improper activities. When ruling on the elements set forth by the plaintiffs to establish motive, the District Court applied the Second Circuit’s “strong inference of scienter test.” In considering prong one of the test (establishing that a defendant had motive and opportunity for committing fraud), the District Court found that the mere receipt of a professional fee was not sufficient to create an inference of scienter of the part of BDO.61 That is, despite the potential risk of complicity that existed as a result of impaired independence, the court found it unlikely that BDO would endanger its professional reputation and expose itself to legal liability merely to preserve the HM account that, although it might represent a significant source of revenue for one of BDO’s field offices, was likely to be a minute portion of BDO’s aggregate revenue. Accordingly, the District Court concluded that the plaintiffs had failed to satisfy the first prong of the strong inference test. However, when considering the alternative prong of the strong inference test (establishing that a defendant acted consciously or recklessly) the District Court

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ruled that BDO’s recklessness could be inferred because there were severe GAAP and GAAS violations, and BDO was faced with multiple “red flags” which should have notified any reasonable auditor of potential wrongdoing. For example, a securities analyst notified BDO that HM’s accounts receivable were artificially inflated, and BDO was also aware that the SEC had inquired about the accuracy of HM’s reported accounts receivable. Despite these warnings, BDO nevertheless refrained from investigating, and the District Court ruled that BDO’s actions were unreasonable. Accordingly, the District Court denied BDO’s Fed. R. Civ. P. 12(b)(6) motion to dismiss the plaintiffs’ claims because the plaintiffs’ claims against BDO met the Second Circuit’s “strong inference” standard for averring fraud. As the previous discussion illustrates, accountants are often held liable for Section 10(b) violations. However, accountants who merely fail to follow GAAP or GAAS or who attest to incorrect accounting numbers are not liable under Section 10(b).62 Thus, although violations of GAAS and negligence on the part of an auditor are factors that, in combination with other factors, may ultimately lead to an inference of scienter, and thus to a viable Section 10(b) securities fraud claim, GAAS violations and mere negligence, in themselves, are insufficient to meet the Section 10(b) scienter threshold.63 Accordingly, in many cases plaintiffs are adequately able to plead scienter with respect to individual defendants (such as corporate officers) but fail to meet the scienter threshold for pleadings against auditors. This situation was illustrated by the District Court’s recent ruling in In re Wellcare Management Group, Securities Litigation.64 In re Wellcare Management involved a holding company engaged in the managed health care business. In making a Section 10(b) claim against Wellcare, a plaintiff class alleged that Ullman (Wellcare’s President and Chief Executive Officer) and Corsones (Wellcare’s Chief Financial Officer and Vice President of Finance), the two corporate officers who primarily oversaw Wellcare’s financial operations, had engaged in a series of improper transactions and non-GAAP accounting practices with the intention of manipulating Wellcare’s financial position so it would be perceived in an unrealistically favorable light by the investment community. As support for their allegations, the plaintiffs inferred that since Wellcare used a system of incentive compensation tied to corporate earnings, Ullman and Corsones had sufficient motive to overstate Wellcare’s earnings. In March 1996, Barron’s magazine published an article exposing Wellcare’s fraudulent activities. The market responded to this article, and Wellcare’s stock prices fell by 12%. Subsequently, Wellcare was forced to restate its financial statements for the fiscal years 1994 and 1995. The 1994 and 1995 restatements resulted in 50 and 75% decreases in Wellcare’s earnings per share (EPS), respectively. In addition to the claims against Ullman and Corsones, the plaintiffs also implicated D&T, Wellcare’s independent auditor. In their Section 10(b) complaint, the plaintiffs alleged that D&T either had actual knowledge of Wellcare’s GAAP

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violations or, alternatively, due to recklessness in the audit process, D&T should be imputed with constructive knowledge of the violations. Specifically, the plaintiffs alleged that: (1) D&T disregarded “red flags” which should have altered any reasonable auditor to Wellcare’s GAAP violations; (2) D&T was aware that Wellcare had purchased a shell corporation in an effort to improve the appearance of Wellcare’s financial statements; and (3) D&T was aware of the scheme in which Ullman conspired to reduce Wellcare’s expenses by channeling his loan proceeds to Wellcare through various health care providers – thus making it appear that Wellcare received deficit payments when in fact it did not. With respect to the allegations against Wellcare’s corporate officers, the District Court found the plaintiffs’ charges sufficient to establish that Ullman and Corsones had opportunity and motive to commit fraud; thus, the plaintiffs adequately supported an inference of scienter. In its discussion, the District Court noted that although the receipt of incentive compensation, as an isolated factor, is an insufficient basis upon which to predicate a sustainable allegation of fraud,65 the plaintiffs’ claims against Ullman and Corsones were sufficient to establish motive and opportunity. This was the case despite the fact that the plaintiffs failed to allege expressly that Ullman and Corsones received direct benefits from their allegedly fraudulent behavior.66 Additionally, in dicta, the court stated that even if the plaintiffs’ complaint had failed the motive and opportunity portion of the strong inference test, the complaint nonetheless would have satisfied the test’s alternative prong – that is, the prong dealing with recklessness. The District Court found that the allegations against the defendants sufficiently established negligence that was tantamount to intent. Accordingly, the District Court rejected Ullman and Corsones’ motion to dismiss the plaintiffs’ complaint. As shown by the preceding discussion, the District Court found the plaintiffs’ complaint against the individual defendants sufficient to meet Section 10(b)’s scienter threshold. By contrast, the court reached a different conclusion with respect to the plaintiffs’ complaint against D&T. In its analysis, the court noted that the plaintiffs alleged that D&T had violated GAAS and that D&T knew or should have known that certain actions by Wellcare’s officers would have the long-term effect of decreasing Wellcare’s reported income and stock price. However, the District Court also noted that the plaintiffs’ complaint made it clear that D&T concealed no specific information from the public. Additionally, the court noted that it was undisputed that D&T had no knowledge that the payments received by Wellcare (and fraudulently reported as deficit payments from third-party doctors) actually came from bank loans guaranteed from Ullman. Furthermore, the court noted that when D&T later became aware

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of the phony deficit payment scheme, D&T restated its audit opinion to reflect the knowledge. Taking the above factors into account, the District Court concluded that the plaintiffs’ complaint merely alleged violations of GAAS that amounted to claims of negligence in D&T’s performance of Wellcare’s audits. Since mere allegations of negligence are insufficient to sustain Section 10(b) claims, the District Court granted D&T’s motion to dismiss the plaintiffs’ claims.

Fed. R. Civ. P. 11(b) [Rule 11(b)] In addition to Rule 9(b)’s procedural rules that apply to Section 10(b) and Rule 10b-5 claims, plaintiffs must also concern themselves with other standard procedural rules as well. For example, in a recent District Court decision (Trovato v. Coopers & Lybrand67 ), the court dismissed a complaint in which the plaintiffs made allegations that ran counter to facts obtained through the legal process of discovery. Trovato v. Coopers & Lybrand involved the accounting firm Coopers & Lybrand (C&L) and its audit of the Happiness company – a business involved in the marketing of children’s entertainment products. C&L audited Happiness’ 1995 financial statements and issued a clean audit report that later was withdrawn. A group of plaintiffs filed a Section 10(b) claim against C&L and certain individual directors of Happiness. In their claim, the plaintiffs alleged that Happiness overstated its 1995 financial statements by recording fictitious credit sales of approximately $6.3 million to two corporate customers – Wow Wee and Hoffman. Regarding C&L’s performance as independent auditor, the plaintiffs alleged that C&L was deficient in its audit of amounts due from Wow Wee and Hoffman. Specifically, the plaintiffs argued that in gathering evidence about the receivable due from Wow Wee, C&L accepted a facsimile (fax) transmission as the sole confirmation of the amount due. With respect to the receivable due from Hoffman, the plaintiffs argued that C&L accepted a false confirmation. Additionally, the plaintiffs argued that although C&L audit workpapers identified alternate procedures to be used in auditing receivables, the workpapers failed to indicate that C&L actually applied any of these alternate procedures to the Wow Wee and Hoffman accounts. Furthermore, the plaintiffs charged C&L with failing to perform any procedures to test the underlying sales transactions from which the accounts receivable were generated. In response to the plaintiffs’ claims, C&L’s attorney notified the plaintiffs that the audit workpapers did in fact show that C&L had employed proper procedures in addition to confirmation to the Wow Wee and Hoffman receivables. Upon

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receipt of the notice from C&L’s attorney, the plaintiffs amended their complaint but continued to assert that the sole procedure used by C&L to confirm the Wow Wee receivables was the reliance on a faxed transmission. The plaintiffs took special exception to this practice and referenced an audit risk announcement issued by the AICPA that alerted auditors to the risks of accepting confirmation via fax. According to the announcement, auditors should be wary of potentially falsified fax transmissions and, when the amount being confirmed is material, should take steps to ascertain the origin of the transmission. The plaintiffs argued that, since C&L took no steps to verify the authenticity of the faxed transmission’s origin, C&L deliberately had violated AICPA guidance. Additionally, the plaintiffs noted that if C&L had examined invoices for sales made to Hoffman, C&L would have noticed that the invoices included a purchase order number that pertained to goods that Happiness was not scheduled to ship until six months after the date of the sale. In its analysis, the District Court scrutinized the plaintiffs’ petition and found that it violated the pleading requirements of Rule 11(b). That is, the plaintiffs’ complaint set forth allegations inconsistent with evidence obtained through discovery. Specifically, the court found that C&L’s workpapers clearly indicated that C&L used several techniques to gather evidence of the correctness of the accounts receivable at issue. The court found that the petition was not grounded in fact because, by virtue of their access to C&L’s workpapers and several clarifying communications from C&L’s legal counsel, the plaintiffs were aware of C&L’s performance of multiple techniques to test the accuracy of the Wow Wee and Hoffman receivables, but the plaintiffs’ complaint nonetheless ignored this knowledge. Accordingly, the court ruled in favor of C&L.

Right of Contribution under Section 11( f ) The right of contribution is a common-law doctrine that applies when two or more parties share a common liability, and one party pays more than his/her/its equitable share. Under contribution, the party who pays an inordinate share of the liability may sue to recover the overpayment from the jointly-liable party or parties. The contribution doctrine usually is associated with contract and tort law. However, the doctrine also has been codified in securities law. Section 11(f) of the 1933 Act provides the following: Every person who becomes liable to make any payment . . . may recover contribution as in cases of contract from any person who if sued separately, would have been liable to make the same payment, unless the person who has become liable was, and the other was not, guilty of fraudulent misrepresentation.68

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However, although the section provides a right of contribution, the PSLRA bars contribution from a covered person once a settlement is executed.69 In re Cendant Corporation Securities Litigation70 (hereinafter, Cendant) is a recent New Jersey District Court case involving the application of the contribution doctrine against an accounting firm. The case illustrates the intricate interaction between the 1933 Act and PSLRA. Cendant Cendant dealt with E&Y’s audit of HFS, a corporation whose upper management was involved in a pervasive pattern of fraud. As a result of the fraud and E&Y’s alleged inadequate audit, HFS’s operating income was inflated by approximately $500 million. This overstatement led to inflated stock prices and subsequent shareholders losses once HFS’s fraudulent activities were revealed. E&Y and Cendant (the surviving corporation in a stock-for-stock merger with HFS)71 entered into a joint settlement agreement that required monetary damages of approximately $3.2 billion be paid to the aggrieved class of shareholders. E&Y paid $335,000 and Cendant paid $2.85 billion. After the settlement agreement was approved by the court, Cendant sued E&Y under various theories. It asserted that E&Y, either through willful acts or negligence, contributed to a pattern of fraudulent activities that resulted in misstated financial statements and inflated stock prices. The primary issue at the federal level was Cendant’s claim for contribution. Cendant conceded that it was not entitled to contribution under the PSLRA, but it argued that it was entitled to contribution independently of Section 11(f). E&Y asserted that it was not liable for contribution under Section 11(f). It argued that since both parties entered into settlement agreements, then neither one had become liable as required by the statute. Alternatively, E&Y also argued that a Section 11(f) analysis was moot because even if Cendant had become liable within the meaning of Section 11(f), the PSLRA contribution ban would eliminate Cendant’s right to contribution. Thus, the District Court considered two primary issues regarding contribution: (1) Can a settling party become liable under Section 11(f)? (2) If a party does become liable under Section 11(f), then does the PSLRA override the 1933 Act and impose a ban on contribution? The District Court concluded that a party may become liable under Section 11(f) even though the party had entered into a settlement agreement. The Court reasoned that since a settling party becomes liable under the settlement agreement, then there is no requirement that a judgment be rendered against the party in order for the statutorily-prescribed liability to attach. Accordingly, if it could be determined that Cendant had paid more than its equitable share of the

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settlement amount, then the Court could sustain Cendant’s Section 11(f) claim for contribution. With respect to the second issue, the District Court found that Cendant’s Section 11(f) claim for contribution was integrally related to securities transactions that initially gave rise to Section 10(b) claims by the settled class (the group of shareholders which originally filed a class action lawsuit against Cendant and E&Y). This intertwining relationship meant that all claims arising from the Cendant fraud were governed by the PSLRA. Since the PSLRA explicitly bars contribution claims, the Court granted E&Y’s motion to dismiss.72 Cendant appealed the District Court decision to the Third Circuit.73 The two issues dealing with the federal level of the case were: (1) the plaintiff class objecting to the size of the settlement (they believed that it was too low); and (2) the ruling to bar contribution claims. The Third Circuit upheld the settlement amount and upheld the position that the PSLRA bars contribution claims.

CONCLUSION Auditor liability for GAAP and GAAS violations continues to be a highly-litigated area. Under the Securities Exchange Act of 1933, CPAs are potentially liable in instances where they have attempted to defraud users of a firm’s financial statements. In order for a CPA to be liable, the plaintiff must establish that the defendant made false statements or omitted material facts and acted with scienter, that the plaintiff relied on the defendant’s false statements, and that these false statements caused the plaintiff’s injury. Scienter and causation are the elements that have caused the most debate, and much of the litigation centers on these elements. Additionally, issues dealing with statute of limitations, pleading standards, and other procedural items have affected the outcomes of the litigation. Accordingly, CPAs must be fully aware of the trends in recent litigation with respect to all of these areas. Such knowledge might help establish better audit procedures and if necessary might help in a subsequent defense of said procedures. This article has dealt with GAAP and GAAS violations (and related legislation) that have been adjudicated as such by the courts. It has not addressed situations where pre-trial settlements were reached and no wrongdoing was acknowledged. It also has not addressed the Enron-Arthur Andersen situation because at this time no GAAP or GAAS violations have been adjudicated by a court of law. (Government officials are still trying to determine if such violations had occurred.) Clearly, if the number of pre-trial settlements (and the dollar amount involved) continues to increase, then this will impact future CPA liability and legislation.74 Also, the

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results of any Enron-related litigation (which could take many years) involving GAAP or GAAS violations will have a significant impact on subsequent litigation and CPA liability.

NOTES 1. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). 2. Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978). 3. See, e.g., Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir. 1978); see also, Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). 4. See, e.g., In re Time Warner Securities Litigation, 9 F.3d 259, 268 (2d Cir. 1993); Decker v. Massey-Ferguson, Ltd., 681 F.2d 111, 120 (2d Cir. 1982); In re The Wellcare Management Group, Securities Litigation, 964 F. Supp. 632, 640 (N.D.N.Y. 1997). 5. See, e.g., Currie v. Cayman Resources Corp.: “Transaction causation, another way of describing reliance, is established when the misrepresentations or omissions cause the plaintiff ‘to engage in the transaction in question.’ ” 835 F.2d 780, 785 (11th Cir. 1988) (quoting Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). 6. The Court established the fraud-on-the-market theory in Basic v. Levinson, 485 U.S. 224 (1988). 7. 963 F. Supp. 301 (S.D.N.Y 1997). 8. Zucker v. Sasaki, 963 F. Supp. 301, 305 (S.D.N.Y 1997); see also Acito v. IMCERA Group, 47 F.3d 47, 53 (2d Cir. 1995) (“defendants’ lack of clairvoyance simply does not constitute securities fraud”). 9. 576 F.2d 465, 468 (2d Cir. 1978). 10. First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994); In Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). 11. Gasner v. Board of Supervisors, 103 F.3d 351 (4th Cir. 1996). 12. Huddleston v. Herman & MacLean, 640 F.2d 534, 548 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983). 13. Murray v. Hospital Corp. of America, 873 F.2d 972 (6th Cir. 1989). 14. Bastian v. Petren Resources Corp., 892 F.2d 680, 683–85 (7th Cir. 1990). 15. Robbins v. Koger, 116 F.3d 1441 (11th Cir. 1997). 16. However, it should be noted that of the appellate courts involved in the debate, the Second Circuit has been the most inconsistent in its application of the loss causation criterion. That is, the Second Circuit first required the explicit showing of loss causation in Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974), but has floundered on the issue over the years. In recent decisions, the Second Circuit has been more consistent in its consideration of loss causation (see Citibank, N.A. v. K-H Corp., 968 F.2d 1489, 1495 (2d Cir. 1991) (“a plaintiff must prove that the damage suffered was a foreseeable consequence of the misrepresentation.”); First Nationwide Bank v. Gelt Funding Corp., 27 F.3d 763, 769 (2d Cir. 1994) (same)), and thus the Second Circuit has joined the majority of the appellate courts. 17. Robbins v. Koger Properties, 116 F.3d 1441, 1448 (11th Cir. 1997). 18. In re Control Data Securities Litigation, 933 F.2d 616 (8th Cir. 1991). 19. Knapp v. Ernst & Whinney, 90 F.3d 1431 (1996).

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20. Knapp v. Ernst & Whinney, 90 F.3d 1431, 1438 (9th Cir. 1996); see also In re Control Data Corp. Securities Litigation, 933 F.2d 616, 619-20 (8th Cir. 1991). (“This is a ‘fraud on the market’ case . . . To the extent that the defendant’s misrepresentations artificially altered the price of the stock and defrauded the market, causation is presumed.”) 21. See Bruschi v. Brown, 876 F.2d 1526, 1531 (11th Cir. 1989); Wilson v. Comtech Telecommunications Corp., 648 F.2d 88, 92 (2d Cir. 1981). 22. See, e.g., Robbins v. Koger Properties, 116 F.3d 1441, 1447 (11th Cir. 1997); Huddleston v. Herman & MacLean, 640 F.2d 534, 556 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983); Schlick v. Penn-Dixie Cement Corp., 507 F.2d 374, 380 (2d Cir. 1974). 23. See, e.g., Huddleston v. Herman & MacLean, 640 F.2d 534, 556 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983). 24. Robbins v. Koger Properties, 116 F.3d 1441, 1447 (11th Cir. 1997). 25. Bruschi v. Brown, 876 F.2d 1526, 1530-2 (11th Cir. 1989); Huddleston v. Herman & MacLean, 640 F.2d 534, 549–56 (5th Cir. Unit A 1981), aff’d in part, rev’d in part on other grounds, 459 U.S. 375 (1983). 26. See, e.g., Ross v. Patrusky, Mintz & Semel, 1997 U.S. Dist. LEXIS 5726, 50 (S.D.N.Y. 1997); Citibank N.A. v. K-H Corp., 968 F.2d 1489, 1496 (2d Cir. 1992). 27. 116 F.3d 1441 (11th Cir. 1997). 28. 991 F. Supp. 234 (S.D.N.Y. 1997). 29. The cash received from these liquidations were more properly characterized as gains rather than revenues. In accounting terminology, cash inflows directly attributable to the primary operating activities of a business entity are considered revenues; conversely, cash inflows from sources other than a business entity’s primary operations are considered gains. For equity investors, revenues are better indicators of a firm’s operating performance than are gains. 30. In the original complaint, the plaintiffs charged KPI and several individual defendants with violations of Section 10(b) and Rule 10b-5. Later, Deloitte and Touche (D&T), KPI’s independent auditor for 1998 through 1990, was added to the list of defendants. Subsequently, the complaints against KPI and the individual defendants were dismissed – thereby leaving D&T as the sole defendant. 31. In general, testimony of expert witnesses is an essential element of securities litigation. Usually each party’s expert witness testifies in favor of said party. However, in situations where a party’s expert witness has given damaging testimony against said party, the testimony may not be recanted later in a self-serving purpose to defeat summary judgment motions by the opposing party. See, e.g., Danis v. USN Communications, 121 F. Supp. 2d 1183; 2000 U.S. Dist. LEXIS 16767. 32. 991 F. Supp. 234 (S.D.N.Y. 1997). 33. The plaintiffs’ failure to establish loss causation was fatal not only to their Section 10(b) claims, but also to their charges that E&Y was liable for common law fraud and negligent misrepresentation. 34. 501 U.S. 350 (1991). 35. See Menowitz v. Brown, 991 F.2d 36, 41 (2d Cir. 1993). (“ ‘discovery’ . . . includes constructive or inquiry notice, as well as actual notice.”) 36. 991 F. Supp. 234 (S.D.N.Y. 1997). 37. See O’Brien v. National Property Analysts Partners, 936 F.2d 674, 676 (2d Cir. 1991); In re Health Management, Securities Litigation, 970 F. Supp. 192, 207 (E.D.N.Y. 1997).

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38. See, e.g., Acito v. IMCERA Group, 47 F.3d 47, 51 (2d Cir. 1995); Mills v. Polar Molecular Corp., 12 F.3d 1170, 1175 (2d Cir. 1993); Goldman v. Belden, 754 F.2d 1059, 1069-70 (2d Cir. 1985). 39. 122 F.3d 1186 (9th Cir. 1997); see also DiLeo v. Ernst & Young, 901 F.2d 624 (7th Cir. 1990) (illustrating that, on Section 9(b) issues, the Seventh Circuit rules in a fashion similar to the Ninth Circuit). 40. Both Merisel’s announced earnings and the securities analysts’ reports indicated that the Computerland acquisition had a positive impact on Merisel’s earnings. 41. Under the modifying convention of conservatism that pervades accounting measurement, when two estimates of amounts to be paid or received equally are likely, accountants should adopt the less optimistic estimate. When applying the principle of conservatism to sales revenue, accountants generally should refrain from anticipating revenues and gains until collectibility is reasonably certain but should recognize losses and expenses immediately. In Merisel’s case, many of the improperly shipped goods and consignment goods were returned – a fact that Merisel allegedly concealed. 42. In reaching this conclusion, the District Court relied on Fed. R. Civ. P. 12(b)(6), which authorizes courts to dismiss complaints that fail to state claims upon which relief can be granted. 43. As per the Supreme Court’s holding in Central Bank, there is no Section 10(b) liability for aiding and abetting securities fraud unless the defendant in question personally commits a deceptive act. However, that is not to say that only persons who directly make fraudulent misrepresentations are subject to liability; instead, Rule 10b-5 may be imposed in cases where a party has knowledge of fraud and assists in its perpetration. See SEC v. First Jersey Securities, 101 F.3d 1450, 1471 (2d Cir. 1996) (quoting Azrielli v. Cohen Law Offices, 21 F.3d 512, 517 (2d Cir. 1994)). 44. In re GlenFed, Securities Litigation, 42 F.3d 1541 (9th Cir. 1994) (en banc). 45. 901 F.2d 624 (7th Cir. 1990). 46. 901 F.2d 624, 627-8 (7th Cir. 1990). 47. The Ninth Circuit remanded the case to District Court so that the substance and accuracy of the plaintiffs’ complaint could be determined. 48. In the Second Circuit, motive must be shown by identifying concrete benefits that a defendant may have been expected to realize as a result of furthering a fraud perpetrated through a financial statement misstatement or wrongful disclosure. “Opportunity” involves the defendant having the means through which to realize such concrete benefits. See, e.g., Shields v. Citytrust Bancorp, 25 F.3d 1124, 1129-30 (2d Cir. 1994). 49. See San Leandro Emergency Med. Group Profit Sharing Plan v. Philip Morris Cos., 75 F.3d 801, 809 (2d Cir. 1996). However, it should be noted that in cases where plaintiffs solely rely on allegations of recklessness in asserting scienter, they must present a greater amount of evidence than is required when alleging motive to create an inference of scienter. See, e.g., Beck v. Manufacturers Hanover Trust Co., 820 F.2d 46, 50 (2d Cir. 1987). 50. See In re Glenfed, Securities Litigation, 42 F.3d 1541, 1546–47 (9th Cir. 1994). 51. Statement of Managers for the Private Securities Litigation Reform Act of 1995, H.R. Conference Report 104-369 (Nov. 28, 1995). 52. Pub. L. No. 104-67; codified at 15 U.S.C. Section 78u-4. (The PSLRA amended the Securities Exchange Acts of 1933 and 1934.) 53. Mednick and Peck (1994) noted that most cases involving CPA firms settled because plaintiffs’ attorneys have an inherent bias toward settlement. The CPA firms are included

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in class action suits because of their “deep pockets.” These deep pockets lead to large settlements (and this avoids all subsequent costs associated with a trial). They further suggest that the concept of proportionate liability be used to help reduce unreasonable and unfair liability claims and settlements. Mednick, R., & Peck, J. J. (1994). Proportionality: A muchneeded solution to the accountants’ legal liability. 28 Valparaiso Law Review, 867–918. 54. 970 F. Supp. 192 (E.D.N.Y. 1997). 55. Malone v. Brincat, 722 A.2d 5, 1998 Del. LEXIS 495. 56. See, e.g., In re Silicon Graphics, Securities Litigation, 1996 U.S. Dist. LEXIS 16989 (N.D. Cal. 1996); Friedberg v. Discreet Logic, 959 F. Supp. 42, 49 (D. Mass. 1997); Norwood v. Venture Corp. v. Converse, 959 F. Supp. 205, 208 (S.D.N.Y. 1997). 57. Helwig v. Vencor, 251 F.3d 540 (6th Cir. 2001). 58. See Page v. Derrickson, 1997 U.S. Dist. LEXIS 3673, 1997 WL 148558, at ∗ 10 (M.D. Fla. 1997); Fugman v. Aprogenex, 961 F. Supp. 1190, 1997 U.S. Dist. LEXIS 3299, at ∗ 11 (N.D. Ill. 1997); Shahzad v. H.J. Meyers & Co., 1997 U.S. Dist. LEXIS 1128 (S.D.N.Y. 1997); Rehm v. Eagle Finance Corp., 954 F. Supp. 1246, 1252-53 (N.D. Ill. 1997); Fischler v. Amsouth Bancorp., 1996 U.S. Dist. LEXIS 17670, 1996 WL 686565, at ∗ 2–3 (M.D. Fla. 1996); Sloane Overseas Fund, Ltd. v. Sapiens Int’l Corp., 941 F. Supp. 1369, 1377 (S.D.N.Y. 1996); Zeid v. Kimberley, 930 F. Supp. 431, 438 (N.D. Cal. 1996); Marksman Partners, L.P. v. Chantal Pharmaceutical Corp., 927 F. Supp. 1297, 1310 (C.D. Cal. 1996). 59. 970 F. Supp. 192 (E.D.N.Y. 1997). 60. In re Health Management, Securities Litigation, 970 F. Supp. 192, 201 (E.D.N.Y. 1997). 61. See also In re Health Management, Securities Litigation, 970 F. Supp. 192 (E.D.N.Y. 1997) (in finding that plaintiffs’ claims failed to meet Fed. R. Civ. P. 9(b)’s pleading requirements, the court noted that the auditor’s mere receipt of audit fees was insufficient to establish scienter); but cf. In re Leslie Fay Cos., Securities Litigation, 835 F. Supp. 167, 174 (S.D.N.Y. 1993) (receipt of professional auditing fee, combined with an “unlikely degree of mere carelessness” by the auditor creates an inference of motive for fraud). 62. In re Worlds of Wonder Securities Litigation, 35 F.3d 1407, 1426 (9th Cir. 1994), cert. denied, 116 S. Ct. 185 (1995)(quoting Malone v. Microdyne Corp., 26 F.3d 471, 476 (4th Cir. 1994)): [Scienter] requires more than a misapplication of accounting principles. The [plaintiff] must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. 35 F.3d at 1426 (quoting SEC v. Price Waterhouse, 797 F. Supp. at 1240).

In a recent case, the District Court for the Southern District of California followed the Worlds of Wonder rationale. Reiger v. Price Waterhouse Coopers, 117 F. Supp. 2d 1003; 2000 U.S. Dist. LEXIS 15185. 63. See, e.g., Decker v. Massey-Ferguson, 681 F.2d 111, 120 (2d Cir. 1982) (generalized statements of accounting violations do not state a fraud claim); Duncan v. Pencer, 1996 U.S. Dist. LEXIS 401, 1996 WL 19043 at ∗ 11 (S.D.N.Y., Jan. 18, 1996) (same). 64. 964 F. Supp. 632 (N.D.N.Y. 1997). 65. See Acito v. IMCERA Group, 47 F.3d 47, 54 (2d Cir. 1995); Shields v. Citytrust Bancorp, 25 F.3d 1124, 1130 (2d Cir. 1994).

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66. In most Second Circuit cases in which there has been found to be a strong inference of fraud based on defendants’ motives, the defendants generally have been shown to have actually received benefits as the result of their allegedly fraudulent actions. See, e.g., Turkish v. Kasenetz, 27 F.3d 23, 24 (2d Cir. 1994) (through fraudulent actions and concealment of material facts, defendants induced sale of 25% interest in family business to an estate); Cohen v. Koenig, 25 F.3d 1168, 1174 (2d Cir. 1994) (motive was sufficient alleged when plaintiffs’ complaint stated that buyers intentionally had misstated assets of corporation to obtain more favorable terms and to close sale). However, although the Wellcare plaintiffs made no explicit allegations that Ullman and Corsones directly benefited from their fraudulent actions, the Wellcare court apparently considered the plaintiffs’ complaint as having implied that Ullman and Corsones received benefits in the form of increased compensation as a result of their actions to fraudulently inflate Wellcare’s profits. 67. 1998 U.S. Dist. LEXIS 52 (S.D.N.Y. 1998) (unreported). 68. 15 U.S.C. Section 77k(f)(1) (emphasis added). 69. The PSLRA defines a “covered person” as: (i) a defendant in any private action arising [under the Securities Exchange Act of 1934] . . . or; (ii) a defendant in any private action arising under section 77k of [section 11 of the Securities Act] . . . who is an outside director of the issuer of the securities that are the subject of the action. 15 U.S.C. Section 78u-4(f)(10)(C). 70. 2001 U.S. Dist. LEXIS 4638. 71. The surviving corporation was originally known as CUC, but its name was changed to Cendant after the merger. 72. The Court also ruled that Cendant could seek legal remedies at the state level for breach of contract, negligence, fraud, and breach of fiduciary duty. 73. 2001 U.S. App. LEXIS 19214. 74. Some recent settlements are: Waste Management ($220,000,000), Sunbeam ($110,000,000) and Colonial Realty ($90,000,000) – Arthur Andersen; YBM Management ($76,000,000) – Deloitte & Touche; Merry-Go-Round ($185,000,000) and Informix ($34,000,000) – Ernst & Young; Orange County ($75,000,000) – KPMG; and Bank of Credit and Commerce International ($95,000,000) – PricewaterhouseCoopers.


PROFESSIONAL REGULATION AND LABOR MARKET OUTCOMES FOR ACCOUNTANTS: EVIDENCE FROM THE CURRENT POPULATION SURVEY, 1984–2000 James Schaefer and Michael Zimmer ABSTRACT This study examines state regulations in the accounting profession and their impact on earnings and employment choices of accountants. It is based on U.S. Current Population Surveys from 1984 to 2000. The results of this study demonstrate that provisions for quality review, limited liability and continuing class of accountants appear to have induced entry of accountants into professional services. In addition, quality review and limited liability provisions appear to be positively associated with self-employment. Moreover, increased entry into the professional services sector appears to have exerted some competitive pressure on earnings.

INTRODUCTION This study examines state regulations in the accounting profession and their impact on earnings and employment choices of accountants. It is based on combined cross Research in Accounting Regulation Research in Accounting Regulation, Volume 16, 87–104 Copyright © 2003 by Elsevier Science Ltd. All rights of reproduction in any form reserved ISSN: 1052-0457/PII: S105204570216005X

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JAMES SCHAEFER AND MICHAEL ZIMMER

sections of accountants in the U.S. Current Population Surveys from 1984 to 2000. The period witnessed significant changes for professional credentials in accounting. First, many states implemented programs for quality review of accountants’ practices. Second, ten states maintained a continuing class of licensure in addition to the Certified Public Accountant (CPA), permitting the continuing class to perform some services traditionally provided by CPAs. Third, some states instituted a limited liability form of CPA practice to address growth in malpractice litigation. These changes were implemented in various years on a state-by-state basis, and some states refrained altogether on one or more initiatives. Since our sample spans all years and states, we augmented the data with indicators that identify years and states in which quality review, limited liability, and continuing classes were implemented. We estimate a model of individual earnings that includes background variables describing human capital and other demographic factors. Inclusion of the regulatory variables isolates the impact of the mandated changes on accountants’ earnings after controlling for relevant background factors. Regulations are issued to help control the behavior of those serving the public. In a post-Enron era the accounting profession will have to function in an increasingly regulated environment. Consequently, there is a need for additional research concerning effects of regulation in the accounting profession. Regulation alters labor market outcomes in ways other than earnings. An additional purpose of this study is to examine effects of quality review, limited liability and continuing class on individuals’ choices of sector of employment. Our data include information on each individual’s industry and his or her choice of salaried employment versus self-employment. The industry choice of interest is accounting and auditing services, which includes public accounting, tax work, and consulting activity related to accounting. We model sector outcomes as a bivariate probit model in which the dependent variables capture combined choices regarding self-employment and the accounting services industry. Inclusion of the regulatory variables reveals whether the mandated changes exerted significant effects on the sector choices of accountants.

BACKGROUND All states have accountancy statutes administered by state boards that set regulations for entry into the profession and govern the practice of public accounting. The American Institute of Certified Public Accountants (AICPA) advocates policies and administers codes of conduct. Substantial interaction takes place between state boards and the AICPA. First, collective action and coordination of policies of the state boards are facilitated by the National Association of State Boards of Accountancy (NASBA), to which state boards belong (Magill &

Professional Regulation and Labor Market Outcomes for Accountants

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Previts, 1991, p. 56). Second, many states join the AICPA in the Joint Ethics Enforcement Program, under which ethics investigations are carried out by the AICPA or state boards. This has expanded the power of the AICPA to regulate accountants, including those who are not CPAs or members of AICPA. While economists have conducted research concerning labor market outcomes of occupational licensing, to date there has been little work focusing on effects on earnings of regulation in the accounting profession. Friedman and Kuznets (1945) studied the institution of certified public accountancy, producing evidence that licensure through certification has the effect of increasing earnings of practitioners. Schaefer and Zimmer (1995) examined effects of education and experience requirements and provisions for quality review. This paper extends that study by exploiting a larger sample over a longer period of time, and by examining effects of limited liability and continuing classes, which have not been studied in previous work. Since additional states adopted quality review programs and limited liability corporations after 1995, our data permit an updated analysis of both issues. Regarding effects of regulation on sector decisions, our study appears to be the first to investigate whether quality review, continuing class, and limited liability have affected accountants’ choices regarding self-employment and employment in the accounting services industry. Labor economists have examined individuals’ choices of self-employment (see, for example, Carrington, McCue & Pierce, 1996). Our focus on accountants, along with the added dimension of industry choice, distinguishes this study from that literature.

THEORETICAL EFFECTS OF REGULATIONS Professional regulations in accounting are intended, in part, to protect the public from incompetent or dishonest practitioners. By placing restrictions on the profession and the manner in which it is practiced, regulation might contribute in conflicting ways to individuals’ decisions to work in the profession. In particular, regulations have potential to affect the sectors in which accountants decide to work and whether they choose to be self-employed. Since these choices naturally have implications regarding barriers to entry and the supply of labor to various sectors, regulations have potential to affect individual earnings. In addition, regulations in some instances can shift the demand for professional services, as they convey valuable information to consumers regarding the reputation of service providers. Quality Review Quality review is intended to evaluate a CPA firm’s audit procedures and to improve the quality of accounting and auditing practices. Accounting firms participating

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in quality review programs are evaluated on whether their policies and procedures are adequate to achieve standard elements of quality control. Due to the rigor of evaluation and costs associated with it, states that implement quality review programs might deter accountants from either working in or becoming self-employed in the accounting and auditing services sector. On the other hand, presence of quality review is likely to reduce the risk of malpractice exposure and increase the perceived value of services to potential clients. If the consequence is to increase the demand for services, practitioners’ earnings are likely to increase as a result, serving to attract individuals to the services sector. Previous research has examined the effect of peer review on the quality of audit services. Wallace and Campbell (1988) found evidence that quality review programs improve the quality of public accounting services. Francis et al. (1990) found no significant fee differences for peer reviewed firms, and they conclude there is an economic disincentive to join the AICPA division for CPA firms where peer review would be required. However, Giroux et al. (1995) using audits of Texas independent school districts, found that peer reviewed audit firms provide higher quality audits, with fee premia related to more extensive audit procedures. Schaefer and Zimmer (1995) found no evidence that a quality review environment affects earnings in either direction. In the range of years covered by our sample, three states had a quality review program for the entire period of study, and 27 more states inaugurated new requirements. These changes provide an opportunity for further analysis of quality review.

Continuing Class Licensure in the form of a CPA establishes professional credibility, which should create a market advantage for those who are licensed. Ten states recognize a second class of licensed accountants (AICPA/NASBA, 1996, pp. 126–127). During the years in our sample, no additional states implemented the continuing class. The additional class has implications for competition in accounting services. By easing entry to the services sector, continuing class provisions might exert competitive pressure on practitioners’ earnings.

Limited Liability Form of Practice In the early days of the accounting profession in the United States, it was common for CPAs to practice as corporations. Corporate status allowed practitioners to protect their personal assets by limiting their liability (Miller, 1993, p. 134). By


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the turn of the century, partnerships had become a common form of practice. As the number of malpractice suits increased after 1980 and accountants sought to protect themselves from litigation, the AICPA moved to allow members to practice under any legal form of organization, effective January 1992. During the range of years in our sample, all states adopted limited liability corporate or limited liability partnership statutes. The effect of these changes was to provide increased protection from tort and general contract claims, as well as limited tax liability. In addition, as a general rule, members of a limited liability organization are not personally liable for its debts. The ability to form an LLC presents no obvious disadvantages to practitioners, and may reduce barriers to entry into self-employment and the accounting and auditing services sector. As in the case of the continuing class provision, the reduction in barriers to entry might put pressure on practitioners’ earnings.

DATA AND SAMPLE COMPOSITION The sample consists of individual records for accountants and auditors from annual March Current Population Surveys (CPS) of the U.S. Census. The CPS gathers data from nearly 60,000 households, selected on the basis of area of residence to be nationally representative. The CPS classifies workers by industry and occupation, both in 3-digit codes, in a manner sufficiently detailed to isolate accountants and auditors (occupation code 023) and those employed in the accounting services industry (industry code 890). By searching annual CPS files for this code, we extracted between 700 and 900 accountants and auditors for each year. Following this procedure for all surveys from 1984 through 2000 resulted in a sample of 13,227 individual records dispersed across every major region and industry. The CPS questions individuals regarding their employment and earnings during the preceding year; thus the data span the period 1983 to 1999. Since the CPS does not subdivide occupation code 023, we cannot distinguish between such categories as management accountants, public accountants, and internal auditors. This limitation of the data prevents us from examining the effects of regulation on individuals’ decisions to engage in managerial rather than public accounting. We adhered to the range of occupation codes defined as “executive, administrative and managerial occupations.” Among occupations excluded from the sample, with census codes in parentheses, are: bookkeepers, accounting and auditing clerks (337); payroll and timekeeping clerks (338); billing, posting and calculating machine operators (344); posting office clerks (379), and secretaries and stenographers (313–315). Classifications are sufficiently detailed to exclude occupations peripheral to accounting and auditing. For example, occupations

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Table 1. State Regulatory Requirements: 1984–2000. Continuing Class of Accountants Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas

All Years All Years

All Years All Years

All Years

All Years

All Years All Years

All Years

Limited Liability Corporation

Quality Review Program

1993 1995 1992 1993 1995 1992 1995 1992 1993 1994 1997 1993 1994 1993 1992 1992 1994 1992 1995 1992 1995 1993 1992 1994 1994 1993 1993 1992 1991 1994 1993 1994 1993 1993 1994 1992 1993 1994 1993 1994 1993 1994 1993

1987

1989 1987 1989 All Years 1992 1996

All Years 1987 1986 All Years

1997 1992 1986 1986 1987 1988 1998 1987 1998 1992 1988 1985 All Years 1994 1988 1988 1987


93

Table 1. (Continued ) Continuing Class of Accountants Utah Vermont Virginia Washington West Virginia Wisconsin Wyoming

All Years

Limited Liability Corporation

Quality Review Program

1991 1995 1991 1994 1996 1993 1990

1994 1987 1987

1988

Notes:

Years indicates the effective date of the regulation (not the year it was passed). “All years” indicates that the regulation was in effect in that state for the entire period of study. Continuing Class of Accountant data were obtained from AICPA/NASBA (1996, pp. 126–127). Limited Liability Corporation data were obtained by reviewing the public accountancy statutes via LEXIS/NEXIS and state board websites. Quality Review Program data were obtained from Wallace and Campbell (1988, pp. 126–127), and by reviewing state public accountancy statutes via LEXIS/NEXIS.

excluded from the sample include underwriters (024) and other financial officers (025). Consequently, the sample encompasses professional accountants and auditors whose job responsibilities are not primarily clerical. Table 1 provides a chronology of implementation, by state, for each of the regulatory initiatives. Entries indicate the year in which each initiative was implemented. Blanks indicate that, as of 2000, the state had not taken up the initiative in question. We used the information in Table 1 to construct person-specific indicators for each regulation. An accountant in a state during any year in which a particular regulation was in effect is assigned a value of one; a value of zero was assigned if the regulation was not in effect. In this manner each sample observation is assigned a value for each of three regulatory dummy variables: quality review, limited liability, and continuing class.

ECONOMETRIC FRAMEWORK AND SPECIFICATION The first item of interest is the allocation of individuals into self-employment versus wage and salary employment and the accounting services industry versus other industries. Suppose each accountant possesses a latent propensity to be selfemployed as opposed to seeking wage and salary employment. The individual becomes self-employed if the latent index, SE∗i , exceeds zero; otherwise he accepts

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wage and salary employment. We do not observe SE∗i . Instead we observe the individual’s response to the CPS question on self-employment: SEi = 1 SEi = 0

if SE∗i > 0 if SE∗i ≤ 0

(1)

A probit model postulates the probability that a randomly selected accountant is self-employed to be a function of explanatory variables and unknown parameters: P(SEi = 1) = (␣ Z i ) − ␯i

(2)

where the error term ␯i is assumed to possess a normal distribution with zero mean and unit variance and denotes the cumulative distribution function of a standard normal distribution. In the self-employment model, explanatory variables include the three regulatory dummy variables. In addition, consistent with Carrington, McCue and Pierce (1996), control variables include age, schooling attainment, and dummy variables for race, marital status, and work-limiting health disabilities. Subject to the assumption of a normal distribution in the error term, the vector of parameters ␣ can be estimated by maximum likelihood probit methods. A similar framework can be established for the industry of employment. Let AS∗i denote individual i’s latent propensity to choose the accounting services industry. We observe only ASi = 1 ASi = 0

if AS∗i > 0 if AS∗i ≤ 0.

(3)

The corresponding probit model is P(ASi = 1) = (␦ W i ) − ␩i

(4)

where the explanatory variables Wi include the three regulatory initiatives and ␦ represents a vector of parameters. The error term ␩i is assumed to possess a standard normal distribution. There is potential for correlation between the random error terms in Eqs (2) and (4). Correlation would be present if, for a given accountant, unmeasured factors that affect his or her propensity for self-employment tend to be associated with unmeasured factors that affect his or her decision to work in the accounting services industry. Consequently, we estimate Eqs (2) and (4) jointly as a bivariate probit model, which permits the error terms ␯ and ␩ to possess a correlation parameter ␳. Since there is no a priori basis for selecting variables for inclusion on the right hand side of (4), aside from the key regulatory variables, we include the same controls as Eq. (2), i.e. age, years of education, marital status, race, and health status.


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In the most common formulation of the earnings equation (Mincer, 1974), the logarithm of earnings is a linear combination of explanatory variables and a random disturbance term: ln E i = ␤ X i + ␧i

(5)

where Ei denotes earnings of worker i, Xi is a vector of explanatory variables measuring human capital as well as other background and demographic information, and ␤ is a vector of unknown parameters. The error term is assumed to possess a normal distribution with zero mean and constant variance. The assumption of constant variance is important in this study. If the error term is heteroscedastic, standard errors of the estimated coefficients are biased and inferences about the critical regulation parameters are unreliable. To obtain correct standard errors, we use White’s (1978) generalized correction for heteroscedasticity. The vector Xi includes the three dichotomous indicators of state regulatory initiatives. In addition, the model has additional controls for schooling; potential work experience, defined as age minus schooling minus four, and experience squared; a race dummy variable equal to one for whites and zero otherwise; a gender dummy variable equal to one for males and zero otherwise; a marital status dummy variable equal to one for marrieds and zero otherwise; a physical limitation dummy variable equal to one for individuals who report a health condition that limits their work, and zero otherwise; a residence dummy variable equal to one for individuals living in a metropolitan statistical area, and zero otherwise; and a series of industry variables to indicate the individual’s 3-digit industry of employment.1 The dependent variable is the natural log of weekly earnings, where earnings are measured in constant 1984 dollars.2 To isolate the regulatory effects from general factors that might be due to macro events in particular years or regions rather than to regulations per se, the model includes dummy variables for years and geographic regions.3

RESULTS OF ESTIMATION Table 2 presents descriptive statistics for selected variables in the model. Average weekly log earnings are 5.97, which corresponds to nearly $650 in 1984 dollars. The average accountant possesses more than 19 years of potential work experience and the schooling equivalent of nearly a college degree. While a majority of the sample consists of whites and marrieds, the distribution between genders is more even, with 49% males. For the regulatory variables, the sample means reveal that 41% of the accountants resided in a state and during a year in which quality review was mandated. For states recognizing continuing class, the proportion is 11%, and for states recognizing limited liability corporations, it is 37%.

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Table 2. Descriptive Statistics. Variable

Sample Mean

Log Earnings

Log of real weekly earnings, 1984 dollars

Earnings

Real weekly earnings, 1984 dollars

Experience

Potential work experience

19.30

12.197

Education

Highest grade attended

15.49

1.797

White

= 1 if white = 0 otherwise

0.878

0.328

Married

= 1 if married = 0 otherwise

0.642

0.480

Male

= 1 if male = 0 if female

0.485

0.500

Disabled

= 1 if health condition limits work = 0 otherwise

0.016

0.124

Reside MSA

= 1 if residence is metropolitan = 0 otherwise

0.451

0.498

Self-Employed

= 1 if self-employed = 0 otherwise

0.088

0.283

Quality Review

= 1 if quality review mandated in the state and during the year of observation = 0 otherwise

0.411

0.492

Continuing Class

= 1 if continuing class is recognized in the state and during the year of observation

0.112

0.316

Limited Liability

= 1 if limited liability corporations recognized in the state and during the year of observation = 0 otherwise

0.370

0.483

Sample Size

5.979

Sample Standard Deviation

648.16

0.675 591.40

13,227

Table 3 reports estimates of the bivariate probit model of sector choice. Estimates for the control variables reveal a profile of individuals who choose self-employment and/or accounting services. They tend to be older and more educated. Both choices are more likely among marrieds and whites. Physical disability is not significant in either case.


97

Table 3. Bivariate Probit Estimates: Self Employment and Accounting Services.* Variable

Constant Age Education Disabled Married White Quality Review Limited Liability Continuing Class Error Term Correlation: N ∗ Figures

Equation (2) Self-Employed

Equation (4) Accounting Services

−5.596 (28.11) 0.031 (20.47) [

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