[Senate Hearing 107-948]
[From the U.S. Government Publishing Office]
ACCOUNTING REFORM AND INVESTOR PROTECTION
VOLUME II
S. Hrg. 107-948
ACCOUNTING REFORM AND
INVESTOR PROTECTION
=======================================================================
HEARINGS
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
VOLUME II
ON
THE LEGISLATIVE HISTORY OF THE SARBANES-OXLEY ACT OF 2002:
ACCOUNTING REFORM AND INVESTOR PROTECTION ISSUES RAISED BY ENRON AND
OTHER PUBLIC COMPANIES
----------
MARCH 5, 6, 14, 19, 20, AND 21, 2002
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Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
87-708 U.S. GOVERNMENT PRINTING OFFICE
WASHINGTON : 2003
____________________________________________________________________________
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Internet: bookstore.gpr.gov Phone: toll free (866) 512-1800; (202) 512�091800
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
PAUL S. SARBANES, Maryland, Chairman
CHRISTOPHER J. DODD, Connecticut PHIL GRAMM, Texas
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
ZELL MILLER, Georgia CHUCK HAGEL, Nebraska
THOMAS R. CARPER, Delaware RICK SANTORUM, Pennsylvania
DEBBIE STABENOW, Michigan JIM BUNNING, Kentucky
JON S. CORZINE, New Jersey MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii JOHN ENSIGN, Nevada
Steven B. Harris, Staff Director and Chief Counsel
Wayne A. Abernathy, Republican Staff Director
Martin J. Gruenberg, Senior Counsel
Dean V. Shahinian, Counsel
Stephen R. Kroll, Special Counsel
Lynsey Graham Rea, Counsel
Vincent Meehan, Counsel
Sarah A. Kline, Counsel
Judith Keenan, Senior Policy Advisor
Alexander M. Sternhell, Staff Director, Securities Subcommittee
Linda L. Lord, Republican Chief Counsel
Stacie Thomas Morales, Republican Economist
Michelle R. Jackson, Republican Counsel
Geoffrey P. Gray, Republican Senior Professional Staff Member
Mark F. Oesterle, Republican Counsel
Katherine McGuire, Republican Economist
Michael D. Thompson, Republican Legislative Assistant
Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator
George E. Whittle, Editor
Irene Whiston Carroll, Assistant Editor
Frank E. Wright, Assistant Editor
Kevin D. High, Assistant Editor
(ii)
C O N T E N T S
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VOLUME I
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TUESDAY, FEBRUARY 12, 2002
Page
Opening statement of Chairman Sarbanes........................... 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 3
Senator Miller............................................... 4
Senator Enzi................................................. 4
Senator Corzine.............................................. 6
Senator Hagel................................................ 7
Senator Stabenow............................................. 7
Senator Bayh................................................. 8
Senator Carper............................................... 8
Senator Johnson.............................................. 9
Prepared statement....................................... 55
Senator Schumer.............................................. 10
Senator Dodd................................................. 11
Senator Akaka................................................ 56
WITNESSES
Arthur Levitt, Chairman, U.S. Securities and Exchange Commission,
1993 to 2000................................................... 14
Prepared statement........................................... 56
Richard C. Breeden, Chairman, U.S. Securities and Exchange
Commission, 1989 to 1993....................................... 16
Prepared statement........................................... 58
Response to written questions of Senator Hagel............... 94
David S. Ruder, Chairman, U.S. Securities and Exchange
Commission, 1987 to 1989....................................... 20
Prepared statement........................................... 69
Response to written questions of Senator Hagel............... 94
Harold M. Williams, Chairman, U.S. Securities and Exchange
Commission, 1977 to 1981....................................... 23
Prepared statement........................................... 75
Response to written questions of Senator Hagel............... 95
Roderick M. Hills, Chairman, U.S. Securities and Exchange
Commission, 1975 to 1977....................................... 26
Prepared statement and exhibits.............................. 78
Response to written questions of Senator Hagel............... 95
----------
THURSDAY, FEBRUARY 14, 2002
Opening statement of Chairman Sarbanes........................... 97
Opening statements, comments, or prepared statements of:
Senator Gramm................................................ 98
Prepared statement....................................... 141
Senator Stabenow............................................. 99
Prepared statement....................................... 141
Senator Enzi................................................. 99
Senator Bayh................................................. 100
Senator Crapo................................................ 101
Senator Bunning.............................................. 101
Senator Shelby............................................... 113
Senator Carper............................................... 113
Senator Akaka................................................ 114
Prepared statement....................................... 142
Senator Miller............................................... 128
Senator Corzine.............................................. 129
Senator Johnson.............................................. 142
WITNESSES
Paul A. Volcker, Chairman, International Accounting Standards
Committee Foundation; Chairman, Arthur Andersen's Independent
Oversight Board; Former Chairman, Federal Reserve System....... 102
Prepared statement........................................... 143
Sir David Tweedie, Chairman, International Accounting Standards
Board; Former Chairman, United Kingdom's Accounting Standards
Board.......................................................... 107
Prepared statement........................................... 147
Additional Material Supplied for the Record
Letter from Paul A. Volcker, Chairman, International Accounting
Standards Committee Foundation; Chairman, Arthur Andersen's
Independent Oversight Board; Former Chairman, Federal Reserve
System to Chairman Paul S. Sarbanes, dated May 17, 2002........ 159
Editorial from The Wall Street Journal by Paul A. Volcker,
Chairman, International Accounting Standards Committee
Foundation, dated February 19, 2002............................ 164
Memo from Sir David Tweedie, Chairman, International Accounting
Standards Board; Former Chairman, United Kingdom's Accounting
Standards Board on Funding of the UK Accounting Standards Board 166
Article from Sir David Tweedie, Chairman, International
Accounting Standards Board; Former Chairman, United Kingdom's
Accounting Standards Board, dated January 2002................. 168
----------
TUESDAY, FEBRUARY 26, 2002
Opening statement of Chairman Sarbanes........................... 181
Opening statements, comments, or prepared statements of:
Senator Gramm................................................ 183
Senator Miller............................................... 184
Senator Enzi................................................. 184
Senator Stabenow............................................. 186
Senator Allard............................................... 187
Prepared statement....................................... 234
Senator Shelby............................................... 187
Prepared statement....................................... 234
Senator Corzine.............................................. 188
Prepared statement....................................... 234
Senator Schumer.............................................. 219
WITNESSES
Walter P. Schuetze, Chief Accountant, U.S. Securities and
Exchange Commission, 1992 to 1995.............................. 189
Prepared statement........................................... 235
Michael H. Sutton, Chief Accountant, U.S. Securities and Exchange
Commission, 1995 to 1998....................................... 193
Prepared statement........................................... 239
Lynn E. Turner, Chief Accountant, U.S. Securities and Exchange
Commission, 1998 to 2001....................................... 196
Prepared statement........................................... 243
Dennis R. Beresford, Former Chairman, Financial Accounting
Standards Board, 1987 to 1997.................................. 201
Prepared statement........................................... 258
Response to question raised by Senator Miller................ 270
Additional Material Supplied for the Record
Article by Walter P. Schuetze in Abacus, a Journal of Accounting,
Finance, and Business Studies, ``What Are Assets and
Liabilities?'' dated February 2001............................. 271
Article by Walter P. Schuetze, 2001 RJ Chambers Research Lecture,
dated November 27, 2001........................................ 288
Letter from Walter P. Schuetze to Senator Charles E. Schumer,
dated March 25, 2002........................................... 296
Letter with attachments from Lynn E. Turner, Director, College of
Business, Colorado State University, dated March 1, 2002....... 302
----------
WEDNESDAY, FEBRUARY 27, 2002
Opening statement of Chairman Sarbanes........................... 341
Opening statements, comments, or prepared statements of:
Senator Gramm................................................ 342
Senator Miller............................................... 343
Senator Corzine.............................................. 362
WITNESSES
John H. Biggs, Chairman, President, and CEO, Teachers Insurance
and Annuity Association-College Retirement Equities Fund (TIAA-
CREF).......................................................... 343
Prepared statement........................................... 373
Ira M. Millstein, Co-Chairman of the Blue Ribbon Committee on
Improving the Effectiveness of Corporate Audit Committees;
Senior Partner, Weil, Gotshal & Manges, LLP.................... 350
Prepared statement........................................... 378
Additional Material Supplied for the Record
Miscellaneous exhibits submitted by Ira M. Millstein, Co-Chairman
of the Blue Ribbon Committee on Improving the Effectiveness of
Corporate Audit Committees; Senior Partner, Weil, Gotshal &
Manges, LLP.................................................... 388
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VOLUME II
----------
TUESDAY, MARCH 5, 2002
Opening statement of Chairman Sarbanes........................... 505
Opening statements, comments, or prepared statements of:
Senator Bunning.............................................. 506
Senator Dodd................................................. 507
Senator Miller............................................... 507
Senator Crapo................................................ 508
Senator Corzine.............................................. 508
Prepared statement....................................... 550
Senator Stabenow............................................. 515
Prepared statement....................................... 550
Senator Bennett.............................................. 515
WITNESSES
David M. Walker, Comptroller General of the United States, U.S.
General Accounting Office; accompanied by: Thomas McCool,
Managing Director, Financial Markets and Community Investment;
and Robert Gramling, Former Director, Corporate Financial
Audits......................................................... 508
Prepared statement........................................... 551
Robert R. Glauber, Chairman and Chief Executive Officer, National
Association of Securities Dealers, Inc......................... 527
Prepared statement........................................... 569
Joel Seligman, Dean and Ethan A.H. Shepley University Professor,
Washington University School of Law in St. Louis; Public
Member, American Institute of Certified Public Accountants
Professional Ethics Executive Committee........................ 530
Prepared statement........................................... 573
John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia
University School of Law....................................... 534
Prepared statement........................................... 582
Additional Material Supplied for the Record
GAO Report, SEC Operations, Increased Workload Creates
Challenges, dated March 2002................................... 594
GAO Report, Highlights of GAO's Corporate Governance,
Transparency and Accountability Forum, dated March 2002........ 638
Business Week article submitted by Senator Paul S. Sarbanes,
dated March 11, 2002........................................... 653
The Wall Street Journal article submitted by Senator Robert F.
Bennett, dated February 25, 2002............................... 654
Letter from GAO Comptroller General of the United States David M.
Walker to Senator Paul S. Sarbanes, dated May 3, 2002.......... 657
Letter from John C. Coffee, Jr., Bevis Longstreth, and Joel
Seligman to Senator Paul S. Sarbanes, dated July 1, 2002....... 670
Letter from SEC Chairman Harvey L. Pitt to Senator Phil Gramm,
dated July 3, 2002............................................. 674
Letter from SEC Attorney General Eliot Spitzer to Senator Paul
Sarbanes, dated June 5, 2002................................... 676
----------
WEDNESDAY, MARCH 6, 2002
Opening statement of Chairman Sarbanes........................... 679
Statement of Senator Gramm....................................... 680
WITNESSES
Shaun F. O'Malley, Chairman, 2000 Public Oversight Board Panel on
Audit Effectiveness (O'Malley Commission); Former Chairman,
Price Waterhouse; Past President, Financial Accounting
Foundation..................................................... 681
Prepared statement........................................... 716
Lee J. Seidler, Deputy Chairman of the 1978 AICPA Commission on
Auditors' Responsibilities; Managing Director Emeritus, Bear
Stearns........................................................ 685
Prepared statement........................................... 725
Arthur R. Wyatt, CPA, Former Chairman, American Institute of
Certified Public Accountants' Accounting Standards Executive
Committee; Former Chairman, International Accounting Standards
Committee; Former Partner, Arthur Andersen & Co.; Professor of
Accountancy Emeritus, University of Illinois................... 689
Prepared statement........................................... 739
Abraham J. Briloff, Emanuel Saxe Distinguished Professor
Emeritus, Bernard M. Baruch College, CUNY...................... 692
Prepared statement........................................... 745
Bevis Longstreth, Member of the O'Malley Commission; Former
Commissioner of the Securities & Exchange Commission, 1981-
1984; Retired Partner, Debevoise & Plimpton.................... 696
Prepared statement........................................... 793
Additional Material Supplied for the Record
Letter from Chairman Paul S. Sarbanes to President George W.
Bush, dated March 6, 2002...................................... 802
Letter from the National Association of State Boards of
Accountancy to Chairman Paul S. Sarbanes and Members of the
Banking Committee, dated March 22, 2002........................ 804
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THURSDAY, MARCH 14, 2002
Opening statement of Chairman Sarbanes........................... 809
Opening statements, comments, or prepared statements of:
Senator Bunning.............................................. 811
Senator Gramm................................................ 811
Senator Corzine.............................................. 813
Senator Enzi................................................. 813
Senator Dodd................................................. 815
Senator Bayh................................................. 816
Senator Stabenow............................................. 817
Prepared statement....................................... 860
Senator Miller............................................... 817
Senator Carper............................................... 842
WITNESSES
James G. Castellano, CPA, Chairman, Board of Directors, American
Institute of Certified Public Accountants (AICPA); Managing
Partner, Rubin, Brown, Gornstein & Company, LLP................ 818
Prepared statement........................................... 860
Response to written question of Senator Miller............... 888
James E. Copeland, Jr., CPA, Chief Executive Officer, Deloitte &
Touche, LLP.................................................... 820
Prepared statement........................................... 862
William E. Balhoff, CPA, CFE, Chairman, Executive Committee,
AICPA Public Company Practice Section; Senior Audit Director,
Postlethwaite & Netterville, A.P.A.C........................... 823
Prepared statement........................................... 865
Olivia F. Kirtley, CPA, Former Chairman, Board of Directors,
AICPA (1998-1999); Retired Vice President and CFO, Vermont
American Corporation........................................... 825
Prepared statement........................................... 866
James S. Gerson, CPA, Chairman, Auditing Standards Board, AICPA;
Partner, PricewaterhouseCoopers, LLP........................... 827
Prepared statement........................................... 868
Robert E. Litan, Vice President and Director, Economic Studies
Program, The Brookings Institution............................. 848
Prepared statement........................................... 870
Response to written question of:
Senator Gramm............................................ 889
Senator Miller........................................... 890
Peter J. Wallison, Resident Fellow and Co-Director, Project on
Financial Market Deregulation, American Enterprise Institute... 853
Prepared statement........................................... 879
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TUESDAY, MARCH 19, 2002
Opening statement of Chairman Sarbanes........................... 893
Opening statements, comments, or prepared statements of:
Senator Gramm................................................ 894
Prepared statement....................................... 939
Senator Corzine.............................................. 894
Senator Dodd................................................. 917
Senator Carper............................................... 936
Senator Akaka................................................ 939
WITNESSES
Charles A. Bowsher, Chairman, Public Oversight Board; Former
Comptroller General of the United States; accompanied by: Alan
B. Levenson, Counsel to the Public Oversight Board............. 895
Prepared statement........................................... 939
Aulana L. Peters, Member, Public Oversight Board; Former
Commissioner, U.S. Securities and Exchange Commission; Retired
Partner, Gibson, Dunn & Crutcher............................... 902
Prepared statement........................................... 963
John C. Whitehead, Former Co-Chairman, Goldman Sachs & Co.;
Former Deputy Secretary of State............................... 918
Prepared statement........................................... 965
L. William Seidman, Former Chairman, Federal Deposit Insurance
Corporation; Former Chairman, Resolution Trust Corporation..... 921
Prepared statement........................................... 967
Michael Mayo, Managing Director, Prudential Securities, Inc...... 925
Prepared statement........................................... 969
Additional Material Supplied for the Record
The Road to Reform, a White Paper from the Public Oversight
Board, dated March 19, 2002.................................... 973
Letter from Harvey L. Pitt, Chairman, U.S. Securities and
Exchange Commission to Charles A. Bowsher, Chairman, Public
Oversight Board, dated January 22, 2002........................ 994
Fortune news article, The Price of Being Right, dated February 5,
2001........................................................... 996
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WEDNESDAY, MARCH 20, 2002
Opening statement of Chairman Sarbanes........................... 1003
Opening statements, comments, or prepared statements of:
Senator Akaka................................................ 1004
WITNESSES
Senator Howard M. Metzenbaum (Ret.), Chairman, Consumer
Federation of America.......................................... 1004
Prepared statement........................................... 1032
Sarah Teslik, Executive Director, Council of Institutional
Investors...................................................... 1009
Prepared statement........................................... 1040
Response to written questions of Senator Akaka............... 1056
Thomas A. Bowman, CFA, President and Chief Executive Officer,
Association for Investment Management and Research............. 1012
Prepared statement........................................... 1043
Damon A. Silvers, Associate General Counsel, American Federation
of Labor and Congress of Industrial Organizations.............. 1016
Prepared statement........................................... 1053
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THURSDAY, MARCH 21, 2002
Opening statement of Chairman Sarbanes........................... 1059
Opening statements, comments, or prepared statements of:
Senator Dodd................................................. 1060
Senator Bunning.............................................. 1060
Senator Corzine.............................................. 1061
Senator Enzi................................................. 1062
Senator Gramm................................................ 1064
Senator Bennett.............................................. 1084
Senator Schumer.............................................. 1087
Senator Carper............................................... 1089
Senator Johnson.............................................. 1102
WITNESS
Harvey L. Pitt, Chairman, U.S. Securities and Exchange Commission 1065
Prepared statement........................................... 1103
Additional Material Supplied for the Record
The Washington Post article, submitted by Harvey L. Pitt,
Chairman, U.S. Securities and Exchange Commission, dated
November 15, 2000.............................................. 1167
Letter from Stephen M. Cutler, Director, Division of Enforcement,
U.S. Securities and Exchange Commission, to Chairman Paul S.
Sarbanes and Congressman Michael G. Oxley, dated July 23, 2002. 1168
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VOLUME III
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MONDAY, JULY 8, 2002
Senate Floor Debate in Regard to the Accounting Reform and
Investor Protection Act of 2002 taken from the Congressional
Record......................................................... 1171
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TUESDAY, JULY 9, 2002
Senate Floor Debate in Regard to the Accounting Reform and
Investor Protection Act of 2002 taken from the Congressional
Record......................................................... 1225
Continuation of the Senate Floor Debate in Regard to the
Accounting Reform and Investor Protection Act of 2002 taken
from the Congressional Record.................................. 1247
----------
WEDNESDAY, JULY 10, 2002
Senate Floor Debate in Regard to the Accounting Reform and
Investor Protection Act of 2002 taken from the Congressional
Record......................................................... 1261
----------
THURDAY, JULY 11, 2002
Senate Floor Debate in Regard to the Accounting Reform and
Investor Protection Act of 2002 taken from the Congressional
Record......................................................... 1355
Continuation of the Senate Floor Debate in Regard to the
Accounting Reform and Investor Protection Act of 2002 taken
from the Congressional Record.................................. 1387
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FRIDAY, JULY 12, 2002
Senate Floor Debate in Regard to the Accounting Reform and
Investor Protection Act of 2002 taken from the Congressional
Record......................................................... 1423
Continuation of the Senate Floor Debate in Regard to the
Accounting Reform and Investor Protection Act of 2002 taken
from the Congressional Record.................................. 1429
----------
MONDAY, JULY 15, 2002
Senate Floor Debate in Regard to the Accounting Reform and
Investor Protection Act of 2002 taken from the Congressional
Record......................................................... 1463
----------
THURSDAY, JULY 25, 2002
Senate Floor Debate in Regard to the Sarbanes-Oxley Act of 2002
Conference Report taken from the Congressional Record.......... 1613
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VOLUME IV
----------
Transcript of President Bush's remarks at the Signing Ceremony
for the Sarbanes-Oxley Act of 2002 on July 30, 2002............ 1653
The Sarbanes-Oxley Act of 2002, Public Law 107-204 signed by
President Bush on July 30, 2002. Text is identical to
Conference Report on H.R. 3763 passed by the House of
Representatives on July 25, 2002, by a vote of 423 Yeas to 3
Nays and by the Senate by a vote of 99 Yeas to 0 Nays.......... 1657
H.R. 5118, Corporate Fraud Accountability Act of 2002, passed by
the House of Representatives on July 16, 2002, by a vote of 391
Yeas to 28 Nays................................................ 1723
S. 2673, Public Company Accounting Reform and Investor Protection
Act of 2002, passed by the Senate on July 15, 2002, by a vote
of 97 Yeas to 0 Nays. For procedural purposes, the bill is
renamed H.R. 3763.............................................. 1737
Senate Committee on Banking, Housing, and Urban Affairs report on
S. 2673, Public Company Accounting Reform and Investor
Protection Act of 2002, filed by Chairman Sarbanes on June 26,
2002........................................................... 1879
S. 2673, Public Company Accounting Reform and Investor Protection
Act of 2002, passed by the Senate Committee on Banking,
Housing, and Urban Affairs on June 18, 2002, by a vote of 17
Yeas to 4 Nays................................................. 1953
Senate Committee on the Judiciary Report on S. 2010, Corporate
and Criminal Fraud Accountability Act of 2002, filed by
Chairman Leahy on May 6, 2002.................................. 2071
S. 2010, Corporate and Criminal Fraud Accountability Act of 2002,
passed by the Senate Judiciary Committee on April 25, 2002, by
a vote of 19 Yeas to 0 Nays.................................... 2109
H.R. 3763, Corporate and Auditing Accountability, Responsibility,
and Transparency Act of 2002, passed by the House of
Representatives on April 24, 2002, by a vote of 334 Yeas to 90
Nays........................................................... 2135
House Committee on Financial Services Report on H.R. 3763,
Corporate and Auditing Accountability, Responsibility, and
Transparency Act of 2002, dated April 22, 2002................. 2193
H.R. 3763, Corporate and Auditing Accountability, Responsibility,
and Transparency Act of 2002, passed by the House Committee on
Financial Services on April 16, 2002, by a vote of 49 Yeas to
12 Nays........................................................ 2257
ACCOUNTING REFORM AND
INVESTOR PROTECTION
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VOLUME II
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TUESDAY, MARCH 5, 2002
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:10 a.m. in room SD-538 of the
Dirksen Senate Office Building, Senator Paul S. Sarbanes
(Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES
Chairman Sarbanes. Let me call this hearing to order.
This morning, the Senate Banking, Housing, and Urban
Affairs Committee conducts the fifth in a series of hearings on
accounting and investor protection issues raised by the
problems of the Enron Corporation and other public companies.
As the serious and far-reaching ramifications of the Enron
situation continue to ripple through our capital markets, and
also through our economy, the Committee seeks to identify
underlying systemic and structural weaknesses that contributed
to the problems, and to seek remedies that will minimize the
possibility of future events of this kind.
The failure of Enron raises numerous important issues that
have arisen on occasion in connection with other public
companies. Among those that have been foremost in the minds of
the witnesses at our earlier hearings are the following: The
integrity of certified financial audits; accounting
restatements; accounting principles and auditing standards;
accounting regulatory oversight system; auditor independence;
corporate disclosure; the SEC's ``selective review'' of
filings; conflicts of interest; stock analyst recommendations;
corporate governance; and the adequacy of SEC resources. And,
indeed, other items as well.
In our previous hearings, the Committee received testimony
on these and other issues from witnesses with long and
distinguished experience in both the public and private
sectors. We have heard from five former Chairmen of the SEC;
the Chairman of the International Accounting Standards Board,
as well as the Chairman of its Trustees; a panel of former SEC
Chief Accountants, a former Chairman of the Financial
Accounting Standards Board, the CEO of a preeminent pension
fund serving the education and research community, and an
authority on corporate governance. Our witnesses have offered
recommendations for legislative and regulatory measures to
address the problems confronting us.
Our witnesses today bring important new perspectives to the
issues under consideration. They are: David Walker, Comptroller
General of the United States; Robert Glauber, the CEO of the
National Association of Securities Dealers, one of the capital
markets' principal self-regulatory organizations; and Joel
Seligman and John Coffee, two of the Nation's most
distinguished law school securities professors.
First, the Committee will hear from Comptroller General
Walker, who is the Nation's chief accountability officer and
the head of the General Accounting Office. Mr. Walker is a
Certified Public Accountant, and formerly was a Partner and
Global Managing Director of Arthur Andersen's Human Capital
Services Practice. Prior to joining Andersen, he was Assistant
Secretary of Labor for Pension and Welfare Benefit Programs and
Acting Executive Director of the Pension Benefit Guaranty
Corporation.
I should note that last spring, I, joined by two of my
colleagues on this Committee, Senators Dodd and Corzine, wrote
to the Comptroller General asking him to ``review whether the
Securities and Exchange Commission's resources are adequate to
stay abreast of the market and technological changes that are
occurring in the domestic and global financial markets.'' We
specifically asked in that letter ``whether the resources
available to the SEC are adequate for its ongoing efforts
regarding full and fair disclosure, enforcement and investor
education.'' Of course, we have now confronted these major
systemic challenges to the workings of the market and they make
those questions even more pertinent and relevant. And we look
forward to receiving from the Comptroller General the results
of the GAO investigation.
We have also invited the Comptroller General to share his
views on the oversight of the accounting industry, auditor
independence, corporate governance, and related issues.
The second panel will address the regulation of accountants
and the advisability of creating a new organization to regulate
the accounting profession, as well as such issues as conflict
of interest and the proliferation of accounting restatements.
We just recently asked the GAO to conduct a study on the
``proliferation of restatements of earnings and other financial
data which have been issued in recent years by publicly-traded
companies.''
I will introduce the individual members of the second panel
at the conclusion of the Comptroller General's testimony.
Before I turn to you, Mr. Walker, let me turn to my
colleagues to see if they have any opening statements.
Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. A short opening statement, Mr. Chairman.
[Pause.]
Chairman Sarbanes. Is that it?
Senator Bunning. No.
[Laughter.]
I won't keep you long, Mr. Walker.
First, I want to thank the Chairman for holding this
important hearing and I would like to thank our witnesses for
testifying.
It is very important to continue to look at the accounting
side of the Enron scandal. We have had some good hearings on
the issue already and I know that we have another hearing
tomorrow. I am fairly certain that we will have more after
that.
The industry has already started to move in the right
direction. All of the major firms have now fully separated
their consulting and auditing arms, but I think we need to do
that permanently. I would prefer to do it legislatively,
although the SEC is doing it by regulation. We have to make
sure that 10 or 20 years from now, we do not have auditors
doing consulting and start the whole process over again. I do
not believe that auditors doing consulting caused the Enron
collapse. It was certainly caused by greed. But it surely did
not stop the collapse.
There are a number of other options that we need to look at
on accounting standards. I look forward to hearing from our
witnesses. I also am very interested in hearing from our
witnesses on what they think of the role of analysts in Enron
and what we should do, if anything, about them.
I spent 25 years in the securities business. I am very
concerned about the so-called firewalls between the analysts
who are supposed to be thinking of their customers first and
foremost, and other aspects of a financial firm. We had
firewalls at the firm that I worked at, but believe me, I knew
what the rest of the firm was doing and so did everyone else.
I am looking forward to your testimony and I thank you for
coming before us today.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you very much, Senator Bunning.
Senator Dodd.
COMMENTS OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you, Mr. Chairman, for holding this
hearing. This has been a very, very helpful set of hearings.
Having had a chance to look at the GAO report, this is
going to be a very worthwhile document I think in making the
case that we have tried to make for some time now. The
rationale for asking the GAO to look at this was based on some
very strong feelings of inadequate resources and other
problems. And as you point out, this is not just a question of
resources, but turn-over rates and also the workload we are
imposing on the SEC as well, contribute to some of the problems
we are facing. But I think this will do a great deal to help us
as we try to fashion some suggestions legislatively to deal
with the issue.
So, Mr. Chairman, I am appreciative of this set of hearings
and look forward to the testimony.
Chairman Sarbanes. Thank you very much.
Senator Miller.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. Thank you, Mr. Chairman. I have no opening
remarks. But I want to say again, thank you for holding these
hearings and I thank our witnesses for being here to testify.
Chairman Sarbanes. Thank you very much.
Senator Crapo.
COMMENTS OF SENATOR MIKE CRAPO
Senator Crapo. Thank you, Mr. Chairman. I also have no
opening remarks and again, thank you for holding these
hearings.
Chairman Sarbanes. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. I have a statement I will put into the
record.
This has been a very revealing set of hearings and
informative to all of us. I think the report on the increased
workload is a very, very positive piece and I appreciate the
response and I look forward to your comments on some of the
structural issues with regard to how we go forward.
I appreciate it very much, Mr. Chairman.
Chairman Sarbanes. Thank you very much. We would be happy
to turn to you, Mr. Walker.
STATEMENT OF DAVID M. WALKER
COMPTROLLER GENERAL OF THE UNITED STATES
U.S. GENERAL ACCOUNTING OFFICE
ACCOMPANIED BY: THOMAS McCOOL
MANAGING DIRECTOR, FINANCIAL MARKETS AND COMMUNITY INVESTMENT
AND ROBERT GRAMLING, FORMER DIRECTOR
CORPORATE FINANCIAL AUDITS
Mr. Walker. Thank you, Mr. Chairman, Senators. It is a
pleasure to be here today to address certain systemic issues
designed to better protect the public interest in light of
Enron and other recent earnings misstatements and business
failures.
I would like, Mr. Chairman, to enter into the record, if I
can, a copy of my full statement, which I think has been
provided to you, of which I might note, the last two pages
represent a copy of these two charts that I will refer to a
little bit later.
Chairman Sarbanes. The full statement will be included in
the record.
Mr. Walker. Thank you, Mr. Chairman. In this statement,
there are a number of key questions dealing with a variety of
elements of our current system that we believe need to be
addressed. We look forward to working with the Congress and
others in doing that, but let me summarize some of the key
points, if I can, Mr. Chairman.
I will not address Enron directly. As you know, there are
many players on the field already with regard to Enron. At the
same point in time, there are a number of systemic issues I
think that are raised by the Enron situation, as well as other
recent earnings restatements and other business failures.
There is a need to examine a range of important and
interrelated systemic issues. I will touch on four this
morning. First, corporate governance. Second, independent
audits. Third, the regulatory and oversight structure. And
fourth, the accounting and financial reporting model.
I will also touch on the recently issued report on the SEC
that you just noted, Mr. Chairman, and I would like to have
that inserted into the record as well, if at all possible.
Chairman Sarbanes. It will be included in the record.
Mr. Walker. Mr. Chairman, I am also going to refer to
another document that is being released today which represents
a summary of a roundtable discussion that we held last Monday
with a number of top experts whose names are included herein,
to talk about a range of corporate governance, transparency and
accountability issues that I would also commend to you and the
Members, and would like for that to be inserted into the
record, if at all possible.
Chairman Sarbanes. Without objection, it will be so
included.
Mr. Walker. Thank you.
In addressing these issues, I would like to note that there
are three key principles that, in our view, need to be
addressed in order to ensure that any system functions
effectively.
First, there needs to be adequate incentives in place for
people to do the right thing. Second, there needs to be
adequate transparency in order to provide reasonable assurance
that the right thing will be done. Third, there needs to be
appropriate accountability if the right thing is not done. And
these three elements, in our view, relate to the entire
testimony, as well as other areas.
I will start with the corporate governance area.
Clearly, serving on a board of directors is an important,
difficult, and challenging responsibility in today's times.
Boards of directors work for the shareholders and they need to
have an adequate number of qualified, independent, and
adequately resourced members in order to do their job
effectively.
Audit committees have a particularly important role to play
in connection with interaction with both internal and external
auditors, as well as in connection with making sure that the
enterprise has a sound and effective system of internal
controls and that they are properly reporting their results in
accordance with applicable standards.
With regard to independent audits, external auditors or
independent auditors play a critically important role in
assuring that our capital markets function effectively and
efficiently. External auditors work for the shareholders and
they hold a public trust. This trust must not be violated.
Auditors need to be both qualified and independent. While
audit firms have the ability to provide a broad range of
services to their clients, they should not perform certain
nonaudit services given related conflict-of-interest issues.
There are certain nonaudit services that should not be a
problem. There are other nonaudit services that do present
problems. In this regard, Mr. Chairman, GAO within the last 2
months has issued a new independence standard, which is
generally included in accepted auditing standards for the
Federal Government entities, the so-called ``Yellow Book,'' in
which we have outlined a principles- and safeguards-based
approach which we believe provides a sound framework for
addressing some of the concerns that have been expressed about
auditors performing certain nonaudit services.
We are in the process of providing additional guidance,
questions and answers commentary that is necessary in a
principles-based approach. We are working with interested
parties to do that and are hopeful that the AICPA will end up
following the GAO's lead in taking a similar approach in
dealing with a range of other independence issues that are
beyond our direct authority to address.
It is very important that auditors focus not just on
whether or not the statements are presented in accordance with
Generally Accepted Accounting Principles. It is also critically
important that they make an affirmative determination as to
whether or not the statements are fairly presented in all
material respects.
Both of these elements are critical. As a result, auditors
have a responsibility to try to assure that there are not
material misstatements. They should assure that the financial
statements are free of these material statements and in
addition, in today's complex and rapidly changing world, it is
critically important, both for boards of directors, as well as
auditors, that they focus adequate attention on the entity's
systems and internal controls. They are critically important.
GAO has for years done additional work on internal controls
with regard to Federal Government entities and in fact, we
express an opinion on whether or not those controls are
effective.
We believe that the same needs to be considered for the
private sector, for at least public companies, as to whether or
not auditors should have a responsibility for expressing an
opinion on these key controls which are becoming increasingly
important given rapid changes in emerging technologies.
With regard to the regulatory and oversight structure,
these two charts, which are presented as the last two pages of
my testimony, provide an illustrated summary of who some of the
key players are who are relying on our current system. You have
individual investors, institutional investors, banks and
lenders or other creditors, and rating agencies, among others.
They are relying upon a wide array of players who have
various rules and responsibilities under the current system.
Time does not allow for me to explain the chart on the
right, but nonetheless, I think it serves to illustrate that
there are a lot of players on the field. It is not always very
clear as to what the different role and responsibility of each
player is. In some cases, there are overlaps. In some cases,
there are gaps. And in some cases, there may be
inconsistencies.
In summary, the current self-regulatory system is deemed by
many to be fragmented, not well-coordinated, and has a
discipline function that is not timely and does not contain
effective sanctions. For example, the AICPA's disciplinary
function is to kick you out of the AICPA. Well, I am a member
of the AICPA and I am a CPA in at least three States, and
obviously, I do not want to be kicked out of the AICPA. If I
get kicked out of the AICPA, and there is no requirement to
join the AICPA, it saves me some annual dues.
I would hardly suggest that that is an effective sanction.
On the other hand, with regard to the State regulatory
authorities, the State boards of accountancies, they have the
ability to pull my license to practice and pull the certificate
of any auditor who violates their standards, the so-called
nuclear device. But they rarely, if ever, use that sanction. As
a result, we need to understand whether or not we have really
meaningful sanctions in order to provide appropriate checks and
balances.
With regard to the accounting and reporting model, the
current accounting and reporting model is inadequate to meet
the needs of the users and it is not properly aligned with our
knowledge-based economy in the 21st Century. Accounting must be
based on the economic substance of a transaction, irrespective
of its form. Additional focus is needed in connection with a
variety of value and risk-related factors inherent in our 21st
Century economy.
In addition, the timeliness and usefulness of current
reporting is also an issue and additional emphasis needs to be
placed on key trend and performance-related data.
Mr. Chairman, with regard to our SEC report, which you have
so kindly put in the record, in summary, I would say the
following.
There is a growing mismatch between the SEC's
responsibilities and their resources. Resources are not just
financial resources, they are human resources, as well as
technological capabilities. There is a need for a comprehensive
and integrated plan to address these matters, focusing on value
and risk. The SEC's human capital challenge or people challenge
is of particular importance given their turn-over rates and the
current environment in which they are
operating.
It is also critically important that the SEC have a strong,
effective and credible enforcement function which will include
both civil, as well as criminal penalties in appropriate
circumstances.
Our current system, as you know, is based largely on civil
sanctions and that is understandable for a variety of reasons.
However, when people violate the law in ways that could violate
criminal statutes, it is critically important that there be
full accountability. You do not have to give very many people
wide stripe suits in order to send a strong signal.
In summary, the effectiveness of our current systems of
corporate governance, independent audits, regulatory oversight,
and accounting and financial reporting, which are the
underpinnings of our capital markets and are designed to
protect the public interest, have been called into question as
a result of Enron and other recent activities.
Many of these issues that are being raised have previously
surfaced from other business failures and restatements of
financial statements that significantly reduced reported
earnings or equity.
The results of the forum that we held last week on
governance, transparency, and accountability identified a range
of major issues that should be addressed and I have touched on
some of those today.
As is usually the case in issues of this magnitude and of
this importance, there is no single silver bullet to quickly
make repairs needed to the systems that support our capital
markets. The fundamental principles of having the right
incentives, adequate transparency and full accountability
provide a good sounding board to evaluate proposals that are
advanced. A holistic approach is also important as the systems
are interrelated and weak links can severely strain their
effective functioning.
Finally, Enron's recent decline and fall, coupled with
other recent business failures, pose a serious range of
systemic risks that must be addressed. Effectively addressing
these issues should be a shared responsibility involving a
number of parties, including top management, boards of
directors, various board committees, stock exchanges, the
accounting profession, standard setters, regulatory oversight
agencies, analysts, investors, and the Congress.
In the end, no matter what system exists, bad actors will
do bad things with bad results. We must strive to take steps to
minimize the number of such situations and to hold any
violators of the system fully accountable for their actions.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you very much. Did you want to
discuss those charts at all? They are such a large presence in
the Committee room----
[Laughter.]
I think we ought to direct your attention to them, if only
for a few minutes.
Mr. Walker. Well, I will give you a couple of highlights,
Mr. Chairman.
Chairman Sarbanes. All right.
Mr. Walker. Time doesn't allow going into a lot of depth.
You have several different components of our system on
which the public relies. And it is not just the shareholders,
obviously, that we are talking about, but it is also the
confidence of the investing community and a variety of other
parties in our capital markets including the key players that
have important roles to play.
There are at least four major elements. You have public
regulation. Public regulation, by and large, is done by the
Securities and Exchange Commission and by the various State
boards of accountancies who regulate the license of independent
certified public accountants to practice.
A variety of private-sector or nongovernmental type
entities are involved in providing regulatory oversight. In
some cases, they are self-regulatory organizations. In some
cases, they are professional associations like the AICPA.
With regard to the self-regulatory concept, on the
accounting side, you have the Financial Accounting Standards
Board, which is noted on the chart. You also have
responsibilities on the audit side, which are divided between
the SEC, the AICPA, and the Public Oversight Board.
You have other key players which have been alluded to, such
as the exchanges, who set certain requirements for being listed
on the exchanges, broker-dealers, and analysts who work for
those broker-dealers. On the far right, you have our overall
corporate governance structure, the board of directors, the
audit committees, and the various sub-entities of the board.
There are various codes of conduct and requirements that
apply. Finally, the public accounting firms obviously have
interaction with a variety of these different parties.
This chart serves to illustrate, Mr. Chairman, that we have
a fragmented system. We have a lot of players on the field.
Quite frequently, there is not adequate coordination.
Timeliness is a question and also the effectiveness of some of
the sanctions when there are violations are a real question as
well.
I will give you an analogy real quickly, Mr. Chairman.
I used to be the Assistant Secretary of Labor for Pensions
and Welfare Benefits, the fiduciary responsibility provisions
involving trillions of dollars and millions of individuals.
The IRS had responsibility for administering the tax
qualification requirements. Their most significant sanction was
they could disqualify a plan. That would have very adverse
consequences on employers, on employees, and on a variety of
other parties.
As a result, they hardly ever utilized that sanction for
understandable reasons. And so, there was a need for more
effective sanctions, both civil and criminal, beneath that, in
order to make the system work.
The analogy also applies to the State boards of
accountancy, in the case of the CPA's, who can pull somebody's
license, but there are not adequate enough sanctions and
incentives short of putting somebody out of business.
Chairman Sarbanes. I understand that the GAO has recently
issued an independent standard for Government audits. It says
that the auditors should not provide both audit services and
material consulting services. Is that correct? And could you
describe those rules and rationale a little more fully?
Mr. Walker. Mr. Chairman, we have issued something dealing
with generally accepted Government auditing standards that
deals with independence. That is the so-called ``Yellow Book.''
Basically, what we have done is we have taken a principle-based
approach.
It is important to note that there are certain types of
nonaudit services or ``consulting services,'' that present
potential conflicts which need to be avoided. However, not all
nonaudit or consulting services present those types of
conflicts. So, therefore, what we did was to, through a several
year process involving a number of parties, come up with a
proposed standard that first relies on two basic principles--
that auditors should not perform management functions or make
management decisions. And second, auditors should not audit
their own work or provide nonaudit services in situations where
the amounts or services involved are significant or material to
the subject matter of the audit. Namely, the subject matter on
which they are expressing an opinion.
In addition to that, we provided examples of services that
would not violate these principles, as well as services that
would violate them. For example, auditors should not maintain
the basic books and records on the entity in which they are
conducting an audit and expressing an opinion. Under the
current AICPA standards, it is possible for that to be done. We
believe that is a fundamental conflict and is inappropriate.
At the same point in time, there are certain types of work
that auditors can do dealing with the systems of internal
controls, et cetera, which would be fine for them to do, which
could be above and beyond the audit.
To the extent that an auditor does not violate these
standards, we also have incorporated certain safeguards that
would provide additional protection not only to shareholders,
but also to other persons who are relying upon the independent
auditor. I think it is important to note that our standard does
not relate to public companies. Our standard relates to audits
of Federal Government entities and certain entities that
receive Federal funds, not to the private-sector entities. That
is the responsibility of the AICPA and the SEC. We are
coordinating with Chairman Pitt and the AICPA in hopes of
reconciling some of the differences here.
Chairman Sarbanes. Well, you seem to have set the AICPA off
because they have now sent out a key alert to all of their
constituency here. I just want to quote from some parts of it:
``Thank you very much for your efforts to reach your Member
of Congress during the President's Day recess. It is important
that you contact your Member of Congress again, and contact
your Representatives and Senators.
``As you are aware, Congress continues to focus on the
Enron failure and its fall-out. More than 30 legislative
proposals have been introduced so far, with more to come. Many
of these bills will not move toward enactment and many
proposals deal with issues that are peripheral to the CPA
profession. However, there is one overriding issue that we must
be especially vigilant about--the prevention of a cascade
effect if legislation is adopted that is intended only to
affect public trading companies or their auditors.''
And then they go on later to talk about the recently issued
GAO independence standard which applies to Yellow Book audits
and so forth. Then everyone is urged to communicate with their
Senators and so forth, about the harmful potential.
``This issue has the potential of being harmful in more
profound ways than any issue we have faced. Your help is
necessary to deflect it before the public and the profession
are adversely affected.''
That is from the AICPA out to its--I think they call them
key persons, the action alert team.
I might note that they have been invited and will be
testifying before the Committee next week. So, they have an
opportunity very directly in open session to make these points
and we look forward to receiving with an open and objective
attitude whatever proposals they bring. But I just thought it
was interesting to see these alarm bells being sounded here,
and I wanted to get some aspects of this into the record.
Mr. Walker. May I respond real quickly, Mr. Chairman?
Chairman Sarbanes. Certainly.
Mr. Walker. First, I think that the AICPA's statement is
clearly an overstatement.
Second, this is not something that GAO started working on
as a result of Enron. We have been working on it for over 2
years.
Third, in the profession, there is a tension, the CPA
profession. And I am a CPA. There is a tension between the
professional side, which I would argue is the public interest
side, and the business side or the economic side.
Reasonable people can differ on where you should draw those
lines. However, it took decades for the profession to build
public trust and gain public confidence. It can be lost very,
very quickly.
We believe it is critically important that one of the
things that has to be addressed is the independence issue and
part of the independence issue is what type of nonaudit or
consulting services are appropriate and which ones aren't?
We feel very comfortable that we have struck a reasoned and
reasonable balance in that regard. But we look forward to
working with the AICPA and other interested parties to answer a
number of questions that have arisen, which is understandable
when you have a principle-based approach. We cannot answer
every situation. We are trying to get people to rise up and
say, hey, do what is right.
It is what I said before about the idea of are the
financial statements fairly presented in all material respects?
It is not just whether you check the boxes off. Is the bottom
line right? Does it pass The Washington Post test? Does it pass
the Congressional committee test?
Chairman Sarbanes. We have been joined by Senators Stabenow
and Bennett. I will yield to them briefly if they have any
opening comments, and then, Senator Bunning, it is your turn to
question.
Senator Stabenow.
COMMENTS OF SENATOR DEBBIE STABENOW
Senator Stabenow. Mr. Chairman, I would just ask that my
statement be put into the record and I want to thank you again.
I realize that this may not have the same headlines as when Ken
Lay and Andrew Fastow come before other committees, but this is
where I believe the real work will be done in terms of the
future and what is in the best interests of the American
people.
So, I want to thank you for this continuation of the
hearings.
Chairman Sarbanes. Thank you.
Senator Bennett, did you have anything?
COMMENT OF SENATOR ROBERT F. BENNETT
Senator Bennett. No, thank you, Mr. Chairman, I do not have
a statement at this time.
Chairman Sarbanes. Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman. Let me see if I
can weed out what you have said and what you haven't said.
Your recommendations are for governmental entities. What we
are really struggling with is recommendations for the private
sector, their auditors being consultants and auditing the same
books that they are consulting with, financial consultants.
I don't think you can separate 80 percent and let them do
20. In other words, I think there has to be a complete
separation for the public to get the confidence back that was
lost with Global Crossing or Enron, I find it impossible to
believe that an analyst for First Boston or J.P. Morgan or
whoever, would not have knowledge that they were in the
underwriting group, the selling group, or have a financial
position in a security. And yet, they are free to make a
recommendation to buy or sell the stock.
What are your solutions to that position? In other words, I
need your help in the publicly-traded companies.
Mr. Walker. I see, let me start with the auditors first.
You are correct, Senator Bunning, that our standard only deals
with the audits of Federal Government entities and entities
that receive Federal funds. However, we believe the principle-
based approach, which would say, you must comply 100 percent of
the time with this principle-based approach, and in addition,
to the extent that you perform certain nonaudit or consulting
services that do not violate those standards, again, you have
to comply with certain additional safeguards.
We believe that type of approach has the potential to be
applied in the public company arena, as well as in other arenas
in addition to the governmental arena. I have already talked to
Chairman Pitt about it and they are looking at it and
considering it as well.
I have also talked to the head of the AICPA because they
promulgate independent standards for CPA's, no matter what type
of work they do, as well as the State boards of accountancy.
They have an interest in this. For example, the Texas State
Board just contacted us within the last couple of days and they
might be interested in adopting our independence rules in lieu
of the current AICPA rules because they see them as addressing
some of the issues that need to be strengthened.
Senator Bunning. What sanctions would you recommend if you
think the current standards are inadequate?
Mr. Walker. I think sanctions are a different issue. I
think one of the things that you ought to consider with public
companies is not just what you should be able to do and what
you shouldn't do. My belief is that one of the biggest problems
we have in the current system is the definition of who is the
client?
I would respectfully suggest that in the case of the
external auditors, the client is the shareholders, not
management. The proxy for the shareholders would be the audit
committee and that you may want to consider whether or not the
audit committee is the entity that ends up making decisions not
only on who is going to be recommended to be hired and retained
as auditors or discharged as auditors, but also you may want to
consider whether or not the audit committee has some role in
overseeing these standards. You may want to think about whether
or not the audit committee should receive the resources for the
corporation to make sure that the right thing is being done by
the auditors.
Senator Bunning. Don't we have a direct conflict here
because sometimes, the audit committee is not well informed by
the auditors. Therefore, they have been either lied to or
distorted audits, audits that are not truthful. And because of
the conflict on the other side, we have a direct effect of what
audit comes out. Therefore, the board of directors or the
auditors on the board of directors that are hired by the audit
committee, maybe, are not getting factual truth and they have
been distorted and lied to by the auditor because of the other
side of the public-held corporation.
Mr. Walker. I believe that it is important to have
qualified, independent, adequately resource members on the
audit committee. They have to meet all of those standards. They
have to be qualified, independent, and adequately resourced. In
certain circumstances, they may need their own staff. They need
to have control over who is doing the audit and what resources
are available for that audit to be done.
I believe that there should be a mutuality of interest
between the audit committee, who is working for the
shareholders, and the auditors, who are supposed to be working
for the shareholders. But in addition to the auditors working
for the shareholders in a public company, they also hold a
public trust because the entire system relies upon certain key
players to do the right thing. If they do not do the right
thing, I think they need to be held accountable.
Senator Bunning. Accountable, to the point of when they
have defrauded, that they be brought before the justice system
and taken care of ?
Mr. Walker. My personal view is that most of the sanctions
are civil in nature for understandable reasons. But there are
appropriate circumstances where criminal sanctions should be
imposed.
Senator Bunning. Thank you.
Chairman Sarbanes. Senator Dodd.
Senator Dodd. Thank you, Mr. Chairman. And thank you to the
panelist. This has been most worthwhile. Mr. Walker, we thank
you for your work. I have two questions I would like to raise
with you. I will try to get through both of them in the time we
have.
Your report indicates, as I mentioned in my opening
comments, that SEC resources are inadequate. That is a point
that Senator Sarbanes has made. We have talked about this over
the past number of hearings. The SEC Commissioners have made
the point that there is significant understaffing and you
highlight the reasons why. Turnover rates, and I suspect a lot
of it has to do with parity and pay, just trying to keep
accountants and lawyers and analysts that are being offered
substantial increases in their annual pay to leave Government
and join private firms, I presume, makes it very difficult for
people to stay.
What I would like to get at, if I can with you, is what
divisions are in most need of additional staff based on your
study? Corporate finance? Enforcement? The accountants'
offices? I would like to get some sense of where the gaps are
here in light of the circumstances that have occurred. Could
you shed some light on that for us?
Mr. Walker. I would like to have Mr. McCool, the Managing
Director of the relevant team, come up, who oversaw that work.
Senator Dodd. Fine.
Mr. McCool. Senator Dodd, we did not actually----
Chairman Sarbanes. Mr. McCool, why don't you identify
yourself, name and position, for the Reporter.
Mr. McCool. Yes. Thomas McCool, Managing Director of
Financial Markets and Community Investment.
Senator Dodd. Mr. Chairman, you cite one example here in
the report. You say, for example, staffing limitations and
increased workload have resulted in SEC reviewing a smaller
percentage of corporate filings and important investment
protection functions.
In 2001, the SEC reviewed about 16 percent of annual
corporate filings or about half of its annual goal of 30 to 35
percent. That would be one area, for instance.
Mr. McCool. We found that there are issues across the board
at most of the major divisions at SEC. I think that we did not
necessarily find that one division was more in need or needed
more resources of a particular type than another.
I would suggest, however, that I think our work did shed
light on the fact that probably corporate finance and
enforcement are the areas where the workload has increased
relative to resources in a more significant fashion than some
of the others.
Senator Dodd. How about accounting? I was told there are
about 25 to 30 people in the chief accountant's office. Am I
wrong in that? Is that number too low?
Mr. McCool. I am not actually sure how many are in the
chief accountant's office. I am sorry.
[Pause.]
That is about right. That is about right, 25. I am sorry.
Senator Dodd. Mr. McCool, a freshman Congressman has a
bigger staff than that.
[Laughter.]
Seriously.
[Laughter.]
Chairman Sarbanes. Just to show how bad things really are.
[Laughter.]
Senator Dodd. It is stunning. That is a stunning number.
Mr. McCool. Again, I think it also does reflect what we
talked about earlier, about the role of SEC in the system. One
of the thoughts would be how you rethink that role, which is
part of the larger question.
Senator Dodd. All right. In other words, you are not
prepared or--some of the examples you cite--what I was looking
for was some additional information that may not be in the
report, where you get into specific areas that you would
recommend that seem to be particularly short.
Mr. McCool. Again, for reasons of lack of data at the SEC
and the time constraints to gather original data, we were
unable to find measures of what were the real impact and where
the impact was differentially greater for one division versus
others.
Senator Dodd. Yes, Mr. Walker?
Mr. Walker. Senator Dodd, I would suggest that one of the
things that needs to be done at the SEC is there is clearly a
mismatch between what they are being asked to do and the
resources they have to be able to do it.
I would assert that there is a need for them to kind of
fundamentally step back and reassess what are they trying to
accomplish, how do they measure success, to what extent are
they relying upon some of these other players in order to do
things that otherwise they might do, to what extent is that
reliance justified?
They need to then come up with what do they think are the
adequate numbers of people that they need in order to discharge
their responsibilities?
It is a comprehensive workforce plan linked to their
strategic plan and their role with regard to the overall
system.
I also think they need to place additional emphasis on
technology. When you look at the number of filings that they
receive every year, it doesn't make any difference how many
people you have. It is going to be virtually impossible to be
able to ever have enough people to do what needs to be done
manually. Therefore, they need to be leveraging technology to a
much greater extent to identify risk areas that they can focus
whatever human resources they have on the areas that likely
represent the greatest risk.
We had this problem when I was at the Labor Department
where we had 900,000 filings every year on pension and other
employee benefit plans. We had people manually going through
them. We designed and implemented an automated system that
helped to leverage those resources to make them more effective.
Last, it is not just a matter of how much you pay people,
and clearly, there is an issue there. It is a matter of on what
basis you pay people. In other words, obviously, people that
have greater skills and knowledge and better performance ought
to be paid a greater amount than other individuals. And I know
that Chairman Pitt has talked about the need to pay people
more. No doubt about that, and he needs to get adequate funding
to get that done.
But he has also expressed an interest to try to relook at
how people are paid. To what extent would be variable pay
versus fixed pay? To what extent would it be based on factors
other than the passage of time and the rate of inflation?
Senator Dodd. When you were looking at the SEC, to answer
your own first question, are they doing it? There is a new
building going up. So there is a new effort here. Are you
satisfied that
they are, in fact, looking at technology to do exactly what you
are
suggesting?
Mr. Walker. We believe that more needs to be done in the
work force planning area and the leveraging of technology,
given the mismatch between what they are being asked to do and
what they have to do it with.
Senator Dodd. I will get back. Thank you, Mr. Chairman.
Chairman Sarbanes. This is an opportune time, I think, to
include in the record, given this questioning, this article
from the March 11 Business Week--``Can The SEC Handle All This
Scandal?--Its Chief Enforcer Faces a Swelling Caseload and a
Frozen Budget.'' This obviously bears very much on what Senator
Dodd has been asking. So, without objection, we will include
that article in the record.
Senator Bennett.
Senator Bennett. Thank you, Mr. Chairman.
Mr. Walker, welcome to the Committee. We always appreciate
hearing from you and appreciate the work you do.
I cannot let the opportunity pass without thanking you and
the GAO for the work that you have all done on auditing the
various statements that have been made about the Olympics. We
understand that you are going to do an after-action report once
the Paralympics are over. We look forward to that.
Chairman Sarbanes. I think we should congratulate Senator
Bennett and the Utah delegation for a job well done with
respect to the winter Olympics.
Senator Dodd. Mr. Chairman, I actually went out and spent a
couple of days. My wife's family is from Utah.
Senator Bennett. He had the youngest credentialed----
Senator Dodd. The only criticism I have is they made my
five-month-old daughter be credentialed.
[Laughter.]
There are various explosions that she was involved in, but
I did not think----
[Laughter.]
The only threat she posed was to her father in that regard,
I might add.
[Laughter.]
But we had a wonderful experience. The people of Utah, the
volunteers, there are a lot of wonderful organizations, but the
thousands of people who volunteered their time from that State
to make this happen--that was the most important feature I saw
in the entire event, the volunteers. So, my congratulations.
Chairman Sarbanes. Yes. Apparently, their hospitality and
their grace drew really terrific plaudits, not only here, but
also abroad as well.
Senator Bennett. Thank you very much. I appreciate that. As
I say, Mr. Walker played a role in that, as did his agency.
I would like unanimous consent to put in the record an
article that appeared in The Wall Street Journal online,
``Listing in a Material World,'' by Andy Kessler.
Chairman Sarbanes. It will be included in the record.
Senator Bennett. I would like to pursue that with you for
just a minute, Mr. Walker. Mr. Kessler says we can solve a
whole lot of these problems if we define more clearly the word
materiality. What is material and what is not?
Senator Dodd and I lived through the Y2K experience and
worked with Arthur Levitt. We tried to get disclosure from
companies as to where they were with respect to their Y2K
preparation. We had some resistance from some companies that
would say, well, we do not have to disclose that because it is
not material. And both Senator Dodd and I would say, the
potential that none of your computers will work and your entire
IT system might shut down is not material?
They said, well, the amount of money that we would spend to
fix it falls below the percentage threshold of materiality, so
we do not need to tell you where we are. And Senator Dodd,
particularly in some of the health care issues, was very
aggressive in naming those companies that would not tell us
where they were.
It was clearly a material fact with respect to the
survivability of the firm. Yet because the numbers fit below
the percentage threshold that the accountants would look at, we
had some problems. Now Arthur Levitt worked with us on that,
and there were SEC regulations on that and they were very
helpful.
I think the point that Mr. Kessler makes is a good one, and
I would like your comment on it, that many times, restructuring
of earnings come about because the original statement is judged
to be immaterial.
In Enron, there was a little bit of immateriality here, and
a little bit of immateriality there. And pretty soon, the old
Everett Dirksen statement applied--a billion here and a billion
there, and pretty soon, you are talking about real money.
So is this something, in your professional judgment, that
could be pursued with profit to get more transparency in all of
these statements?
Mr. Kessler makes another point that I will give you, and
then I will listen to your response. He said the materiality
threshold should be voluntary. If I might read from his
article, he said, ``Want to stay at 10 percent? Fine, just tell
me. Oh, your stock may trade at a lower earnings multiple,
though, since no one can trust your earnings. Want to claim a 1
percent materiality threshold? Great, but you better back it up
with all sorts of details about how revenues break down,
prices, larger customers, and so on.''
For his final comment, he said: ``Don't have that much
detail at hand about your own company? I would get your number-
crunchers on it real quick. And if you do not want to disclose
information, stay private, and try borrowing money from your
local bank.''
I think these are very significant observations, and I
would like your response.
Mr. Walker. In addition to the issues of who is the client
being a fundamental question, I think the issue of materiality
is also a fundamental question.
Auditors are supposed to focus on the concept of
materiality, not just in quantitative terms, but also in
qualitative terms. Some things cannot be translated into
numbers, if you will.
I think the idea of trying to focus more time and attention
on what is a reasonable definition of that, the idea of trying
to couple that with additional transparency to the extent that
judgment is being used, then what are the parameters that
individuals have chosen as the basis of making that type of
judgment, is something that is worthy of further discussion and
debate.
Senator Bennett. Thank you, Mr. Chairman.
Chairman Sarbanes. Senator Miller.
Senator Miller. I will pass, Mr. Chairman.
Chairman Sarbanes. Senator Corzine.
Senator Corzine. Thank you, Mr. Chairman.
I would like to go through a little bit of this chart, if I
could, and try to get at the question of who audits the
auditors and how that would flow through this method of
oversight of the current structure, and is it with a bias of
trying to find out whether it is a clear flow of
accountability.
Mr. Walker. Basically, if we focus on public companies, you
have the SECPS, which is the SEC practice section, which deals
with public companies. And for firms that audit public
companies, a peer review must be conducted.
Senator Corzine. What does the SEC do with regard to----
Senator Dodd. Jon, can you pull that microphone a little
closer to you?
Senator Corzine. Can you say what the SEC has to do with
regard to the auditing? Is there any oversight function or is
there any auditing of the auditors by the SEC?
Mr. Walker. They have mandated that a peer review be done.
But they have basically relied upon the Public Oversight Board
as the entity that would actually oversee the peer review
process. The Public Oversight Board is an entity that was
created through consultation between the AICPA and the SEC.
Senator Corzine. The AICPA is a trade association.
Mr. Walker. A professional and a trade association. It has
features of both.
Senator Corzine. Not publicly-chartered, though.
Mr. Walker. No, it is not publicly-chartered, that is
correct.
Senator Corzine. And does the POB have peer reviews of
every audit?
Mr. Walker. No. Basically, there is a requirement that
every major firm must have a peer review on a cycled basis.
Practically, what has happened in the past is that firms
hire other firms to do that review.
Senator Corzine. Every audit or of----
Mr. Walker. No. It is the system. Basically, what is
audited----
Senator Corzine. So Enron's audits were never reviewed on a
peer-review basis by another auditor.
Mr. Walker. I cannot comment on whether or not Enron
specifically was. It has been reported that Enron was not the
subject of the initial peer review by Deloitte & Touche, which
was the firm that Arthur Andersen had hired to do their peer
review work. And since that case was in litigation, I am not
sure whether or not they subsequently went back and did
anything or not.
My understanding is, no, they did not.
Senator Corzine, what is important here is whether or not
they looked at Enron because, by definition, they are going to
look at a sample of engagements. They are not going to look at
every audit.
Senator Corzine. Sure.
Mr. Walker. Part of the question is, on what basis are they
picking the ones they are going to audit? I would assert that
one of the things that needs to be done, not only by the SEC,
but also by the self-regulatory organizations, is they need to
have a more risk- oriented approach to determining which ones
are going to be looked at, and----
Senator Corzine. You mean like restatements.
Mr. Walker. Right. What caused them to occur? What are the
factors and how can that be worked into the oversight process,
the peer-review process, to minimize, but not eliminate, the
possibility of it happening again?
Senator Corzine. Let me get this straight. POB, through its
supervision of the peer-review process, is not looking at an
individual audit to see whether the operations of that audit
are conforming with the rules and regulations.
To try to pick an analogy, it is not the same thing that
you would see from the New York Stock Exchange coming in and
looking at a broker-dealer firm to see whether you were
complying with capital adequacy rules.
Mr. Walker. No. The individual firms that--for example, it
is my understanding that Arthur Andersen hired Deloitte &
Touche. Deloitte & Touche is conducting the peer review on
Arthur Andersen. That involves looking at their overall system
and it also involves them selecting a number of engagements
that they would end up testing. And the POB ends up overseeing
the process at a higher level, typically not down to the
individual engagement level.
Senator Corzine. First of all, what is the output of those
reviews? Are there any disciplinary or correcting
recommendations that come from that process? And are they
public?
Mr. Walker. There are reports that are issued--in fact, if
you do not mind, Senator Corzine, I would like Bob Gramling,
who is our expert on all the details here, to come forward. He
has done the most recent work here and I know there have been
some recent changes. So, I would like to have the benefit of
his thoughts, if at all possible.
Mr. Gramling. I am Bob Gramling, and I am a former GAO
employee of 30-some years who retired 2 years ago as the
Director of Corporate Financial Audits. I have come back to
help the GAO on a consultant basis here in doing some of this
work related to the accounting profession.
The peer review results in publicly-available reports. Also
there is another entity within the SEC practice section that is
called the Quality Control Inquiry Committee. We did not put
all the alphabet soup on here because the poster board just
wouldn't be large enough.
Chairman Sarbanes. And the room wouldn't be large enough
for the poster board.
[Laughter.]
Mr. Gramling. The Quality Control Inquiry Committee also
looks at the results of peer review and deals at the firm level
with necessary corrections or, I should say, enhancements that
may be necessary to their internal quality control and
assurance system to make sure they are living up to the
required standards. In addition, the Committee will look at
individual performance in terms of relationship to complying
with the auditing standards. The firm will be given a plan of
action to address those weaknesses.
There is, though, no disciplinary function there on
individual members. If an issue like that were to arise, then
that particular case where there is, say, legal action involved
in terms of a legal suit, an alleged audit failure, the
discipline of the individual members involved, is handled in
another place within the AICPA--the Professional Ethics
Executive Committee.
Senator Corzine. The SEC does not have disciplinary
responsibility, nor has it delegated disciplinary
responsibility directly. It is a self-initiative of the AICPA.
Mr. Gramling. Well, that is correct in actions initiated by
the self-regulatory system. The SEC does provide oversight over
the Public Oversight Board, as well as annually picking certain
peer reviews and selective work papers and actually looking at
those from its own standpoint of whether the peer review system
is measuring up.
Senator Corzine. Have there been any significant
disciplinary actions that are the outgrowth of the SEC's review
of the peer review system?
Mr. Gramling. I would say the significant disciplinary
actions result from the filing of lawsuits.
Senator Corzine. Thank you.
Chairman Sarbanes. Senator Stabenow.
Senator Stabenow. Thank you, Mr. Chairman.
Thank you, again, Mr. Walker for being here, and members of
your staff. I appreciate your service. It was important to hear
from you last week in the Budget Committee and I hope our
Federal budget will have the same credibility that we are
asking of others. So, we have some real challenges ahead of us.
In your testimony, you talk about the accounting industry
needing to create the right incentives to protect the public
interest. And part of what we are talking about really is
cultural. I am wondering at this point what your feeling is
about the culture of corporate America. We have heard from
others about the incentives right now, the short-term
incentives. And I am wondering if you could comment about the
culture of corporate America that does or does not allow
dissent.
I have real questions about whether or not the culture
involved right now allows dissent, or whether earnings
management and interest in the short-term profits of the day
will win out at this point in time. I know that this is not
easy to change. But if we are talking about a large measure of
private-sector regulation, it seems to me that there has to be
the right incentives to protect the public interest. I wondered
if you would speak to this challenge and what you think we
should do about it.
Mr. Walker. There is a major challenge at the present point
in time in that there is a real emphasis on short-term results.
The market, to a great extent, has penalized entities who have
not hit projected earnings.
Although, let's face it, management has the responsibility
to come up with what those projected earnings are. There has
been a feeling that one has to continue to show growth or
profitability in order to continue to grow stock price and
shareholder value.
I think that, as I mentioned before, there are some
cultural challenges here. One of the key things that has to be
focused on is who is the client? What role do each of the
respective parties play in trying to make sure that there are
adequate checks and balances in the system to make it work?
Also certain other definitions such as what is materiality and
what is the proper materiality format?
I think the short-term focus is a problem. I think it is a
problem, quite frankly, in the public sector, too. At the
Budget Committee hearing last week, we talked about how we look
short-term versus how we look long-term. What are we going to
do to provide adequate incentives, transparency, and
accountability to make sure we don't be overly short-term
focused in the public sector as well.
Senator Stabenow. I agree with that. In your testimony you
talk about the fact that Enron's November 2001 8-K filing
restating its earnings acknowledges the fact that their
financial reports from 1997 to 2002 did not follow Generally
Accepted Accounting Principles and therefore, could not be
relied upon.
Now given the fact that this was a bad-faith reporting by
Enron and it had such a devastating impact on so many thousands
of individuals and, frankly, the confidence in the whole system
at this point, should Congress consider creating penalties for
corporate leaders or auditing firms who misrepresent earnings?
On the other hand, how might we balance such penalties with
the need to encourage timely and honest updates on previous
accounting misrepresentations or mistakes?
Mr. Walker. My personal view is I think that there are
actions that need to be taken by a variety of parties, many of
which do not require legislation.
You have the SEC, who can do certain things on its own. You
have the self-regulatory entities that have the ability to make
certain changes. You have the stock exchanges that have the
ability to make certain requirements in order to be listed or
continue to be listed, if you will.
You have some of these fundamental definitions that I
think, quite frankly, would be difficult to legislate, but need
to be addressed, like who is the client and what is
materiality?
I do think that there are possibilities for the Congress to
be involved in certain ways, including to try to make sure that
there is adequate transparency in certain critical areas and
that there are adequate penalties if people violate their
responsibilities.
Frankly, we would have to do a lot more work for me to get
to a level of specificity with regard to what we think the
Congress might want to consider doing in that regard. In part,
I think it depends upon what others do. In other words, do you
want the Congress to be the first resort or do you want to see
if others do what they should do and then, if they do not, then
take action?
I think we need to work at this in a coordinated manner.
Senator Stabenow. Thank you.
Senator Dodd. Mr. Chairman, may I ask one more thing?
Chairman Sarbanes. We could keep the Comptroller General
here obviously all day. And since we have him here in town and
fairly easily available to follow up with, I do want to get the
other panel on, a majority of whom have come from out of town.
But I will yield to you.
Senator Dodd. Just quickly because I did not realize you
were a CPA, Mr. Walker, until you mentioned it in your comments
here.
Mr. Seligman will be testifying shortly, and I recall him
saying, and I am paraphrasing, that the historical calamity of
1929 involved 1.2 percent of the population that owned shares
in public companies. Today, roughly 50 percent of the American
public do in one form or another. And so, when you face an
Enron kind of situation, you get a sense of the magnitude we
are talking about.
Which raises the question, without getting into the
specifics, and I understand that you cannot do that, but I
wanted you to, just for a minute, take off your GAO hat and
answer the question that in a sense has been referenced both by
Senator Corzine and Senator Stabenow, and that is who
arbitrates for the public, in a sense, when you have an Enron-
type of calamity?
Just a reaction here to the notion of an independent
regulatory organization rather than a POB over here that has
raised some serious concerns about the independence. What is
your reaction to that, as a CPA now, about having an
independent regulatory body rather than this Public Oversight
Board?
Mr. Walker. Without getting into a lot of detail, I can
tell you that I believe that steps need to be taken to increase
the interaction between the green and the yellow, for there to
be more green involvement in order to deal with the public
interest aspects of what CPA's are responsible for.
Senator Dodd. Okay.
Mr. Walker. It is more than just the shareholders. But
there is the public interest aspect as well.
Senator Dodd. That is what I meant by the public. I did not
mean just the shareholder because when 50 percent of the
American public are engaged is, I think it is the point that
Professor Seligman makes, which is a dramatic point, the 1.2
percent in 1929 versus 50 percent today, that there is a lot
more at stake in this--public confidence and trust, and who
does arbitrate at that particular point on behalf of the
public, speaking just beyond the shareholder interest.
Mr. Walker. Exactly.
Senator Dodd. In other words, we need more green on that
chart than yellow.
Mr. Walker. Or at least interaction between the green and
the yellow. The green needs to play a more significant role
than it does right now. And while, obviously, not everybody
owned Enron stock, the fact of the matter is a significant
percentage of the American population owns some stock, and
their question is--is that me, but for the grace of God? What
about the stocks that I own? And that is where you deal with
trust and confidence as a system as a whole, rather than just--
--
Senator Dodd. And investigating.
Mr. Walker. Exactly.
Senator Dodd. Thank you, Mr. Chairman. I apologize.
Chairman Sarbanes. Well, Mr. Walker, we thank you very
much. A great deal of work has gone into these reports and we
will work through them very carefully. We look forward to
coming back to you and your associates about them as we
continue to probe this matter and as we address seeking
systemic and structural changes.
Mr. Walker. Thank you, Mr. Chairman. A lot of good people
contributed to this and I appreciate your interest.
Chairman Sarbanes. We understand that. Thank you.
Now, we will turn to our next panel, if they would come
forward and take their seats at the table.
[Pause.]
Before turning to the panel, I just want to reiterate a
point that I made previously. It is my own very strongly held
view that the Administration should be seeking now a
supplemental budget for the SEC. I think the SEC clearly does
not have adequate resources to deal with the challenge that
confronts them. Maybe they should re-study their mission and
all the rest of it as some people have suggested. But in the
very short run, they need to get at it.
They are losing skilled and expert staff because of the
failure of the Administration to do the pay parity, which was
part of the legislation that this Committee reported out and
that was passed. They have a number of positions down there
that aren't filled. They have a great deal on their plate, as
this Business Week article noted when it raised the question,
``Can the SEC handle all this scandal?''
While we work through to get these systemic and structural
changes, immediately the SEC, it seems to me, should be
enhancing its capacity.
Now, we have written to the President urging that they
address this budget situation. I intend to repeat that request.
But it seems to me that they should be in to the Congress with
a supplemental request with respect to their budget to get on
about the task.
Our concluding panel this morning has three very able and
distinguished people on it, Robert Glauber, who is the Chairman
and Chief Executive Officer of the NASD, a self-regulatory
organization for securities broker-dealers. Mr. Glauber was
Under Secretary for Finance at the Treasury Department from
1989 to 1992. He was the Executive Director of the Brady
Commission Task Force which studied the 1987 stock market crash
and had a very distinguished academic career on the faculty at
the Harvard Business School, and also at the Kennedy School of
Government. We are very pleased to have him back with us.
Professor Joel Seligman, who is Dean of the Washington
University School of Law in St. Louis. Actually, Professor
Seligman joined with Professor Coffee in the classic textbook
on securities law, called ``Securities Regulation.'' He has
also written a number of interesting books, including this
one--``The Transformation of Wall Street''--we will put a plug
in for your publisher here.
[Laughter.]
Then Professor John Coffee, who has been a very
distinguished professor of law at Columbia Law School, where he
has taught since 1980. Professor Coffee is also on the SEC's
Advisory Committee on the Capital Formation and Regulatory
Processes, and on the legal advisory boards of the NASD and the
New York Stock Exchange.
Both Professor Seligman and Professor Coffee have been very
active in various professional bodies dealing with the
financial markets, securities laws, corporate governance, and
finance.
We are very pleased to have this panel with us today.
I think, Mr. Glauber, we will start with you and we will
just go right across the panel, and Professor Coffee can
conclude the testimony this morning.
STATEMENT OF ROBERT R. GLAUBER
CHAIRMAN AND CHIEF EXECUTIVE OFFICER
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
Mr. Glauber. Thank you, Mr. Chairman. I will read a short
statement and then I would request that my full testimony be
entered into the record.
Chairman Sarbanes. Your full statement will be included in
the record.
Mr. Glauber. Thank you.
Mr. Chairman and Members of the Committee, thank you for
this opportunity to testify on the vital, troubling and timely
issues of investor protection and accounting regulation
revealed by the collapse of Enron.
Let me begin with a quick overview of the NASD--because who
we are bears directly on both the substance of what I will be
saying and on the usefulness of the private-sector self-
regulatory model that we embody.
The National Association of Securities Dealers is not a
trade association, but rather, the largest self-regulatory
organization, or SRO, in the world. Under Federal law, every
one of the roughly 5,500 brokerage firms and almost 700,000
registered representatives in the U.S. securities industry
comes under our jurisdiction.
For more than six decades, our mission and our mandate from
Congress has been clear--to bring integrity to the markets and
confidence to investors. We do this by writing rules to govern
the conduct of brokerage firms and their employees, licensing
industry participants, and maintaining a massive registration
data base of brokers and firms, educating our members on legal
and ethical standards, examining them for compliance with the
NASD rules and the Federal securities laws, investigating
infractions, and disciplining any members who fail to comply.
A professional staff and independent governance provide
needed expertise and indispensable credibility. And the
standards we set are not mere trade group best practices, but
enforceable regulatory requirements.
As detailed in my written statement, the NASD's history is
to a large degree the history of successful self-regulation in
the United States. Every brokerage firm in the country that
does business with the public must, by law, be a member of the
NASD. With a staff of 2,000, 15 district offices, and an annual
budget of some $400 million, we touch virtually on every aspect
of the securities business and monitoring all trading on Nasdaq
and on selected other markets.
By providing this layer of private-sector regulation
between the SEC and the industry, the NASD is not only a
guardian for investors, but also a bargain for taxpayers. If we
did not exist, the SEC would have to increase its budget by
roughly two-thirds and its staff by about half, just to pick up
all the regulatory duties now performed by the NASD.
It is little wonder that Congress and the SEC throughout
the years have repeatedly identified securities industry self-
regulation as a national asset worth preserving and enhancing.
Of course, our evolution has not been without its false steps.
In 1996, the SEC, in its Section 21(a) report, criticized
the NASD in part for putting its interests as the operator of
Nasdaq ahead of its responsibilities as the regulator of the
entire industry. The NASD responded promptly by carving out
NASD regulation and Nasdaq as two distinct corporate entities
with separate boards, management, and staff. And since then, we
have spun off Nasdaq entirely, selling our last 27 percent
stake in the company earlier this year.
As a result, NASD over the past half-dozen years has
returned to its regulatory roots with greater independence,
resources, and focus than ever before. And I believe that we
are in a unique position to contribute to the vital national
discussion this Committee is helping to lead on how to
strengthen investor protection by improving accounting industry
regulation.
Given the limited time, Mr. Chairman, I think the best way
for me to do that quickly is to identify the attributes that
are key to the NASD's effectiveness from which I have sought to
derive some first principles for successful private-sector
regulation.
An essential ingredient of the NASD's success is
independent, strong governance. At least half our board of
governors comes from outside the securities industry and our
large, experienced, professional staff is not beholden in any
way to the industry.
The NASD's benefits from the combined ability to write
rules, examine for compliance, and provide tough enforcement,
all under one roof. This consolidation of the industry's chief
regulatory functions reinforces our authority, competence, and
credibility.
Our governing structure also relies on parties that have
the right incentives to insist upon market integrity and
investor confidence.
Our board includes representatives of the public, corporate
issuers, and institutional investors, as well as brokerage
firms that make up our membership. The beauty of this system is
that all of these interests, including the brokerage industry,
want markets that investors will recognize as fair, efficient,
and safe.
This leads to our next key attribute, which is assured
funding, from that part of the private sector having the
greatest interest in our effectiveness. The right people pay
for the NASD's services. Namely, the brokerage firms who know
that market integrity leads to investor confidence, which is
good for their business.
This steady and sufficient funding means that we can afford
the sophisticated technology, techniques, and infrastructure it
takes to regulate a fast-charging, technology-intensive
industry. NASD's technology budget alone is $150 million per
year. No private-sector regulator can succeed without
sufficient ways and means.
Next, I cannot overstate the importance of the NASD being
empowered to discipline our members with tough public
sanctions. Last year, we brought more than 1,200 disciplinary
actions resulting in over 800 expulsions or suspensions from
the industry.
It is a big stick--the ability to bar someone from earning
a livelihood in their chosen field.
In an average year, we levy well in excess of $10 million
in monetary sanctions. Already this year, acting jointly with
the SEC, NASD sanctioned Credit Suisse First Boston $50 million
for violations relating to its allocation of hot IPO's.
I should contrast this with the accounting industry where
no Big 5 firm has ever failed a peer review conducted by
another.
The lesson is clear--strong private-sector regulation leads
to one serious body keeping its industry clean. Weak private-
sector regulation leads to one hand washing the other.
Of course, with authority comes responsibility. Just as our
members are accountable to the NASD, so are we accountable to
the SEC. Strong oversight by governmental regulators protects
investors by ensuring that someone is watching the industry
watchdog.
Mr. Chairman, this is not the time and it is not the place
to prescribe in detail what a new regulatory regime for the
accounting industry might look like. But based on our
experience in the securities industry, the question can fairly
be asked whether a private-sector regulator could help restore
confidence in the accounting industry and if so, what are its
essential characteristics?
First, the threshold question.
It is my judgment that if properly designed, a new private-
sector regulator can make a major contribution by tapping
industry resources and insights not available to the
Government. To get the best of both worlds, however, these
advantages should be matched with tough SEC oversight under the
watchful eye of Congress.
So the question becomes how best to obtain these potential
benefits. To do so, the new body would need to follow these
essential features.
One, a new private-sector regulator should be an
independent organization with a sizable professional staff and
with sufficient technology and infrastructure to stay apace of
the accounting profession. It should seek maximum industry
input consistent with maximum industry accountability.
Two, it should have a strong mandate from the Government
that sets its structure and empowers its enforcement arm with
full authority to discipline the industry. And it should bring
under one roof as many of the essential regulatory functions
outlined earlier as is feasible.
Three, it should have a governance structure based on
enlightened self-interest. Namely, the need for effective
auditing to produce numbers that investors can rely on and
markets can trust. This implies a board with many of the same
parties as the NASD's--reputable corporate issuers who want
their financial statements to carry weight, institutional
investors, broker-dealers, and the public. Accountants should
be a small minority.
Four, it should have assured funding from some of these
same self-interested parties, especially those with the biggest
stake in the success of the system. Good candidates might be
issuers, broker-dealers, and certainly, since they have a major
stake in the credibility of their audits, the accounting firms
themselves.
Finally, the private-sector regulators should be subject to
strong, appropriate oversight from the SEC and from Congress.
Mr. Chairman, I am convinced that even in the accounting
industry, where self-regulation has suffered a bad name, there
is a vital role to be played by private-sector regulation.
Clearly, shaping such a system represents a great challenge,
but the benefits to be gained are even greater.
The NASD and I stand ready to help in any way we can.
Thank you.
Chairman Sarbanes. Thank you very much.
Professor Seligman.
STATEMENT OF JOEL SELIGMAN
DEAN AND ETHAN A.H. SHEPLEY UNIVERSITY PROFESSOR
WASHINGTON UNIVERSITY SCHOOL OF LAW IN ST. LOUIS
PUBLIC MEMBER, AMERICAN INSTITUTE OF CERTIFIED
PUBLIC ACCOUNTANTS PROFESSIONAL ETHICS
EXECUTIVE COMMITTEE
Mr. Seligman. Mr. Chairman, I would ask that my statement
be entered into the record.
Chairman Sarbanes. Your full statement will be included in
the record. I want to thank all three witnesses for the obvious
work and effort that went into these prepared statements. We
appreciate that very much.
Mr. Seligman. Let me paraphrase a little bit of the
statement and emphasize certain points.
First, we have the most successful securities markets in
the world at this point, which have just been through an
extraordinary period where the aggregate worth of securities
traded increased 11-fold, between 1981 and 2000. Senator Dodd
suggested nearly half of American households today own stock.
The challenge before this Committee is to maintain and, indeed,
strengthen, that level of confidence in our securities markets.
Second, it is worth remembering that most of the people in
the securities industry, in corporations, and in accounting are
honest, hard-working, decent people. But Enron and related
cases have powerfully reminded us that even a small number of
dysfunctional firms can provide enormous challenges to
confidence in our system.
Third, it is very, very important to appreciate how complex
the relevant regulatory systems involved are. Professor Coffee
and I, as was mentioned, coauthor a casebook which has an
1,800-page supplement, which includes SEC statutes, rules, and
forms today. It doesn't so much grow, as metastasize from year-
to-year.
[Laughter.]
It is very constructive for Congress to play a leadership
role here. But it will be important to recognize that the SEC
can be terribly important in filling in the details and
carrying out the mission you prescribe to them.
I want to highlight the mandatory disclosure system which
focuses on the SEC's disclosure requirements, auditing and
accounting. I also agree with the point made by Senator
Sarbanes that among the most critical needs at this moment is
to address a veritable crisis in the SEC's budget.
It seems to me when you look at the Enron case, the two
most sobering aspects of it are that the SEC last examined an
Enron annual report called Form 10-K in 1997, in spite of the
fact that this was a firm that quadrupled in size between 1996
and 2000, and for a variety of reasons, should have received
some attention.
I am very concerned that we are meeting at a time when the
Office of Management and Budget has recommended, in effect, a
flat budget for the SEC next year.
The SEC only desperately needs more staff, but you have to
focus on the pay parity issue. That is, how do you hold onto
the very best of the staff ? It is the SEC employees who have
been there 3 years who you can keep up to 10 years, who are the
key, I would submit, to strengthening the Division of
Corporation Finance, strengthening the Division of Enforcement,
and strengthening the Office of Chief Accountant, all of which
are vitally necessary now.
With respect to the specific issues before you, I think the
focus of this Committee has devoted to accounting standard
setting and auditing is particularly appropriate at this time.
Accounting standard setting, which is currently
administered by the private organization, Financial Accounting
Standards Board, should be sharply questioned at this moment.
The notion that transactions as obviously material in
retrospect, as the off balance sheet transactions that Enron
and other corporations engaged in, were not required to be
disclosed in financial statements or notes.
I would submit to you, in looking at the Financial
Accounting Standards Board, as former SEC Chairman Levitt so
aptly recognized, the big challenge is independence. How do we
create a FASB or a new similar Financial Accounting Standards
Board which can both focus on how one articulates a fair
presentation of financial data and deals with the many detailed
standards. And the bottom line, I would submit to you, the key
here, as will often be in your investigations, is money. You
cannot expect a FASB to operate in a truly independent way
without a more assured source of funds than the FASB currently
has.
I would encourage you to explore means to legislate some
user or accounting firm fee system that will provide to the
FASB, or whatever the standard setting is called, true
independence.
Enveloping the Generally Accepted Accounting Principles
that the FASB develops is the SEC mandatory disclosure system.
This too deserves to be under sharp question today. One must
ask, how could financial reporting practices sufficient to
bankrupt the seventh largest industrial firm in this country,
so long go undisclosed? Is this simply an isolated instance of
bad disclosure practices, or is Enron suggestive of more
systematic failure?
The SEC, under its current chairman, to its credit, has
begun to grapple with the latter, more disturbing possibility.
In the last few months, it has issued cautionary releases in
areas like pro forma financial statements, selection and
disclosure of critical accounting policies and practices, and
the management, discussion and analysis item. I would urge,
however, much more needs to be done.
The last time the SEC systematically reviewed its corporate
disclosure system was in the mid-1970's when commissioner, and
then private citizen, Al Sommer led an advisory committee on
corporate disclosure. It examined the great disclosure issues
of the day.
A similar systematic approach is now well overdue. It
should focus not only on SEC's requirements, but also on their
link to accounting and auditing.
At its core, Enron involved an audit failure. The outside
auditor in that case both appeared to operate with significant
conflicts of interest and to have been far too beholden to a
highly aggressive corporate management. Several aspects of the
Enron audit failure deserve particular focus.
First, I would urge, and here I support the testimony that
Mr. Walker gave earlier, it is time for a new auditing self-
regulatory organization to be created. It should replace not
just the Public Oversight Board, but also a positively
Byzantine structure of accounting disciplinary bodies which
generally lack adequate and assured financial support, clear
and undivided responsibility for discipline, and an effective
system of SEC oversight.
The success of such a new auditing SRO will be in careful
attention to detail. I would particularly recommend a legal
structure similar to that in Sections 15(a) and 19 of the
Securities and Exchange Act which apply today to securities
associations such as the NASD and other self-regulatory
organizations in the securities industry, and address in some
detail such topics as purposes, powers, and discipline.
Second, a clear scope provision articulating which auditors
should be subject to the new auditing SRO and a mandate that
the auditors be subject to the SRO.
Third, a privilege from discovery of investigative files to
facilitate auditing discipline during the pendency of other
Government or private litigation.
Part of the reason auditing discipline doesn't work very
well now is it is often held in abeyance while the SEC or the
Justice Department pursues a case. It is strikingly different
than the more appropriate ways in which the NASD and the New
York Stock Exchange, among others, look at such cases.
Crucially, the new SRO's should be permitted, subject to
SEC oversight, to adopt new auditing standards that can evolve
over time. These rules would be limited by SEC rulemaking and,
of course, Congressional legislation.
As with the accounting standards body, a key question
involves funding. To effectively operate over time, any new
auditing SRO must have an assured source of funding. The most
logical basis of such funding may prove to be a Congressionally
mandated fee on covered auditing firms.
The new SRO should draw on the expertise of the accounting
profession to ensure technical proficiency, a supervisory board
with a minority of industry representatives, and a majority of
public representatives may prove to be an appropriate balance.
The chair of such board, however, I would recommend should be a
public member.
I believe the most significant issue may prove to be who
conducts periodic examinations and inspections of auditors. To
paraphrase a classic adage--who will audit the auditors?
I would urge serious consideration be devoted to replacing
peer review with a professional examination staff in the new
auditing SRO. Peer review has been to some degree unfairly
maligned. But even at its best, it involves competitors
reviewing competitors. The temptation to go easy on the firm
you review lest it be too critical of you is an unavoidable
one. While the inspection and examination processes of the New
York Stock Exchange and the NASD are not panaceas, they suggest
a workable improvement.
Finally, it may prove particularly wise to statutorily
replicate Section 15(b)(4)(e) of the Securities Exchange Act
which can impose liability on a broker-dealer who has failed
reasonably to supervise. Particularly in firms with as many
offices as the leading auditing firms, a clearly delineated
supervision standard strikes me as vital to effective law
compliance.
A separate, not mutually exclusive, approach would be to
require mandatory rotation of auditors at specific intervals
such as 5 or 7 years. I thought that you received thoughtful
testimony from the former SEC Chairman Harold Williams on
February 12.
I would particularly emphasize, however, the SRO as the
most constructive element, if you will, to emphasize.
Third, particular attention has been devoted to the wisdom
of separating accounting firm audit services from consulting.
One early result of Enron has obviously been an acceleration of
this process by voluntary means in the Big 5 accounting firms.
Congress or the SEC should consider whether a statute or
regulation should require such separation and if so, how best
to define which consulting services and which accounting firms
should be subject to the new law or rule.
Finally, a key reform of the 1970's--the board of directors
audit committee--has been sharply criticized for its
ineffectuality. I was particularly struck by the testimony of
the former SEC Chairman Roderick Hills at your February 12
hearing. He concluded with recommendations that I strongly urge
you to consider to find ways to strengthen the independent
audit committee, to find ways to create an independent
nominating committee with the authority to secure new directors
and to appoint all members of the audit committee, and
crucially, that audit committees be solely responsible for the
retention of auditing firms and be responsible for the fees
paid.
Thank you, Senator Sarbanes.
Chairman Sarbanes. Thank you very much. It was a very
helpful statement.
Professor Coffee.
STATEMENT OF JOHN C. COFFEE, JR.
ADOLF A. BERLE PROFESSOR OF LAW
COLUMBIA UNIVERSITY SCHOOL OF LAW
Mr. Coffee. Thank you, again, Mr. Chairman, and I want to
second enthusiastically everything that I have heard on this
panel.
I, however, am going to cover a slightly different topic.
In my prepared remarks, I also go at length through the
structure of an SRO for the auditing profession and I think
that is one of the most important things that is before your
Committee. But I want to talk about the securities analyst,
because I think that has received less attention. Let me start
with a simple comparison.
Analysts and auditors basically are very much alike. They
both are in the business of serving investors as watchdogs who
examine and verify financial information. What is sauce for one
should be sauce for the other and it is noteworthy that we
already have an SRO covering the analyst in the NASD, and that
is an argument for why the other body, the auditor, should be
similarly regulated.
Let me take this comparison further.
I think it is true to say, difficult as it will be to
accept, that both the auditor and the analyst are compromised
by the unavoidable fact that they receive their compensation
from those that they are supposed to watch. That is simple but
fundamental. It means that there is going to be an inherent
conflict always. And in both the cases of the analysts and the
auditors, something significant and relatively invisible
happened during the decade of the 1990's.
Let me give you just two statistics and then I won't bore
you with statistics. From 1990 to 1997, earnings restatements
were fairly flat and level and they averaged 49 times a year,
publicly-held companies restated their prior earnings. In 1998,
that number soared to 98. Then in 1999, it went to 150; and in
2000, it went to 156. That is an over 300 percent rise in just
a 2 to 3 year period. Something lies behind that spike because
earnings statements are something that companies bitterly
resist. They are both painful, embarrassing, and they will
trigger often litigation and SEC investigations. But, suddenly,
they spiked.
Let me return now to the analyst. There is a study by
Thompson Financial, which runs the First Call service, that
finds that the ratio of buy recommendations to sell
recommendations increased from 6 to 1 in the early 1990's, to
the now-proverbial 100 to 1 by 2000.
I personally do not put great weight on what the number is.
It is the fact that there was this very rapid change over the
decade that again suggests to me that in the case of both of
these watchdogs, there was an increasing problem from
conflicts.
And my generalization would be that both the analyst and
the auditor became more compromised by conflicts of interest as
the decade wore on. In the case of the analyst, let me give you
again some studies because we all talk about Enron, but to the
social scientist, Enron is just one data point, vivid and
tragic though it be. But there is a lot more data points that
suggest there is a pervasive problem.
With regard to the research securities analyst, there is a
study by McHaley & Wolmack that finds that the long-run
performance of firms recommended by securities analysts who
were associated with an underwriter were significantly worse
than the long-run performance of firms recommended by analysts
who were independent of any underwriter. And this was a broad
data sample.
By the way, they also found that the market knows this. The
market responds much more positively to a buy recommendation
from an independent analyst than from an analyst who is
affiliated with an underwriter. They tend to discount those
recommendations greatly. So the market knows something and I
think it is based on real evidence.
Another study by CFO magazine finds that analysts who work
for full-service investment banking firms, firms that provide
underwriting services, tend to make earnings forecasts that are
6 percent higher on average than analysts who work only for
independent firms that do not do underwriting, and these
affiliated analysts tend to have 25 percent more buy
recommendations than analysts who again are not associated with
any full-service brokerage firm.
There is more research--I won't bore you with it--but the
common denominator in these and other studies is just what you
would intuitively expect. Conflicts of interest count and
analysts and auditors tend to become compromised by these
conflicts, meaning that the analyst who is associated with an
underwriter tends to behave differently and more deferentially
toward companies that are their clients than independent
analysts behave.
That is one line of research. There is one other line of
research I want to point you to.
A lot of studies have shown that analysts are frequently
pressured and intimidated basically to cause them to temper
negative research reports or not to make changes that downgrade
earnings forecasts. Sixty-one percent of all analysts surveyed,
one fairly large study, said that they had personally
experienced threats of intimidation by representatives of
management of a client that they had surveyed and did a
negative report on. Twenty percent of all CFO's in a study
cited by former SEC Acting Chairman Laura Unger, self-reported
that they had made complaints to brokerage firms about analysts
who put out negative research and asked that broker be somehow
disciplined.
Early in their career, the typical analyst learns that
negative research reports can be hazardous to your health and
many analysts learn that, therefore, they had better be very
cautious and better temper what they say. The truth suffers in
that process.
Now what regulatory response is appropriate given this
description of current reality?
In part, this depends on what the self-regulators are
already going to do. The NASD has posed, I think, a very
sensible, sound rule, Rule 2711, which has just been proposed,
which would try to change some of the internal structure so
that analysts no longer report or are responsible to and no
longer clear research reports with the investment banking side
of the firm.
All of that is desirable. There are a number of exceptions
and qualifications in these rules and how this will play out in
practice, it is a little too early to predict. But I would have
to tell you that, much as I would endorse Rule 2711, it is not
going to be a complete solution to the problem. Analysts will
always know who is paying their salary and it is the deal side
of the firm. Thus, analysts are not going to be completely
objective when they know that their compensation comes from
investment banking, and Rule 2711 doesn't change that. There is
a basic choice to be made.
One way to go is to take what I would call the radical
Glass-Steagall approach and to try to divorce investment
banking from securities research. Some people, serious
commentators, would recommend that route on the grounds that
nothing else will make the analyst independent.
I personally fear that approach. I think we spent 50 years
trying to crawl out from underneath Glass-Steagall and its
separation of commercial from investment banking. I think it is
far more dangerous in this context because I do not believe
that securities research is self-sustaining or self-supporting.
It can only be financed by revenues that come from the
investment banking side. And my great fear is that if we took
the simple Glass-Steagall approach of cutting the baby in two,
one half the baby is not going to survive and we are going to
have far less securities analysts out there, far fewer
companies would be covered, and there would be a danger of real
social loss, much of a significant portion of the market not
regularly followed by securities analysts.
So, I at least would say that I wouldn't recommend that
course. Others would. But having aside from that more radical
step, I think we have to talk about how we can police conflicts
in this field. And I think that there are more rules that
Congress needs to encourage.
My suggestion would be not that Congress itself try to
write these rules and legislation, but that Congress can pass
some legislation, a general instruction to both the SEC and the
other SRO's, and there are multiple SRO's, telling them that
they should fine-tune rules that address the following
Congressional goals. Congress has done this before in other
legislation.
Let me just give you four rules briefly that I think need
to be an integrated approach to the problem of conflicts of
interest among securities analysts.
First, I think we need an antiretaliation rule. Congress
should seek to protect analysts by requiring the drafting of
rules, both at the SEC and the NASD, which would protect an
analyst who has his compensation reduced or loses his job in
retaliation for a negative research report or other unfavorable
research. Of course, that involves a very fact-specific issue.
Why was the analyst reduced in salary or terminated? It may
have been a poor performance.
We have a body that can deal with this. We have an
elaborate arbitration system already set up under the NASD and
it would be possible to give the analyst recourse to that,
possibly with the right to get some kind of penalty, double his
salary or double the loss, if there were a demonstration before
that panel that he had been the victim of intimidation or of
retaliation because of the published research.
That is one kind of approach. There are different ways of
going at this, but the goal of an antiretaliation rule responds
to evidence that retaliation is there regularly.
Second, I think that we have to address what I call a no-
selling rule. This will be more controversial. If we want the
analyst to be a neutral umpire, he cannot also be a salesman.
Today, the analyst regularly participates in the roadshows,
regularly sells the IPO's to the various clients and
institutional investors who attend the roadshows.
That selling is inconsistent, in my view, with the goal
that we may have of wanting the analyst to be a more careful,
objective, neutral umpire. It also takes the analyst over the
proverbial Chinese wall--and I think if we want that Chinese
wall, and I agree with Senator Bunning that the Chinese wall
can often be permeable--I think we should make it more
respected by not allowing the analyst to hop over that wall,
participate in the roadshow, and then come back and be an
analyst. I do not think you can keep playing those two
different roles more or less simultaneously without there being
problems.
A third rule, which I won't go into at any length, I think
that there is one abuse called the booster shot under which
analysts are under great pressure to make a favorable
recommendation of the issuer's stock just before stock lock-ups
expire. This is because the issuer management is not able to
sell its shares at the time of the IPO. They are only able to
sell their shares typically under stock lock-up arrangements 6
months later. And there often have been norms that are more
implicit than negotiated, under which the analyst puts out a
very favorable recommendation just 1 or 2 days before the
management of the IPO firm becomes able to sell its own shares.
Recommendations at that point are both dubious and
dangerous and I would think that at least those analysts who
are related to the underwriter, who are associated in any way
with that client, should be prohibited from putting out buy
recommendations during the period of time shortly before and
shortly after the expiration of stock lock-ups. It is really
the important period.
Now, last, and most importantly, I think Congress should
ask the SEC and the SRO's to define the term, independent
analyst. This has been done by the SRO's for purposes of
directors who serve on the audit committee. But if there is one
lesson that should be learned by investors, it is that the
investor cannot trust reliably the recommendation of a single
sell-side analyst--that is, the individual sell-side analyst--
but instead, should look at what the consensus is of
independent analysts.
I think that could easily be prepared by the industry. If
we distinguish between who's independent and who's not and
permit only the former to use the term, independent analyst, it
will be very simple for the industry, people like First Call,
to quickly produce on websites everywhere the consensus of
independent analysts.
This is not a disqualification. It doesn't say other
analysts could not put out research. I have no need at all to
bar analysts from putting out research. I am merely saying that
the term, independent analyst, should be elevated so that the
public gets greater confidence looking at the recommendations
of the independent analyst, who empirically turns out to be
more accurate and a better, less biased judge.
I think these are the less drastic alternatives and the
less drastic alternatives are superior. They recognize that we
want essentially a private system of corporate governance. But
in the last analysis, our system of corporate governance relies
on the credibility of the numbers. And those numbers are
principally guarded by auditors and analysts and they are
probably the most important side of this still-developing Enron
story.
Thank you.
Chairman Sarbanes. Thank you very much.
I have a few questions and then I will yield to Senator
Corzine.
Do you have a scheduling problem, Jon?
Senator Corzine. [Nods in the negative.]
Chairman Sarbanes. Mr. Glauber, would you just outline the
funding mechanism for the NASD?
Mr. Glauber. Certainly. Essentially all of our funding
comes from the broker-dealer community. Most of it is raised by
assessments on broker-dealers which reflect their size.
Chairman Sarbanes. Okay. Now the broker-dealer is required
to be a member of the NASD. Is that correct?
Mr. Glauber. That is correct.
Chairman Sarbanes. And if he is evicted by membership under
your disciplinary procedures, he can no longer be a broker-
dealer. Is that right?
Mr. Glauber. He cannot be a broker-dealer that deals with
the public, that is correct.
Chairman Sarbanes. So, you levy a fee on each firm.
Mr. Glauber. On each firm.
Chairman Sarbanes. Related to the size of the firm?
Mr. Glauber. Related to its size, related to its trading
operations, as well as we levy some user fees that cover the
cost of maintaining our central depository of registration
information. And we levy user fees on actually new issues. When
a company files a new issue, we have to read the prospectus and
we levy a user fee on that.
Chairman Sarbanes. So that is all an automatic process.
They have to pay that as, in a sense, the cost of doing
business. Is that correct?
Mr. Glauber. Absolutely.
Chairman Sarbanes. Well, it is very interesting because one
of the things that is obvious in the accounting context is that
these people go around with a tin cup trying to beg money to
run the FASB and the international group. Volcker is running
around now with his tin cup out trying to get funding for these
things.
Mr. Glauber. Mr. Chairman, I think you are absolutely
right. And as I said in my statement, I believe assured funding
of this private-sector regulator is absolutely crucial. I think
one can look to issuers, to broker-dealers, and to the
accounting industry as the source of that funding.
Chairman Sarbanes. I want to ask the two academics--this
American Institute of Certified Public Accountants action alert
that they have sent out has caught my attention here. They talk
about the cascading effect and then they raise the specter that
restrictions will be adopted that will impact on small- and
medium-sized businesses. They say, what would small business
clients do if they could not go to their CPA for tax services
or other business advice? They would pay substantial additional
fees to hire someone else to perform the necessary services.
And then they say, Members of Congress have to be made acutely
aware of this.
It raises the question of whether, in addressing this
issue, we separate out accounting for public companies from
other accounting, and whether our focus should be primarily on
the accounting for public companies or a structure that in
effect, it may be a two-level structure, or a bifurcated
structure, however you want to describe it. Could you address
that issue for us? Because I am very concerned.
We have the danger here that they are going to get all up
in arms to try to forestall very important and needed changes
by raising a specter which is really a scarecrow and not a
realistic danger, although you can always argue the slippery
slope. But the answer to the slippery slope is you just do not
go down the slippery slope. It ought not to be used to
bootstrap an argument that you do not do anything, at least it
seems to me.
Mr. Coffee. I suggest that the SEC's auditor independence
rule was always intended to apply only to publicly-held
companies. And I do not know that you need to deal with the
relationship between the auditor of a family controlled firm.
In that world, where you have a family controlled firm, you
know who the client is--it is the family that owns 98 percent
of the stock and six or seven people. And they may well want
you to be both the tax advisor and the auditor.
When we have the publicly-held firm, with 150,000
shareholders or more, there is no way to get the true decision
from the shareholders who we believe are the client. Therefore,
we need a more prophylactic rule in that context to represent
the public shareholders who have no voice and no real
mechanism. But there is no need to adopt these strong rules and
auditor independence beyond the context of the publicly-held
company, the company that the SEC has jurisdiction over. And I
do not believe the SEC or anyone else has been intimating that
they mean to regulate the behavior of accountants dealing with
family controlled companies.
Mr. Seligman. I think those points are exactly right. Since
the time of the POB and certain experiments in the 1970's, a
clear distinction has been drawn in existing auditing
regulation between those firms which regularly have clients
that appear before the SEC and those that do not.
In suggesting a new SRO mechanism to you, I think that you
can address this type of issue through the scope provisions. If
you can focus just on the public impact of the accounting
profession, the firms that are before the SEC that make up our
securities markets, you will have done a great service.
Mr. Glauber. Mr. Chairman, I agree completely with the
other members of the panel. This is an issue of investor
confidence and it is an issue of investor confidence in
publicly-traded securities. That is what you ought to attack
and you shouldn't be, I think, thrown off the job by concerns
raised about the way auditing is done for small family
companies.
Chairman Sarbanes. What I am concerned with here is an
argument is going to be advanced for the small family
companies, the conclusion of which will be that we ought not to
address the public companies.
Senator Corzine.
Senator Corzine. Thank you, Mr. Chairman.
I want to explore a little bit the analogue of Nasdaq with
the accounting industry and how FASB fits into that analogue.
It is one of the more difficult pieces for me to get a
conceptual view about. If I understand it right, Nasdaq does
set out standards for behavior and the rules with which markets
operate, if I am not mistaken. Is that true, Mr. Glauber?
Mr. Glauber. It does, indeed. Since we have just sold our
last shares in Nasdaq and are now completely separate from
Nasdaq, I want to emphasize that it is the NASD that does the
regulation of broker-dealers and, in fact, sets out a group of
rules that deal with conduct. It is different from the FASB,
the FASB deals with standards. Really, ours are conduct or
behavior or ethics rules.
Senator Corzine. How would any of you comment FASB might
fit into a structure where we developed an SRO or an IRO, an
independent regulatory organization of some form that fits the
analogy of Nasdaq or the New York Stock Exchange for
supervision of the accounting industry?
Mr. Seligman. Could I take a stab at that one because I
thought about that to some degree.
I really think the distinction between accounting standard
setting which could be done under a strengthened FASB with, I
would submit, heightened SEC oversight, and auditing, and
particularly the disciplinary functions, can be treated
separately.
I would submit that what is of clearest analogy between the
NASD and a new auditing SRO is the requirement that broker-
dealer firms and representatives in effect are subject to the
NASD regulation, which is subject to SEC oversight and
ultimately, the SEC can independently bring actions as well.
When you compare that with the current structure of auditing
oversight, there are just too many steps. It takes too long.
There is no clear body that has responsibility. The SEC's
oversight is attenuated.
To be sure, the SEC, in a parallel way, can bring what are
called Rule 102(e) actions and disbar or condition someone from
practicing before the Commission. But the initial
investigations take so long, that it is almost a dysfunctional
process. And I would submit, I think the FASB is largely an
issue of independence, largely an issue of revivification of
the fair presentation concept, and giving them support through
financial means so that they can deal with what will be a lot
of detailed rules. I think, in contrast, the auditing
discipline function is a lot further from the mark today and
needs, in effect, a clean slate and needs an approach similar
to what NASD has.
Senator Corzine. The reason that I think there is reason
for debate about this, both parties need funding. Are we going
to have separate funding, independent funding sources for FASB
and some new SRO?
That is a question, perfectly reasonable. We have two sets
of fees, but you may want to all have that combined into one
independent source of funding for both FASB and the SRO, if
that is the direction you would want to take.
And the second element is, is it possible that the
information that one gains, the knowledge, the synergies that
one gains from auditing the auditors and the questions that
come up and the challenges that are revealed through that
process, are the reasons that you get actions out of FASB with
regard to the direct questions that need to have clarification
and rule setting and standard setting in the FASB process?
So, I can make the case on the one hand. I can also say
that we are making it a more complex structure. I think I am
hearing Professor Seligman say that he would separate the two.
But I would love to hear the other witnesses and their pros and
cons.
Mr. Coffee. Let me add one word to this, if I can. I think
I also am happier with the relative insularity of the FASB. If
FASB was immediately subject to the control of the SRO body, it
might be forced to make changes more quickly than we would
like. For the future, the problem with debating FASB standing
alone is that----
Senator Corzine. We do not have that problem now.
Mr. Coffee. Well, the problem in the future is that there
is something else called the International Accounting Standards
Committee. And FASB is part of the process of reaching uniform
international accounting standards which is going to transfer,
I think, the most critical decisions to the International
Accounting Standards Committee.
So if you really want to raise the standard setting issue
of where standard setting belongs in this total structure, you
have to focus at least as much, and probably more, on this
international body in London, the International Accounting
Standards Committee. And for that reason, I think that I would
advise you as a matter of prudence, do what you can today
because dealing with FASB really doesn't for the future resolve
the standard setting process.
Chairman Sarbanes. We had Sir David Tweedie, who is the
Chairman of the International Accounting Standards Board, here
to testify before the Committee.
The European Union, apparently, by 2005, will adopt the
standards, or it is expected to adopt the standards of the
International Accounting Board. That is a powerful economic
player worldwide, the European community. So, we are moving
toward this situation where there is going to be this standard,
the international standard that applies in the European Union.
And I guess the United States--I do not know where our standard
will be at that point. But the old game where our standard was
the standard and everyone else had to follow it, is going to
be, it seems to me, impacted by that, once you have a body of
the economic size of the European Union with a set of
standards.
Excuse me. Go ahead, Jon.
Senator Corzine. I am curious about this funding
arrangement as well. I am sympathetic that there are problems,
or at least concerns that one could have by having FASB, the
rule setter and the auditors on a regulatory basis combined. I
can see where that is.
My own experience with the New York Stock Exchange and the
NASD is that those are combined functions, although it is not a
perfect match. But I am concerned on funding. You are going to
end up with two separate, additional charges which are going
out to some element of our economic system. I think we are
going to get a lot more letters like the Chairman is mentioning
about how burdensome we are now, creating a structure that will
impose on the very viability of a lot of companies. Does anyone
want to comment on that?
Mr. Seligman. I think I am troubled by the fact that FASB's
funding, to some degree, comes from the organizations that will
be subject to FASB's regulation, that there have been threats
from time to time that if a rule is adopted that the issuers or
registrants do not like, they will cut off the funding. And
that just doesn't work. You have to have a more automatic
mechanism.
I sympathize with your point that it is complex, that there
will be more than one charge, in all probability, that there
will be more than one ultimate treasury here, but that is the
reality today. When you go public with a corporation, you will
end up with fees to the SEC, to the NASD. You will have
registration fees on the securities exchange, conceivably, as
well as NASD. The question is, how can we get the most
effective overall body of regulation?
Mr. Glauber. I think a tolerable argument can be made to
keep the FASB separate. But you raise the two correct issues.
First of all, the funding. And think, clearly, there, it has to
be some kind of automatic funding so that it is not subject to
challenge. And the second is governance, so that you can make
certain that the FASB functions as an independent operation and
it has not always succeeded in doing that. That is just what
Professor Seligman said. If you are going to have it stand
separately, you have to have some kind of governance in place
to protect it.
Chairman Sarbanes. Professor Seligman, you said that it was
the difficulty of getting the money to fund the operation from
the people that are being regulated. If they do not like it,
they won't pay the money. But NASD gets the money from the
people that they regulate. The only difference is that it is a
mandatory requirement. It is just like lawyers who have to pay
into the bar association that runs the grievance process. So it
seems to me, as long as it is mandatory or automatic or
required, we get over that hurdle, don't we?
Mr. Seligman. One hopes. But that is clearly the direction
that you have to go.
Senator Corzine. Does the SEC, given the overall mandate
and mission, even though maybe we ought to step back and have a
strategic planning session with regard to what the SEC does,
does it have the wherewithal to adequately supervise FASB?
We are the 25 accountants that we heard about in the
accounting division, to really be plugged into the supervision
and oversight of FASB, to make sure that it is moving forward?
Mr. Seligman. I think that needs to be augmented. Clearly,
it will be much more of a priority for the Commission in the
next couple of years. But you need more staff in the Office of
Chief Accountant and you need high-quality staff.
Mr. Coffee. I think you are hearing from all of us that the
SEC is resource-constrained and I think the less visible
casualty of that are the offices such as the Office of Chief
Accountant, where you cannot really measure the output until a
scandal like Enron comes along, and you suddenly say, why did
they ever think that even 3 percent was enough? Now that is a
strange, bizarre feature of Enron that you say, 3 percent
equity, even if you had that much, it still is a glaring
failure of disclosure to the market.
Senator Corzine. Can I ask one other?
Chairman Sarbanes. Yes, go ahead. We may turn it into a
free-form here.
[Laughter.]
Senator Corzine. I apologize for the follow-up on this FASB
issue. I think that this is actually one of the more difficult
calls.
An IRO or an SRO seems sensible to me. I wonder whether we
are going to miss some of the synergies that come from looking
at the real problems of auditing, actual auditing statements
and what are questions that come up, and whether you will get
the kind of resources for the SEC to be able to stay on top of
that FASB process, which has apparently not occurred as
effectively as people would like.
Chairman Sarbanes. Now, Mr. Glauber, you all combine the
two, don't you?
Mr. Glauber. We write rules which are mainly rules of
behavior and ethics. We do not have something which is
equivalent to a standard setting like the accountants. If you
look at the kinds of rules that we write, they are rules of
quality control and behavior, conduct.
Chairman Sarbanes. Well, who writes the standards?
Senator Corzine. That is not entirely true, is it? If I go
back to my experience of 1996 and 1997, we set up some specific
rules in NASD with regard to both standards and procedures,
with regard to spreads and over-the-counter markets and how
they actually operate. It is very much similar in some ways to
the kinds of standards that one might put down with regard to
accounting rules. It wasn't law. It was sort of----
Mr. Glauber. Rules.
Senator Corzine. They were rules that people had to abide
by, unless I am mistaken.
Mr. Glauber. No, that is perfectly correct, Senator. They
are. And if you want to characterize those as standards, then I
think you are quite right. I think they are not quite the same
thing as accounting principles, and that is why it is very
difficult.
Senator Corzine. I am quite in concurrence that we have
different functionalities going on here, so you are going to
have little differences in analogy.
Mr. Glauber. Yes.
Mr. Seligman. Senator, if I could just add, the current
structure of NASD is to separate the standard setting from the
NASD reg, which is the enforcement arm. But your point is well
taken. It is not essential that it be done that way. If you
separate them, you obviously have to have effective
coordination. I would submit to you, the key, though, is
however you structure it, you need to focus on independence and
insured sources of funds.
Senator Corzine. I think we are all in agreement there.
I have one question for Professor Coffee.
I appreciate the kinds of commentary you are making with
regard to security analysts and, in fact, I have seen some of
that intimidation that you are referencing. But you did not
speak to the rating agencies which play almost an equally
important analytical role and commentary and observation. I
think if you put statistics down with regard to the independent
rating agencies, you ended up with results that weren't a lot
different than what you saw from your so-called conflicted
investment banking analysts.
Mr. Coffee. I think the level of conflict and the level of
compromise is somewhat less. But the fundamental fact is there
in all three of these cases--auditors, analysts, and debt-
rating agencies are all paid by the people they are supposed to
watch and does not create the absolutely optimal incentives
that you would like.
I am not sure in the rating agencies that I have a simple
solution for you at this moment. It is possible that there
could be heightened liabilities, but I do not need to
necessarily endorse that.
I don't know that either the rating agencies or the
securities analysts should be exposed to massive class-action
attacks. I think more surgical remedies, such as dealing with
the process and dealing with the particular prophylactic rules
you want to adopt are better than just always universally
heightening liabilities.
Senator Corzine. I think that is one of the positives of,
hopefully, our efforts in this Committee and the Congress, is
to come up with some rules of the road that actually do not
make it a legal courtroom process to bring about enforcement or
redress, but where the rules of the road are actually laid out
ahead of time and people then have a disciplinary process.
Mr. Coffee. Let me suggest this. Although there has been a
good deal of study of what has gone wrong with securities
analysts, and we have found out that independent ones behave
better than ones that are associated with the client, there has
been very little empirical investigation of the debt-rating
agencies. I think that, there, the information basis for a
quick solution is right now lacking. It may well be that you
want the SEC or someone else to conduct a more thorough study.
Chairman Sarbanes. We will keep going here because this is
a very helpful panel. On the analyst issue, I wanted to ask
this question. First of all, Professor Coffee, I am not sure
here. You said that you had some analysts that were not
connected with investment houses. Then later, you said you
could only finance the securities research from the investment
side. So, you could not really create some bright line of
separation because then you could not function. How do I square
those two?
Mr. Coffee. Okay. What I am telling you is, you could
certainly have a rule under which analysts could only work for
brokerage firms that did not do underwriting. There are such
firms. Names like Sanford Bernstein stand out as independent
analyst firms.
If we adopted such a firm, I think the consequence of it
would be a very sharp reduction in the number of analysts who
would be employed in this industry because most of the revenue
that supports research analysts comes from the sell side. This
is a consequence of the very desirable ending of fixed
brokerage commissions back in 1975. It made the brokerage
commissions so thin, that I do not think that they are able to
support from the buy side the analysts who are employed in
these firms.
The consequence would be that we would still have the
Sanford Bernsteins and many other such firms, but we might have
a reduction in the total number of analysts by a very large
fraction. And I think that this would inflict a social injury
because we would have less firms follow.
There is the bottom side of the Nasdaq market right now
that is very thinly followed by analysts. And if we reduce that
population by half, we would have a darker, less transparent
market.
Chairman Sarbanes. Did you want to add to that?
Mr. Glauber. I would like to underline what Professor
Coffee just said. I think the consequences of a surgical
solution, a Glass-Steagall type solution of separating security
analysis from investment banking services, would be a very
substantial reduction in the amount of information available to
investors. I think a better approach is, indeed, the right
kinds of rules imposed by the NASD and others. We have just, as
Professor Coffee said, put out what is a very comprehensive and
very tough rule. Some of the proposals he made, I hope he will
include in comments on that rule. The rule is presently out
from the SEC for comment.
Chairman Sarbanes. You mean these four suggestions he had
here, like the booster shot, for example.
Mr. Glauber. The antiretaliation provisions. Because they
are very useful alternatives to consider as part of that rule.
But I think the best, most effective way to approach this is
through rules.
Chairman Sarbanes. How about disclosure? Is it adequately
disclosed now that the analyst is connected with a firm that is
doing underwriting as well, and therefore, you should perhaps
take his recommendation with a grain of salt?
Mr. Coffee. Well, as he will point out, Rule 2711 also
addresses the disclosure that should be given. I think that is
also desirable.
Chairman Sarbanes. Does that address the analyst's own
holdings as well? And that was not heretofore the case?
Mr. Glauber. That is correct. What it does do is require
disclosure by the analyst of his holdings and it requires a
disclosure by the firm of its investment banking relationship.
Chairman Sarbanes. You may do a lot of good if the analyst
has to say up front, my firm is underwriting this company and I
own this amount of stock. You are going to look at it and say,
what kind of recommendation is this? You will, presumably,
discount it.
Mr. Glauber. We believe that disclosure plays a very
important role. The rule contained both of these disclosure
provisions, including, I might add, one in which the analyst
has to publish a history of the price of the stock, together
with his or her recommendations superimposed on that price
history, so that you can see where the analyst was saying buy
and where the analyst was saying sell.
I think disclosure plays a very important role and then
there are specific prohibitions. For example, no pre-IPO stock.
The analyst cannot receive cheap stock as part of his
compensation. I think those together are a very effective rule.
It perhaps could be embellished and that is why I hope that
Professor Coffee will add these suggestions to his comments.
Mr. Coffee. All I was suggesting, Senator, was that it is
difficult for the individual investor to go through all the
boilerplate that you are likely to get, even under a much-
improved system. And if you were to define a term, like
independent analyst, and say only analysts who have met the
following standards. I would say the first standard is, you are
making a recommendation about a company that your firm has no
economic relationship with.
Now there are many in the industry who would disagree and
say analysts are independent, even though their firm is
underwriter.
I think we would give a lot more value to investors if we
tried to define a simply understood term, independent analyst,
and say that you can only use that term if you meet the
following qualifications. That condenses the disclosure to the
bottom-line fact that I think is most important to the
investor.
Chairman Sarbanes. I want to ask two more questions----
Senator Corzine. Mr. Chairman, I have to leave. I would
make one observation. I do not think this should be limited
just to underwriting. The relationships that drive some of
those retaliation actions, some of the interests go well
beyond. Actually, they are more subtle.
Mr. Coffee. I certainly agree with you. I did not mean to
limit it that way.
Mr. Glauber. Absolutely.
Senator Corzine. We have to be careful about the
characterization of only tying it to IPO's or----
Mr. Coffee. I agree entirely with you. That is why you need
a rule-based approach, because only an agency can draft those
full rules.
Mr. Glauber. That is right.
Chairman Sarbanes. Let me ask two more questions.
One is, in the Enron situation, we apparently have
instances in which banks extended loans to Enron in very
substantial amounts because it was then being connected to the
possibility of underwriting or other business that would flow
from Enron to the lending institution.
Now, we went through this Glass-Steagall thing here over a
sustained period of time. And in the end, you used the phrase,
came out from under it, or something. In any event, now we have
this situation where this issue has now come before us. What is
your reaction to that?
Mr. Coffee. Well, we each may have different reactions.
Chairman Sarbanes. No, no. You do not all have to have the
same reactions.
[Laughter.]
We invite different reactions.
[Laughter.]
Mr. Coffee. I think we have two distinct problems here. One
is the problem of the Chinese wall, while necessary, sometimes
can work to the injury of the public investor.
This is where the investment bank or the commercial bank
has gone out and found investors for private equity deals, such
as the private partnerships that were involved in the Enron
story. And pursuant to that, you learn a lot of nonpublic
information, none of which ever reaches the public side of your
firm, which is making recommendations to investors. And one of
the ironies and problems is that you may be touting a stock
that one half of the firm knows is a very risky, highly
leveraged firm. That is a problem that the schizophrenia within
the firm doesn't work to the best interests of the investor and
I think it needs some further study.
The other problem you are raising is that a lot of banks
felt pressured to raise this equity or to form these services
in order to be first in line to serve as commercial lenders.
And I think that is a problem, but I actually do think that
banks are capable of protecting themselves and you should focus
more on the problems of the public investor, who is not as
capable of protecting himself and doesn't know that there may
be very adverse information that is not reaching the market
because of this partial penetration of the information through
the firm.
Mr. Seligman. If I can just amplify the first point that
Professor Coffee made.
There were some very troublesome journalistic stories and
some intimations in the Powers report prepared about Enron to
the effect that different financial data was provided to
private investors, I believe including banks, than was being
made publicly available.
Now this may be effectively addressed by enforcement
actions of some sort. But this is an issue which I think is
worth exploring with Chairman Pitt when he testifies before
you, and addressing how it can be possible that, at least if
the newspaper accounts are accurate, that nearly
simultaneously, the assets described publicly were only about
two-thirds of those that were being described privately. I do
not understand how you can reconcile those data. It is
plausible. There may be ways to do it. But it hasn't been
presented in a way that makes sense to date.
Mr. Glauber. Well, let me return to the second issue. That
is, the commercial pressures between the commercial banking
side and the investment banking side or underwriting side of
now these complex institutions.
Chairman Sarbanes. Right.
Mr. Glauber. I think the pressures flow both ways. The
pressures may be, indeed, to offer a loan as a way to perhaps
encourage the investment banking services. Those exist. One
hopes, and I believe that, over time, the managements, for
their own commercial interests, will manage the sets of
tensions and pressures because, to make a bad loan in order to
get the investment banking business, is just a very bad
commercial decision. I believe that they will find a way to
manage those pressures, and the shareholders will demand that
they do. But it is the early stages of having both of these
under one roof and mistakes will be made, I am sure.
Chairman Sarbanes. Let me ask you this question. This is a
broader question. It is fairly clear that the existing
structure, had it worked or had the will been there to be
strong or tough or however you want to phrase it, they could
have done a lot of things that--I mean, the exchanges could
have had listing requirements or the SEC could have pushed the
exchanges to have had listing requirements.
The SEC itself could have done a host of things. FASB could
have done standards, on and on and on. Of course, the way the
system works, FASB is thinking about doing a standard and the
next thing you know, everyone is beating down FASB's door,
including Members of the Congress, not to do the standard.
Now, everyone's saying, FASB should have done this
standard. Where was FASB? Why didn't they do the standard we
needed? FASB is moving to do some standards. The exchanges, I
think to their credit--we had Ira Millstein in here on the
audit committees and they are making, as I understand it, some
constructive changes with respect to audit committees.
But one of the decisions we are going to have to face, or
judgments, is how much we have to move in with legislation--
well, one area, and Senator Corzine was focusing on it, is what
structural changes we need, systemic changes, like with an SRO
for accountants that is different from the current because the
current thing obviously is not working.
The other question is whether we have to move in with
standards of some sort on the argument, this is the only way we
can prevent sliding back. Maybe the current regulatory
arrangements will do these standards, but maybe not. Or maybe
if they do them later, they will fall back from them. It is
kind of a broad, somewhat vague question, but I would be
interested in getting your perceptions of that issue.
Mr. Glauber. Starting from the left and working to the
right, I guess.
[Laughter.]
Mr. Coffee. I think the priority should be on the
governance of auditing. I think that is the demonstrated
failure, the data about the number of earnings restatements and
the way in which earnings management peaked in the late 1990's,
should give you the number-one priority, focusing on creation
of an SRO.
Now your second point, which I agree with, is that there
are times when one way that Congress can interact with SRO's
and other bodies, is to give them standards for their future
rulemaking.
This would not impose a fine-tune obligation, but you could
tell the SRO's that you want them to address in rules the
problem of conflicts of interest among research analysts or you
want them to study and direct and adopt appropriate rules to
deal with enhancing the objectivity of analysts and disclosing
any possible biases.
I don't think that really hurts the SRO's. It tells them
this is a Congressionally mandated priority and it leaves the
front-line problem of drafting, of making things work, in the
hands of the body with the greatest expertise, either the SEC
or the SRO.
I believe there are things you can do, but I would be
cautious about trying to cut through the Gordian Knot with a
single stroke, such as by legislating the complete separation
of securities research from investment banking.
Mr. Seligman. I mentioned earlier Section 15 and 19(a) of
the Securities and Exchange Act. I think that gives you a
useful model in response to your very thoughtful question.
It seems to me, at a kind of constitutional law level,
there are certain principles you should delineate. You should
require a new SRO to be created and you should require it to
register with the SEC. You should have in place an adequately
funded SEC staff, whether it is in the Office of Chief
Accountant or otherwise, that can carefully review the filing
with the Commission to ensure compliance with the standards you
have established.
There is a great deal of highly detailed work and fine-
tuning that will have to evolve over time, subject to SEC
oversight. When you periodically have the Commission before
you, you can question whether they are doing it well enough.
But to try to delineate all of that level of detail, I think
would be unwise and too rigid.
Chairman Sarbanes. Mr. Glauber.
Mr. Glauber. You have now three, between you, Mr. Chairman
and these two gentlemen, wise lawyers discussing this issue. I
am not a lawyer.
Chairman Sarbanes. It puts you at an advantage.
[Laughter.]
Mr. Glauber. I tread here very, very lightly. I think that
what Professor Coffee said is right. The Congress could easily
sketch out some broad principles that it wanted. But I hope
that it would not get into the position of writing detailed
rules.
This is a fast-changing scene that requires flexibility and
I think the right way to get rules written is through either
the SEC or some independent regulatory organization that would
be created. So, I just would simply encourage you in that
direction.
Chairman Sarbanes. Well, one of the first things that I did
when I became Chairman was to begin an oversight process. I do
think that there is much more that the Congress can do in terms
of oversight to make sure that the regulatory authorities are
anticipating and measuring up to the problems.
That is actually where this drumbeat that we continue to
sound about giving adequate resources--you put the SEC out
there as a front-line agency for all of this, we call it the
jewel in our regulatory crown. It has an incredibly
distinguished history over the years. We constantly brag about
the integrity of the American markets and how integral this has
been to our economic success and how it commands worldwide
respect and everything.
Then the very agency who carries the prime burden for all
of this is so short-changed in its resources--we have not had a
witness yet who has come before us who has even entertained the
idea of arguing that their existing level of resources is
adequate to their task. Now, they may differ about how far we
ought to go, but no one has come in and said, oh, no, they have
plenty of resources. That just underscores that situation.
Well, gentlemen, you have been enormously helpful. I hope,
as we work through this, we can come back to you for further
counsel because we think that that would be very helpful.
Let me simply say, tomorrow, we will have a further
hearing. We will be hearing from: Shaun O'Malley, who is Chair
of the 2000 Public Oversight Board Panel on Audit
Effectiveness, the so-called O'Malley Commission; Lee Seidler,
who is Deputy Chairman of the 1978 American Institute of CPA
Commission on Auditor's Responsibilities; Arthur Wyatt, Past
President of the American Accounting Association; Professor
Abraham Briloff, Professor Emeritus of Baruch College of the
City University of New York; and Bevis Longstreth, who is a
member of the O'Malley Commission and a distinguished member of
the SEC.
So this panel will, in a sense, follow along very much with
some of the issues that have been developed here today.
Thank you all very much.
This hearing is adjourned.
[Whereupon, at 12:45 p.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF SENATOR JON S. CORZINE
Mr. Chairman, thank you for holding this hearing.
In the wake of the Enron debacle, Congress has an enormous
responsibility to take a careful look at the factors that contributed
to the company's precipitous fall.
Enron Corporation, along with other high-profile business failures,
and the growing discomfort with reported earnings restatements, have
highlighted the need for a comprehensive review of our financial
reporting system and the regulatory structure that supports it.
For the past few decades, Washington has been focused on
deregulation and the development of pro-business policies. Often, these
policies have been necessary to adjust for excessive rigidities in our
regulatory structure.
To be certain, deregulating our financial system has had many
benefits, including the democratization of the market. Productivity has
improved dramatically and we have created millions of new jobs. That
said--excesses accompanied the good--and once clearly defined
boundaries have now become blurred.
The pendulum seems to have swung too far. And as we have heard from
many of our witnesses, the culture of business has increasingly become
a culture of excess.
Mr. Chairman, with occurrences like we have witnessed at Enron,
Global Crossing, Tyco, and PNC Bank, more and more investors are
becoming uncomfortable with what they perceive to be a lack of full
disclosure in financial statements--those concerns ultimately hurt our
markets. And they highlight the glaring need for the SEC to be better
prepared, better funded, and better staffed in order to fulfill its
enormous mission. We will hear about the challenges the SEC confronts
as a result of their increasing workload shortly.
It also shows the need for an improved regulatory structure, one
that provides sufficient checks and balances and promotes the integrity
of the audit function. A structure that provides the SEC with the
resources it needs, and provides independence to the Financial
Accounting Standards Board, so that it too may be better equipped to
serve its vitally important purpose.
Mr. Chairman, in holding these hearings, I hope we will seek to
find out not only ``what happened,'' but also move forward with a plan
to diminish the increasing pressures on companies to ``play in the
gray.''
Last week, Senators Dodd, Stabenow, Johnson, and I introduced
legislation to address many of these issues.
Mr. Chairman, we look forward to working with you, and the other
Members of this Committee to bring a bill before this Committee that
will not only provide investors with greater confidence, but also
restore credibility to the accounting profession and ensure that the
SEC is able to fulfill its oversight responsibility--and has the
resources to do so.
The train wreck has occurred. And now that it has, we have a
responsibility to ensure that it never happens again.
I look forward to the testimony of our witnesses.
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PREPARED STATEMENT OF SENATOR DEBBIE STABENOW
Thank you, Mr. Chairman. Let me begin by commending the thorough
approach this Committee is taking under your leadership.
While the work of this Committee may not attract the headlines that
we see when the Ken Lays and Andrew Fastows of the world are subpoenaed
to appear before Congress, I believe that the careful and deliberative
work of this Committee is what will ultimately reform the shortcomings
in our current accounting system.
Mr. Chairman, I have approached the issues before us with an open
mind and have no predetermined conclusions. I appreciate the
interesting and diverse opinions of the witnesses we have had so far. I
welcome the witnesses before us today.
We need to continue to explore the serious policy questions at
hand.
In particular, we have heard repeatedly that there is a culture of
gamesmanship where earnings management is commonplace. We should
explore this issue further. Changing a culture is a lot more
complicated than changing the law.
In addition, I hope that we will continue to examine: The issue of
the best oversight mechanism for the accounting industry; how an
oversight board, as well as the Financial Accounting Standards Board
should be financed; and, what should be done about perceived problems
in the accounting industry's long-standing peer review process.
I also think it is worth exploring what should be done to help
whistleblowers who are trapped in a corporate culture that discourages
dissent, and to ask what more needs to be done to promote investor
education.
All of these issues are complicated. There are differing points of
view on many of these matters and we must carefully consider how best
to proceed. However, I have every confidence that by working
cooperatively, we can put an end to the problems in the industry and we
can reassure the American people that our securities market is the best
in the world.
Thank you, Chairman Sarbanes.
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PREPARED STATEMENT OF DAVID M. WALKER
Comptroller General of the United States
U.S. General Accounting Office
March 5, 2002
Mr. Chairman and Members of the Committee, I appreciate the
opportunity to discuss with the Committee my perspectives on some of
the issues that are now receiving extensive national interest following
the rapid and unexpected decline of Enron Corporation (Enron) and the
resulting huge losses suffered by Enron's shareholders and employees.
The rapid failure and bankruptcy of Enron has led to severe criticism
of virtually all areas of the Nation's financial reporting and auditing
systems, which are fundamental to maintaining investor confidence in
our capital markets. At last count, 12 Congressional committees, the
Department of Justice, the Securities and Exchange Commission (SEC),
and the Department of Labor's Pension and Welfare Administration all
have ongoing investigations of Enron. The individuals responsible for
the Enron debacle should be held accountable for any misdeeds. At GAO,
accountability is one of our core values and must be a critical
component of any system in order for it to function effectively.
The facts regarding Enron's failure are still being gathered to
determine the underlying problems and whether any civil and/or criminal
laws have been violated. Therefore, I will not comment on the specifics
of the Enron situation and who is at fault. At the same time, the Enron
situation raises a number of systemic issues for Congressional
consideration to better protect the public interest. It is fair to say
that other business failures or restatements of financial statements
have also sent signals that all is not well with the current system of
financial reporting and auditing. As the largest corporation failure in
U.S. history, Enron, however, provides a loud alarm that the current
system may be broken and in need of an overhaul.
I will focus on four overarching areas--corporate governance, the
independent audit of financial statements, oversight of the accounting
profession, and accounting and financial reporting issues--where the
Enron failure has already demonstrated that serious, deeply rooted
problems may exist. It should be recognized that these areas are the
keystones to protecting the public's interest and are interrelated.
Failure in any of these areas places a strain on the entire system. The
overall focus of these areas should be guided by the fundamental
principles of having the right incentives for the key parties to do the
right thing, adequate transparency to provide reasonable assurance that
the right thing will be done, and full accountability if the right
thing is not done. These three overarching principles represent a
system of controls that should operate with a policy of placing special
attention on those areas of greatest risk. In addition, an established
code of ethics should set the ``tone at the top'' for expected ethical
behavior in performance of all key responsibilities. The 1980's savings
and loan crisis, for which this Committee was instrumental in shaping
the reforms to protect deposit insurance and the public interest, is a
prime example of the serious consequences that can result when one or
more components of an interrelated system breaks down.
My comments today are intended to frame the broad accountability
issues and provide our views on some of the questions and options that
must be addressed to better safeguard the public interest going
forward. There will no doubt be many views on what needs to be fixed
and how to do it. We look forward to working with the Congress to
provide assistance in defining the issues, exploring various options,
and identifying their pros and cons in order to repair any weaknesses
that threaten confidence in our capital markets and that inhibit
improvements in the current system and appropriate actions by the key
players. In considering changes to the current system that gave rise to
Enron and other earlier financial reporting failures, it will be
important that the Congress consider a holistic approach to addressing
the range of interrelated issues. From all that has been heard from the
inquiries to date, it is clear that there is no single silver bullet to
fix the problems. It is also clear that many parties are focusing on
various elements of the issues but do not seem to be taking a
comprehensive approach to addressing the many interrelated issues. This
is what we are trying to do for the Congress.
On February 25, 2002, GAO held a forum on various governance,
transparency, and accountability issues that was attended by experts in
each of these areas. A summary of the results of the forum is being
released today and is available at our website.\1\ Also, we have
completed the study of the SEC's resources that you requested and the
report is being released today.\2\ I will discuss the results of that
work today as well.
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\1\ Highlights of GAO's Forum on Corporate Governance,
Transparency, and Accountability (GAO-02- 494SP, March 5, 2002).
\2\ SEC Operations: Increased Workload Creates Challenges (GAO-02-
302, March 5, 2002).
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Before discussing these matters, I would like to quickly provide an
overview of the current corporate governance system, the independent
audit function, regulatory oversight, and the accounting and financial
reporting framework. An attachment to my prepared testimony graphically
illustrates the interrelation and the complexity of these systems.
Overview of the Current Governance, Auditing, Oversight Systems,
and Financial Reporting
Public and investor confidence in the fairness of financial
reporting is critical to the effective functioning of our capital
markets. The SEC, established in the 1930's following the stock market
crash of 1929 and the Great Depression, protects investors by
administering and enforcing Federal securities laws, and its
involvement with requirements for financial disclosures and audits of
financial statements for publicly-traded companies. In this respect,
the public accounting profession, through its independent audit
function, has received a franchise to audit and attest to the fair
presentation of financial statements of publicly-traded companies.
However, such a franchise brings with it not only the important role of
attesting to the reliability of financial statements and related data,
but also the concomitant responsibility of protecting the public
interest and ensuring the public confidence through appropriate
independence, professional competence, and high ethical standards for
auditors.
The SEC, the primary Federal agency involved in accounting and
auditing requirements for publicly-traded companies, has traditionally
relied on the private sector for setting standards for financial
reporting and independent audits, retaining a largely oversight role.
Accordingly, the SEC has accepted the rules set by the Financial
Accounting Standards Board (FASB) \3\--Generally Accepted Accounting
Principles (GAAP)--as the primary standard for preparation of financial
statements in the private sector. The SEC has accepted rules set by the
American Institute of Certified Public Accountants' (AICPA) Auditing
Standards Board--Generally Accepted Auditing Standards (GAAS)--as the
standard for conducting independent audits of financial statements for
private sector entities. The SEC monitors the performance of the
standard setting bodies and also monitors the accounting profession's
system of peer review, which checks compliance with applicable
professional standards.
---------------------------------------------------------------------------
\3\ FASB, as part of the Financial Accounting Foundation (FAF), is
a not-for-profit organization supported by contributions from
accounting firms, corporations, and the other entities that are
interested in accounting issues. FASB consists of seven full-time
members who are selected and approved by the FAF.
---------------------------------------------------------------------------
The SEC also oversees the activities of a variety of key market
participants. It does this using the principle of self-regulation.
According to this principle, the industry regulates itself through
various self-regulatory organizations (SRO's) overseen by the SEC.
SRO's are groups of industry professionals with quasi-governmental
powers to adopt and enforce standards of conduct for their members.
They include the nine securities exchanges, such as the New York Stock
Exchange (NYSE) which regulate their marketplaces and the National
Association of Securities Dealers (NASD) which regulates the over-the-
counter market. In addition to regulating member broker-dealers, the
SRO's establish listing standards for those firms that list on their
market.
The AICPA administers a self-regulatory system for the accounting
profession that includes setting auditing and independence standards,
monitoring compliance, and disciplining members for violations of ethic
rules and standards. The Public Oversight Board, administratively
created by the AICPA in consultation with the SEC in 1977, monitors the
public accounting firms' compliance with professional standards and
oversees the Auditing Standards Board. State boards of accountancy
license public accounting firms and individuals to practice public
accounting within each State's jurisdiction.
The audit is a critical element of the financial reporting
structure because it subjects information in the financial statements
to independent and objective scrutiny, increasing the reliability and
assurance that can be placed on those financial statements for
efficient allocation of resources in a capital market where investors
are dependent on timely and reliable information. Management of a
public company is responsible for the preparation and content of the
financial statements, which are intended to disclose information that
accurately depicts the financial condition and results of company
activities. In addition, public companies registered with the SEC must
maintain an adequate system of internal accounting control. The
independent auditor is responsible for auditing the financial
statements in accordance with generally accepted auditing standards to
provide reasonable assurance that the financial statements are fairly
presented in accordance with GAAP. The auditor's opinion on the
financial statements is like an expert's stamp of approval to the
public and the capital markets.
United States stock exchanges require listed companies to meet
certain corporate governance standards, including that boards of
directors have independent audit committees to oversee the accounting
and financial controls of a company and the financial reporting
process. Audit committees can help protect shareholder interests by
providing sound leadership and oversight of the financial reporting
process by working with management and both internal and external
auditors.
The interrelation and complexity of the systems of corporate
governance, auditing, oversight, and accounting and financial
reporting, which cumulatively are the foundation for maintaining
investor confidence in our capital markets, is graphically illustrated
in the charts attached to this statement. The many links within and
between the systems further illustrate the strain that can be placed on
the overall system when weaknesses occur within any part of the system.
I would now like to focus on each of the four overarching areas
that I mentioned earlier, starting with corporate governance.
Corporate Governance
I want to acknowledge immediately that serving on the Board of
Directors of a public corporation is an important, difficult, and
challenging responsibility. That responsibility is especially
challenging in the current environment with increased globalization and
rapidly evolving technologies having to be addressed while at the same
time meeting quarterly earnings projections in order to maintain or
raise the market value of the corporation's stock. These pressures, and
the related executive compensation arrangements, unfortunately often
translate to a focus on short-term business results. This can create
the perverse incentives, such as managing earnings to inappropriately
report favorable financial results, and /or failing to provide adequate
transparency in financial reporting that disguises risks,
uncertainties, and/or commitments of the reporting entity.
On balance though, the difficulty of serving on a public
corporation's board of directors is not a valid reason for not doing
the job right, which means being knowledgeable of the corporation's
business, asking the right questions, and doing the right thing to
protect the shareholders and the public interest. A board member needs
to have a clear understanding of who is the client being served.
Namely, their client should be the shareholders of the company, and all
their actions should be geared accordingly. Audit committees have a
particularly important role to play in assuring fair presentation and
appropriate accountability in connection with financial reporting,
internal control, compliance, and related matters.
Enron's failure has raised many questions about how its Board of
Directors and audit committee were performing their duties and
responsibilities. These questions include the following:
Did the board of directors fulfill its fiduciary
responsibility to shareholders and protect the public interest in
overseeing Enron's management?
Did the board operate in a proactive manner and raise the
appropriate questions designed to identify key problems and
mitigate related risks?
Did the board have the appropriate industry, financial, or
other appropriate expertise?
Did board members have personal or business relationships that
may have either in fact or in appearance affected their
independence?
Did the board, especially its audit committee, have an active
interface and appropriate working relationship with Enron's
internal and external auditors?
Did the board and its audit committee have appropriate
resources to do the job including staff and independent advisors?
Did the board and its audit committee report meaningfully on
their activities?
These are fundamental questions that as I previously mentioned are
being addressed by various investigations and, therefore, I will not
comment on those issues. However, these issues are instructive and, as
a minimum, call for a review of the applicable rules and regulations
that govern boards of directors. In that respect, the Administration
recently formed a group of top financial policymakers and regulators to
consider corporate governance and disclosure reforms. The SEC has asked
the NYSE and Nasdaq to review corporate governance and listing
standards, of public companies, including the important issues of
officer and director qualifications and the formal codes of conduct.
The SEC Chairman recently announced that the NYSE has established a
Special Committee on Corporate Accountability and Listing Standards to
examine corporate governance issues, including the possibility of
requiring continuing education programs for officers and directors, and
the Nasdaq also is taking similar steps. The corporate chief executives
who make up the Business Roundtable have stated that they are reviewing
their voluntary standards for corporate governance. The AFL - CIO has
petitioned the SEC to amend its proxy disclosure requirements regarding
conflicts of interest reportable by Board members. The California
Public Employees' Retirement System (CalPERS) is also reviewing
definitions and standards for independent corporate directors.
These examples are not intended to be a complete listing of reviews
underway on corporate governance requirements. We applaud these
initiatives. Hopefully, they will provide the opportunity for a
thorough review of corporate governance requirements. These efforts
will help to identify and frame the issues and to serve as a basis for
determining whether the fundamental underpinnings for effective
performance of boards of directors and audit committees are in place
along with controls to monitor performance. Some basic factors to
consider in reviewing the various requirements that govern membership
and responsibilities of boards of directors of public companies include
the following:
Is there a clear understanding of whom the board is serving
and its fiduciary responsibility to shareholders and related impact
on the capital markets?
What type of relationship should the board have with
management (for example, constructive engagement)?
What, if any, selection process changes are necessary in order
to assure the proper identification of qualified and independent
board members?
Is the nominating process for board membership designed to
ensure that the board is getting the right mix of talent to do the
job?
Do board membership rules address who other than management
would nominate board members?
Are the independence rules for outside directors and audit
committee members sufficient to ensure the objectivity of the
members?
Do board membership rules address whether the corporation's
CEO should be allowed to be the board chairman?
Do board membership rules address whether independent board
members should nominate the chairman of the board?
Do board membership rules address whether members of
corporation management, including the CEO, should be allowed to be
board members, and if so, what percentage of total board
membership?
Do board membership rules address whether corporation service
providers, such as the major customers or other related parties,
should be allowed to be board members?
Do requirements ensure that the board will have access to the
resources and staff necessary to do the job, including its own
staff and access to independent legal counsel and other experts?
Do requirements ensure that the responsibilities of board
members, including the members who serve on audit committees and
other committees, such as the nominating, finance, and compensation
committees, are required to be committed to a charter that governs
their operation?
Do requirements address the appropriate working relationship
between the audit committee and the internal and external auditors?
Do requirements provide for the board of directors to
establish a formal code of conduct to set the tone for expected
personal and business ethical behavior within the corporation?
Do requirements provide that waivers of the code of conduct
are not expected and should such circumstances arise, which should
be extremely rare, that any exceptions must be approved by the
board of directors and publicly reported?
Do requirements provide for public reporting on the
effectiveness of internal control by management and independent
assurances on the effectiveness of internal control by the
corporation's independent auditors?
Do requirements provide for public reporting by the board of
directors, the audit committee, and other committees of the board
on their membership, responsibilities, and activities to fulfill
those responsibilities?
Do the stock exchanges and the SEC have sufficient authority
to enforce requirements governing boards of directors and audit
committees and to take meaningful enforcement actions, including
imposing effective sanctions when requirements are violated?
Does the SEC have sufficient resources and authority to
fulfill its responsibilities under the Federal securities laws and
regulations to operate proactively in monitoring SEC's registrants
for compliance and to take timely and effective actions when
noncompliance may exist?
Is the SEC efficiently and effectively using technology to
manage its regulatory responsibilities under the Federal securities
laws by assessing risks, screening financial reports and other
required filings, and accordingly prioritizing the use of its
available resources?
Boards of directors and their audit committees are a critical link
to fair and reliable financial reporting. A weak board of directors
will also likely translate into an ineffective audit committee. That
combination makes the difficult job of auditing the financial
statements of large corporations, which usually have vast, complex, and
diversified operations, much more challenging.
Regulation and Oversight of the Accounting Profession
The model for regulation and oversight of the accounting profession
involves Federal and State regulators and a complex system of self-
regulation by the accounting profession. The functions of the model are
interrelated and their effectiveness is ultimately dependent upon each
component working well. Basically, the model includes the functions of:
Licensing members of the accounting profession to practice
within the jurisdiction of a State, as well as issuing rules and
regulations governing member conduct, which is done by the State
boards of accountancy.
Setting accounting and auditing standards, which is done by
the Financial Accounting Standards Board and the Auditing Standards
Board, respectively, through acceptance of the standards by the
SEC.
Setting auditor independence rules, which within their various
areas of responsibility, have been issued by the AIPCA, the SEC,
and GAO.
Oversight and discipline, which is done through systems of
self-regulation by the accounting profession and the public
regulators (the SEC and the State boards of accountancy).
The Enron failure has brought a direct focus on how well the
systems of regulation and oversight of the accounting profession are
working in achieving their ultimate objective that the opinions of
independent auditors on the fair presentation of financial statements
can be relied upon by the investors, the creditors, and the various
other users of financial reports.
The issues currently being raised about the effectiveness of the
accounting profession's self-regulatory system are not unique to the
collapse of Enron. Other business failures or restatements of financial
statements over the past several years have called into question the
effectiveness of the system. A continuing message is that the current
self-regulatory system is fragmented, is not well-coordinated, and has
a discipline function that is not timely nor does it contain effective
sanctions, all of which create a public image of ineffectiveness.
Reviews of the system should consider whether overall the system
creates the right incentives, transparency, and accountability, and
operates proactively to protect the public interest. Also, the links
within the self-regulatory system and with the SEC and the State boards
of accountancy (the public regulatory systems) should be considered as
these systems are interrelated and weaknesses in one component can put
strain on the other components of the overall system.
I would now like to address some of the more specific areas of the
accounting profession's self-regulatory system that should be
considered in forming and evaluating proposals to reshape or overhaul
the current system.
Accounting Profession's Self-Regulatory System
The accounting profession's current self-regulatory system is
largely operated by the AICPA through a system, largely composed of
volunteers from the accounting profession. This system is used to set
auditing standards and auditor independence rules, monitor member
public accounting firms for compliance with professional standards, and
discipline members who violate auditing standards or independence
rules. AICPA staff support the volunteers in conducting their
responsibilities. The Public Oversight Board oversees the peer review
system established to monitor member public accounting firms for
compliance with professional standards. In 2001, the oversight
authority of the Public Oversight Board was expanded to include
oversight of the Auditing Standards Board. The Public Oversight Board
has five public members and professional staff, and receives its
funding from the AICPA.
On January 17, 2002, the SEC Chairman outlined a proposed new self-
regulatory structure to oversee the accounting profession. On January
20, 2002, the Public Oversight Board passed a resolution of intent to
terminate its existence no later than March 31, 2002. The Public
Oversight Board's Chairman was critical of the SEC's proposal and
expressed concern that the Board was not consulted about the proposal.
The SEC's proposal provided for creating an oversight body that would
include monitoring and discipline functions, have a majority of public
members, and be funded through private sources. No further details have
been announced.
The authority for the oversight body is a basic but critical factor
that can influence its operating philosophy, its independence, and,
ultimately, its effectiveness. Related factors to consider include:
Determining whether the body should be created by statute or
administratively, such as is the case for the current Public
Oversight Board.
Deciding the basic scope of the body's enabling authority,
such as whether oversight authority should be limited to coverage
of the public accounting firms that audit SEC registrants, which is
the authority of the current Public Oversight Board, or whether it
should be expanded to other public accounting firms that also
provide audit services to a broader range of entities.
Determining mission objectives clearly to ensure that
protecting the public interest is paramount.
Membership of the oversight body and its funding may also influence
the body's operating philosophy (proactive as opposed to reactive),
independence, and resolve to actively assess and minimize risks within
the system that affect protecting the public interest. Factors to
consider include:
Whether the membership should be limited to public members
(exclude practicing members of the accounting profession), such as
is the case for current Public Oversight Board.
Whether membership should allow some practicing members of the
accounting profession to sit on the board.
How the members will be selected, including the chairman,
their term limits, and compensation.
How the amount and source of funding will be established since
a problem with either may present potential conflicts or limit the
oversight body's ability to effectively protect the public
interest.
The responsibilities of the oversight body and its powers to
perform those responsibilities will largely define whether the
oversight body is set up with a sufficient span of responsibility to
oversee the activities of the accounting profession and to take
appropriate actions when problems are identified. Related factors to
consider include:
Whether the current system of peer review should be continued
in its present form and monitored by the oversight body, such as
was done by the Public Oversight Board, with oversight by the SEC.
Whether the oversight body should have more control over the
peer review function, such as selecting and hiring peer reviewers,
managing the peer review, and being the client for the peer review
report.
Whether the oversight body's authority should extend to all
standard setting bodies within the accounting profession so that
accounting, auditing, quality control and assurance, and
independence standards are subject to oversight (currently the
Public Oversight Board does not oversee the setting of accounting
standards or auditor independence rules).
Whether the oversight body's authority related to standard
setting should be expanded to direct standard setting bodies to
address any problems with standards and approve the adequacy of
revised standards (currently the Public Oversight Board does not
have such direct authority).
Whether the oversight body's authority should extend to the
discipline function (currently the Public Oversight Board does not
oversee the discipline function).
Whether the oversight body should have investigative authority
over disciplinary matters (currently this function is housed within
another component of the AICPA) or authority to request
investigations.
Whether the body within the self-regulatory system responsible
for investigations of disciplinary matters should have power to
protect investigative files from discovery during litigation to
facilitate cooperation and timeliness in resolving cases.
Accountability requirements can provide for stewardship of
resources, help to set the operating philosophy of the oversight body,
and provide a means of monitoring the oversight body's performance. The
current Public Oversight Board, POB, issues an annual report and its
financial statements are audited. Related factors to consider include:
Whether the oversight body should prepare strategic and annual
performance plans.
Whether the oversight body should have an annual public
reporting requirement and what information should be included in
the report, such as whether the report should be limited to the
oversight body's activities or whether the report should provide
more comprehensive information about the activities of the entire
self-regulatory system, and whether the oversight body should have
audited financial statements.
Whether and, if so, how Congress should exercise periodic
oversight of the performance of the self-regulatory system and the
performance of the oversight body.
At this time, the outcome of the SEC's proposal to establish a body
for overseeing the accounting profession that would include monitoring
and discipline functions is uncertain. There is considerable overlap in
the functions of the current self-regulatory system and the functions
of the SEC related to the accounting profession. For example, the AICPA
sets auditor independence rules applicable to its membership, and the
SEC sets auditor independence rules for those auditors who audit the
SEC's registrants. Also the AICPA disciplines its members for
noncompliance with independence rules or auditing standards. The SEC,
through its enforcement actions, disciplines auditors of SEC
registrants who violate its laws and regulations, which include
noncompliance with independence rules and auditing standards. In
addition, the SEC also conducts various activities to oversee the peer
review function of the self-regulatory system.
As proposals are considered for reshaping or for overhauling the
self-regulatory system, the overlap of functions with the SEC's
responsibilities should be considered to provide for oversight of the
accounting profession that is both efficient and effective. Related
factors to consider include the following:
Whether current independence rules are adequate to protect the
public interest.
Whether independence rules for auditors should be consistent
and set by the Government or private sector, or whether the status
quo is acceptable.
Whether the current system of peer review is acceptable or
whether the SEC should play a role that exercises more direct
control or oversight of the accounting profession's compliance with
standards.
How the investigative/enforcement functions of the self-
regulatory system and the SEC can be jointly used to efficiently
and to effectively achieve their common objectives to resolve
allegations of audit failure.
Similarly, the discipline functions of the SEC and the self-
regulatory system overlap with the State boards of accountancy, which
are the only authorities that can issue or revoke a license to practice
within their jurisdictions. The communication and working relationship
opportunities for efficiency and effectiveness that exist between the
SEC and the self-regulatory system also exist for their relationship
with the State boards of accountancy in resolving allegations of audit
failure.
The Independent Audit Function
For over 70 years, the public accounting profession, through its
independent audit function, has played a critical role in enhancing a
financial reporting process that facilitates the effective functioning
of our domestic capital markets, as well as international markets. The
public confidence in the reliability of issuers' financial statements
that is provided by the performance of independent audits encourages
investment in securities issued by public companies. This sense of
confidence depends on reasonable investors perceiving auditors as
independent expert professionals who have neither mutual nor conflicts
of interests in connection with the entities they are auditing.
Accordingly, investors and other users expect auditors to bring to the
financial reporting process integrity, independence, objectivity, and
technical competence, and to prevent the issuance of misleading
financial statements.
The Enron failure has raised questions concerning whether auditors
are living up to the expectations of the investing public; however,
similar questions have been repeatedly raised over the past three
decades by significant restatements of financial statements and
unexpected costly business failures. Issues debated over the years
continue to focus on the auditor independence concerns and the
auditor's role and responsibilities, particularly in detecting and
reporting fraud and assessing the effectiveness of and reporting on
internal control.
Auditor Independence Concerns
The independence of public accountants--both in fact and in
appearance--is very crucial to the credibility of financial reporting
and, in turn, the capital formation process. Auditor independence
standards require that the audit organization and the auditor be
independent in fact and in appearance. These standards place
responsibility on the auditor and the audit organization to maintain
independence so that opinions, conclusions, judgments, and
recommendations will be impartial and will be viewed as being impartial
by knowledgeable third parties.
Since the mid-1970's, many observers of the auditing profession
have expressed concern about the expanding scope of professional
services provided by the public accounting profession. Specifically,
questions have been raised by the media, the Congress, and others
concerning the propriety of performing both audit and certain nonaudit
services for the same client. While these services and their perceived
impact on accounting firms' independence have been the subject of many
studies and while actions have been taken to strengthen auditor
independence, the Enron failure has brought this issue once again to
the forefront and has sparked new proposals to prohibit or limit
auditors from providing nonaudit services to audit clients. A common
concern is that when auditor fees for consulting services are a
substantial part of total auditor fees, this situation can create
pressures to keep the client happy and can threaten auditor
independence.
Auditors have the capability of performing a range of valuable
services for their clients, and providing certain nonaudit services can
ultimately be beneficial to investors and other interested parties.
However, in some circumstances, it is not appropriate for auditors to
perform both audit and certain nonaudit services for the same client.
In these circumstances, the auditor, the client, or both will have to
make a choice as to which of these services the auditor will provide.
These concepts, which I strongly believe are in the public interest,
are reflected in the revisions to auditor independence requirements for
Government audits,\4\ which GAO recently issued as part of Government
Auditing Standards.\5\ The new independence standard has gone through
an extensive deliberative process over several years, including
extensive public comments and input from my Advisory Council on
Government Auditing Standards.\6\ The standard, among other things,
toughens the rules associated with providing nonaudit services and
includes a principle-based approach to addressing this issue,
supplemented with certain safeguards. The two overarching principles in
the standard for nonaudit services are that:
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\4\ Government Auditing Standards, Amendment No. 3, Independence
(GAO/A-GAGAS-3, January 2002).
\5\ Government Auditing Standards were first published in 1972 and
are commonly referred to as the ``Yellow Book,'' and cover Federal
entities and those organizations receiving Federal funds. Various laws
require compliance with the standards in connection with audits of
Federal entities and funds. Furthermore, many States and local
governments and other entities, both domestically and internationally,
have voluntarily adopted these standards.
\6\ The Advisory Council includes 20 experts in financial and
performance auditing and reporting drawn from all levels of Government,
academia, private enterprise, and public accounting, who advise the
Comptroller General on Government Auditing Standards.
The auditors should not perform management functions or make
management
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decisions.
The auditors should not audit their own work or provide
nonaudit services in situations where the amounts or services
involved are significant or material to the subject matter of the
audit.
Both of the above principles should be applied using a substance
over form determination. Under the revised standard, auditors are
allowed to perform certain nonaudit services provided the services do
not violate the above principles; however, in most circumstances
certain additional safeguards would have to be met. For example: (1)
personnel who perform allowable nonaudit services would be precluded
from performing any related audit work, (2) the auditor's work could
not be reduced beyond the level that would be appropriate if the
nonaudit work were performed by another unrelated party; and (3)
certain documentation and quality assurance requirements must be met.
The new standard includes an express prohibition regarding auditors
providing certain bookkeeping or recordkeeping services and limits
payroll processing and certain other services, all of which are
presently permitted under current independence rules of the AICPA.
The focus of these changes to the Government Auditing Standards is
to better serve the public interest and to maintain a high degree of
integrity, objectivity, and independence for audits of Government
entities and entities that receive Federal funding. However, these
standards apply only to audits of Federal entities and those
organizations receiving Federal funds, and not to audits of public
companies. In the transmittal letter issuing the new independence
standard, we expressed our hope that the AICPA will raise its
independence standards to those contained in this new standard in order
to eliminate any inconsistency between this standard and their current
standards. The AICPA's recent statement before another Congressional
committee that the AICPA will not oppose prohibitions on auditors
providing certain nonaudit services seems to be a step in the right
direction.\7\ In 2000, the SEC considered a principle-based approach
for auditor independence rules applicable to auditors of the SEC's
registrants, but decided in the end to set specific rules by types of
nonaudit services. We believe a principle-based approach is more
effective given the wide variety of nonaudit services provided by
auditors and the continuing evolution of the market.
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\7\ Testimony of AICPA Chairman before the House Energy and
Commerce Committee (Subcommittee on Communications, Trade and Consumer
Protection), February 14, 2002.
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The new independence standard is the first of several steps GAO has
planned in connection with nonaudit services covered by Government
Auditing Standards. In May 2002, we plan to issue a question and answer
document concerning our independence standard, and I will ask my
Advisory Council on Government Auditing Standards to review and monitor
this area to determine what, if any, additional steps may be
appropriate. In addition, the Principals of the Joint Financial
Management Improvement Program, who are the Comptroller General, the
Secretary of the Treasury, and the Director of the Office of Management
and Budget, have agreed that the 24 major Federal departments and
agencies covered by the Chief Financial Officers Act should have audit
committees. The scope, structure, and timing of this new requirement
will be determined over the next several months. This will include
determining what role these audit committees might play in connection
with nonaudit services.
Another auditor independence issue, which also existed with Enron,
concerns the employment by the client of its former auditor. The
revolving door between auditors and the companies they audit has
existed for years. This is due in part to the mandatory retirement of
partners from public accounting firms, often before the partners are
ready to leave the profession. Another contributing factor that entices
auditors to work for audit clients is the lucrative compensation for
executives in public companies. Employment by the client of its former
auditor can have a clear implication on the quality of audits and has
been cited as a factor in the savings and loan scandal of the late
1980's. The AICPA asked the SEC in 1993 to prohibit public companies
from hiring their audit partner for a year after an audit. The SEC
rejected the proposal as too difficult to enforce. However, Enron has
resurfaced the issue. One Congressional proposal would prohibit an
accounting firm from providing audit services to a company whose
controller or chief financial officer had worked for that public
accounting firm. This issue again raises the auditor independence
perception problem and provides another opportunity to further enhance
auditor independence. A factor to consider in this debate includes
mandating a ``cooling off period'' in which a partner or senior auditor
from a firm cannot go to work for a former audit client for a period of
time after separating from their firm.
A related issue is whether an audit firm should be allowed to serve
as the client's auditor of record without a limit on the period of
time. Currently, there are no time limits for rotation of audit firms,
although the AICPA requirements for member firms that audit SEC
registrants require partner rotation every 7 years. The concerns are
that the auditor may become too close to management over a period of
years and, therefore, threaten the auditor's objectivity. Also the
auditor's familiarity with the business operations of the client may
result in a less than thorough audit. Opposing arguments against
auditor rotation include that there is a significant learning curve for
a new auditor and, during that time, there is a greater risk of the
auditor overlooking transactions that may result in misleading
financial statements. Also, auditor rotations can increase audit costs
for the client.\8\ Building on the current AICPA requirement for
rotating the audit engagement partner every 7 years, rotating
additional key members of the audit team is another alternative to
consider. Rotating additional key members of the audit team should have
less of an impact of the auditor's learning curve and not increase
audit costs, although this option would still leave open the appearance
of an independence issue for the firm.
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\8\ Federal, State, and local government auditors generally have
their responsibilities defined by law or regulation. Therefore,
rotation of Government auditors raises different considerations than in
the private sector. However, the rationale behind rotation of auditors
(enhancing auditor independence) is addressed in Government Auditing
Standards. The standards add organizational criteria that consider
factors in the appointment, removal, and reporting responsibilities of
the head of the audit organization to ensure independence. The
organizational criteria for determining auditor independence are in
addition to personal and external requirements that are considered in
judging the independence of Government auditors.
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Study groups over the years have recognized that corporate boards
and their audit committees could and should play a more significant
role in strengthening the independence of audits. The situation with
Enron and its auditors is another event that highlights the necessity
to reexamine relationships of boards of directors, audit committees,
and management with the independent auditor in order to strengthen the
objectivity and professionalism of the independent auditor and to
enhance the independent audit. Factors to consider in making changes
include the following:
Who should be the client for the audit?
Should the audit committee be actively responsible for hiring,
determining fees, and terminating the auditor?
Should there be more required communication and interaction
between the auditor and the audit committee?
Should the audit committee preapprove the provision of certain
nonaudit services by audit firms?
Should the audit committee be required to review and to
approve the staffing of audit firm personnel?
Auditor's Roles and Responsibilities for Fraud and Internal Control
Under current auditing standards, auditors are responsible for
planning and performing the audit to obtain reasonable, but not
absolute, assurance about whether the financial statements are free of
material misstatement, whether caused by error, illegal acts, or fraud.
As stated over the years by many who have studied the profession, no
major aspect of the independent auditor's role has caused more
difficulty than the auditor's responsibility for detecting fraud. In
August 2000, the Panel on Audit Effectiveness concluded that the
auditing profession needs to address vigorously the issue of fraudulent
financial reporting, including fraud in the form of illegitimate
earnings management.\9\ The study expressed concern that auditors may
not be requiring enough evidence, that is, they have reduced the scope
of their audits and level of testing, to achieve reasonable assurance
about the reliability of financial information that the capital markets
need for their proper functioning. The study recommended that auditing
standards be strengthened to effect a substantial change in auditors'
performance and thereby improve the likelihood that auditors will
detect fraudulent financial reporting. The AICPA is working on a new
auditing standard to improve auditor performance in this area, which it
expects to issue by the end of this year.
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\9\ The Panel on Audit Effectiveness Report and Recommendations
(August 31, 2000). The Panel was formed by the Public Oversight Board
at the request of the SEC to study the effectiveness of the audit model
and other issues affecting the accounting profession.
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We have long believed that expanding auditors' responsibilities to
report on the effectiveness of internal control over financial
reporting would assist auditors in assessing risks for the opportunity
of fraudulent financial reporting or misappropriation of business
assets. Currently, the auditor's report on a public company's financial
statements does not address internal control or purport to give any
assurance about it, and auditors are not required to assess the overall
effectiveness of internal control or search for control deficiencies.
The important issues of the auditor's responsibility for detecting and
reporting fraud and for reporting on internal control overlap since
effective internal control is the major line of defense in preventing
and detecting fraud. Taken together, these issues raise the broader
question of determining the proper scope of the auditor's work in
auditing financial statements of publicly-owned companies. The auditor
would be more successful in preventing and detecting fraud if auditors
were required to accept more responsibility for reporting on the
effectiveness of internal control. The Congress recognized the link
between past failures of financial institutions and weak internal
control when it enacted the Federal Deposit Insurance Corporation
Improvement Act of 1991 that grew out of the savings and loan crisis.
The Act requires an independent public auditor to report on the
effectiveness of internal control for large financial institutions.
And for all of the financial statements audits that we conduct,
which include the consolidated financial statements of the Federal
Government, and the financial statements of the Internal Revenue
Service, the Bureau of Public Debt, the Federal Deposit Insurance
Corporation, and the numerous smaller entities' operations and funds,
we issue separate opinions on the effectiveness of internal control
over financial reporting and compliance with applicable laws and
regulations. We require extensive testing of controls and of compliance
in our audits. We have done this for many years because of the
importance of internal control to protecting the public interest. Our
reports have engendered major improvements in internal control. And as
you might expect, as part of the annual audit of our own financial
statements, we practice what we recommend to others and contract with a
CPA firm for both an opinion on our financial statements and an opinion
on the effectiveness of our internal control over financial reporting
and compliance with applicable laws and regulations. We believe
strongly that the AICPA should follow suit and work with the SEC to
require expanded auditor involvement with internal control of public
companies.
The AICPA Chairman recently expressed the accounting profession's
support for auditor reporting on the effectiveness of internal
control.\10\ Auditors can better serve their business clients and other
financial statements users and protect the public interest by having a
greater role in providing assurances of the effectiveness of internal
control in deterring fraudulent financial reporting, protecting assets,
and providing an early warning of internal control weaknesses that
could lead to business failures. The SEC, the AICPA, and the corporate
boards of directors are major stakeholders in achieving realistic
auditing standards for fraud and internal control. However, as we
stated in our 1996 report on the accounting profession,\11\ the SEC is
the key player in providing the leadership and in bringing these
parties together to enhance auditor reporting requirements on the
effectiveness of internal control. We believe it would be difficult for
the AICPA to unilaterally expand audit requirements without SEC
support.
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\10\ See footnote 7.
\11\ The Accounting Profession Major Issues: Progress and Concerns
(GAO/AIMD-96-98, September 24, 1996).
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Accounting and Financial Reporting Model
Business financial reporting is critical in promoting an effective
allocation of capital among companies. Financial statements, which are
at the center of present-day business reporting, must be relevant and
reliable to be useful for decisionmaking. In our 1996 report on the
accounting profession,\12\ we reported that the current financial
reporting model does not fully meet users' needs.
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\12\ See footnote 11.
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We found that despite the continuing efforts of standard setters
and the SEC to enhance financial reporting, changes in the business
environment, such as the growth in information technology, new types of
relationships between companies, and the increasing use of complex
business transactions and financial instruments, constantly threaten
the relevance of financial statements and pose a formidable challenge
for standard setters. A basic limitation of the model is that financial
statements present the business entity's financial position and results
of its operations largely on the basis of historical costs, which do
not fully meet the broad range of user needs for financial
information.\13\
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\13\ The accounting and reporting model under Generally Accepted
Accounting Principles is actually a mixed-attribute model. Although
most transactions and balances are measured on the basis of historical
cost, which is the amount of cash or its equivalent originally paid to
acquire an asset, certain assets and liabilities are reported at
current values either in the financial statements or related notes. For
example, certain investments in debt and equity securities are
currently reported at fair value, receivables are reported at net
realizable value, and inventories are reported at the lower of cost or
market value. Further, certain industries such as brokerage houses and
mutual funds prepare financial statements on a fair value basis.
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In 1994, the AICPA's Special Committee on Financial Reporting,
after studying the concerns over the relevance and usefulness of
financial reporting and the information needs of professional investors
and creditors, concluded that the current model is useful as a reliable
information basis for analysts, but concluded that a more comprehensive
model is needed that includes both financial information and
nonfinancial information. In addition to financial statements and
related disclosures, the model recommended by the study would include:
High-level operating data and performance measures that
management uses to manage the business.
Management's analysis of changes in financial and nonfinancial
data.
Forward-looking information about opportunities, risks, and
management's plans, including discussions about critical success
factors, as well as information about management and shareholders.
Background about the company, including a description of the
business, its industry, and its objectives and strategies.
The Committee acknowledged that many business entities do report
nonfinancial information, but it stressed the need to develop a
comprehensive reporting package that would promote consistent reporting
and the need to have auditors involved in providing some level of
assurance for each of the model's elements. Opposing views generally
cite liability concerns as a risk to reporting forward-looking and
other related nonfinancial information, concerns over the cost of
preparing the information, and concerns whether more specific
disclosures would put business entities at a competitive disadvantage.
Although standard setters have addressed certain issues to improve the
financial reporting model, a project to develop a more comprehensive
reporting model has not been undertaken.
Enron's failure and the inquiries that have followed have raised
many of the same issues about the adequacy of the financial reporting
model, such as the need for transparency, clarity, and risk-oriented
financial reporting, addressed by the AICPA's Special Committee on
Financial Reporting. The limitations of the historical cost-based model
were made more severe in the case of the Enron failure by accounting
rules and reports designed for a pipeline operator that transitioned
into a company using numerous offshore, off balance sheet, quasi-
affiliated, tax shelter entities to operate, invest in, trade or make a
market for contracts involving water, electricity, natural gas, and
broadband capacity. However, criticism of the financial reporting model
should also consider the criticisms of the corporate governance system,
the auditing profession, and the regulatory and the self-regulatory
oversight models which may impact the quality of financial reporting.
Also, human failure to effectively perform responsibilities in any one
or in all four of these areas has been raised by the many inquiries
following Enron's sudden failure. In addition, Enron's November 8, 2001
reporting to the SEC (Form 8-K filing), which restated its financial
statements for the years ended December 31, 1997 through 2002, and the
quarters ended March 31 and June 30, 2001, acknowledges that the
financial reports did not follow Generally Accepted Accounting
Principles and, therefore, should not be relied upon.
Among other actions to address the Enron-specific accounting
issues, the SEC has requested that the FASB address the specific
accounting rules related to Enron's special purpose entities and to
related party disclosures. Therefore, the SEC is expecting the FASB to
revise and to finalize the special purpose accounting rules by the end
of this year. The FASB has stated it is committed to proceed
expeditiously to address any financial accounting and reporting issues
that may arise as a result of Enron's bankruptcy. In that respect, the
FASB at a recent board meeting set a goal of publishing an exposure
draft by the end of April 2002 and a final statement by the end of
August 2002 that would revise the accounting rules for special purpose
entities. The SEC has also announced specific areas for improving
disclosures, and they include:
More current disclosure, including ``real-time'' disclosure of
unquestionable material information.
Disclosure of significant trend data and more ``evaluative''
data.
Financial statements that are clearer and more informative for
investors.
Disclosure of the accounting principles that are most critical
to the company's financial status and that involve complex or
subjective decisions by management.
Private-sector standards setting that is more responsive to
the current and immediate needs of investors.
In addition, the SEC has announced plans to propose new corporate
disclosure rules that will:
Provide accelerated reporting by companies of transactions by
company insiders in company securities, including transactions with
the company.
Accelerate filing by companies of their quarterly and annual
reports.
Expand the list of significant events requiring current
disclosure on existing Form 8-K filings (such events could include
changes in rating agency decisions, obligations that are not
currently disclosed, and lock-out periods affecting certain
employee plans with employer stock).
Add a requirement that public companies post their Exchange
Act reports on their websites at the same time they are filed with
the SEC.
Require disclosure of critical accounting policies in
Management's Discussion and Analysis of Financial Condition and
Results of Operations contained in annual reports.
The SEC Chief Accountant has also raised concerns that the current
standard setting process is too cumbersome and slow and that much of
the FASB's guidance is rule-based and too complex. He believes that (1)
principle-based standards will yield a less complex financial reporting
paradigm that is more responsive to emerging issues, (2) the FASB needs
to be more responsive to accounting standards problems identified by
the SEC, and (3) the SEC needs to give the FASB freedom to address the
problems, but the SEC needs to monitor projects and, if they are
languishing, determine why.
We support the SEC's stated plans to specifically address the
accounting issues raised by the Enron failure and the broader-based
planned initiatives that begin to address some of the overarching
issues with the current financial reporting model. It will be important
that these initiatives be aimed at the end result of having a financial
reporting model that is more comprehensive while, at the same time,
more understandable and timely in providing current value financial
information and nonfinancial information that will provide users with
data on the reporting entity's business risks, uncertainties, and
outlook, including significant assumptions underlying the nonfinancial
information. We also support a more direct partnering between the SEC
and the FASB to facilitate a mutual understanding of priorities for
standard setting and realistic goals for achieving expectations.
On balance, standard setting is inherently difficult and subject to
pressures by those parties most affected by proposed changes. Today's
business environment that includes increased globalization, rapid
technological advances, real-time communication, and extremely
sophisticated financial engineering is a difficult challenge for
accounting standard setters as our commercial world moves from an
industrial base to an information base. Further more, creative use of
financial reports, such as the recent phenomenon of using ``pro forma''
financial statements to present a ``rosier picture'' than GAAP may
otherwise allow, adds another challenge for standard setters and
regulators. On December 4, 2001, the SEC issued FRR No. 59, Cautionary
Advice Regarding the Use of ``Pro Forma'' Financial Information in
Earnings Releases. One of the key points in the cautionary advice
release was that the antifraud provisions of the Federal securities
laws apply to a company issuing ``pro forma'' financial information.
With that said, we believe that the underlying principles of
accounting and of financial reporting are still valid, namely, that
financial reporting must reflect the economic substance of
transactions, be consistently applied, and provide fair representation
in accordance with Generally Accepted Accounting Principles. In
applying these underlying principles, it is important to recognize the
variety of users of financial information and their financial acumen.
One size will not likely fit all, and targeted audiences for reported
financial information may need to be identified, such as sophisticated
investors, analysts, and creditors versus the general public. We also
believe that the auditors need to be active players in developing a
more comprehensive model with the objective of adding value to the
information through independent assurances. Finally, effective
corporate governance, independent auditors, and regulatory oversight
must accompany accounting standards and financial reporting. For
meaningful and reliable financial reporting, it is not enough to say
the rules were followed, which is the minimum expectation. Those with
responsibilities for financial reporting and their auditor must ensure
that the economic substance of business transactions is, in fact,
fairly reported.
I would now like to turn to the results of the work that you
requested in asking us to look at the resource issues at the SEC.
The SEC's Ability to Fulfill Its Mission
Over the last decade, securities markets have experienced
unprecedented growth and change. Moreover, technology has fundamentally
changed the way that markets operate and how investors access markets.
These changes have made the markets more complex. In addition, the
markets have become more international, and legislative changes have
resulted in a regulatory framework that requires increased coordination
among financial regulators and requires that the SEC regulate a greater
range of products. Moreover, as I discussed earlier, the recent, sudden
collapse of Enron and the other corporate failures have stimulated an
intense debate on the need for broadbased reform in such areas as
financial reporting and accounting standards, oversight of the
accounting profession, and corporate governance, all of which could
have significant repercussions on the SEC's role and oversight
challenges. At the same time, the SEC has been faced with an ever-
increasing workload and ongoing human capital challenges, most notably
high staff turnover and numerous vacancies.
In our work requested by this Committee, for which our report is
being released at this hearing, we found that the SEC's ability to
fulfill its mission has become increasingly strained due in part to
imbalances between the SEC's workload (such as filings, complaints,
inquiries, investigations, examinations, and inspections) and staff
resources.\14\ Although industry officials complimented the SEC's
regulation of the industry given its staff size and budget, both the
SEC and industry officials identified several challenges that the SEC
faces. First, resource constraints have contributed to substantial
delays in the turnaround time for many SEC regulatory and oversight
activities, such as approvals for rule filings and exemptive
applications.\15\ Second, resource constraints have contributed to
bottlenecks in the examination and inspection area as the SEC's
workload has grown. Third, limited resources have forced the SEC to be
selective in its enforcement activities and have lengthened the time
required to complete certain enforcement investigations.\16\ Fourth,
certain filings were subject to less frequent and less complete reviews
as workloads increased. Fifth, today's technology-driven markets have
created ongoing budgetary and staff challenges. Finally, the SEC and
industry officials said that the SEC has been increasingly challenged
in addressing emerging issues, such as the ongoing internationalization
of securities markets and technology-driven innovations like
Alternative Trading Systems \17\ (ATS's), and exchange-traded funds.
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\14\ Staff resources are measured in this report in terms of full-
time equivalent staff years.
\15\ A company files an exemptive application when it seeks an SEC
decision to exempt a new activity from existing rules and laws.
\16\ The SEC Chairman has recently announced an initiative called
real-time enforcement, which is intended to protect investors by (1)
obtaining emergency relief in Federal court to stop illegal conduct
expeditiously, (2) filing enforcement actions more quickly, thereby
compelling disclosure of questionable conduct so that the public can
make informed investment decisions, and (3) deterring future misconduct
through imposing swift and stiff sanctions on those who commit
egregious frauds, repeatedly abuse investor trust, or attempt to impede
the SEC's investigatory processes. According to the SEC, insufficient
resources may inhibit the effectiveness of this initiative, which
depends upon prompt action by enforcement staff.
\17\ An ATS is an entity that performs functions commonly performed
by a stock exchange.
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The SEC routinely prioritizes and allocates resources to meet
workload demands, but faces increasing pressure in managing its
mounting workload and staffing imbalances that resulted from its
workload growing much faster than its staff. Critical regulatory
activities, such as reviewing rule filings and exemptive applications
and issuing guidance, have suffered from delays due to limited
staffing. According to industry officials, these delays have resulted
in forgone revenue and have hampered market innovation. Oversight and
supervisory functions have also been affected. For example, staffing
limitations and increased workload have resulted in the SEC reviewing a
smaller percentage of corporate filings, an important investor
protection function. In 2001, the SEC reviewed about 16 percent of the
annual corporate filings, or about half of its annual goal of 30 to 35
percent. Although the SEC is revamping its review process to make it
more risk-based, recent financial disclosure and accounting scandals
illustrate how important it is that the SEC rise to the challenge of
providing effective market oversight to help maintain investor
confidence in securities markets.
SEC Staff Turnover
In addition to the staff and workload imbalances, other factors
also contribute to the challenges the SEC currently faces. SEC
officials said that although additional resources could help the SEC do
more, additional resources alone would not help the SEC address its
high staff turnover, which continues to be a problem. Furthermore, in
recent years the staff turnover and large differentials in pay between
the SEC and other financial regulators and industry employers resulted
in many staff positions remaining vacant as staff left at a faster rate
than the SEC could hire new staff. Although the SEC now has the
authority to provide pay parity, its success will depend upon the SEC's
designing an effective implementation approach and the agency receiving
sufficient budgetary resources. We found that the SEC's budget and
strategic planning processes could be improved to better enable the SEC
to determine the resources needed to fulfill its mission. For example,
unlike recognized high performing organizations, the SEC has not
systematically utilized its strategic planning process to ensure that
(1) resources are best used to accomplish its basic statutorily
mandated duties and (2) workforce development addresses the resource
needs that are necessary to fulfill the full scope of its mission,
including activities to address emerging issues.\18\
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\18\ High performing organizations are organizations that have been
recognized in the current literature or by the GAO as being innovative
or effective in strategically managing their human capital.
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As we noted in our 2001 report on the SEC's human capital
practices, about one-third of the SEC's staff left the agency from 1998
to 2000.\19\ The SEC's turnover rate for attorneys, accountants, and
examiners averaged 15 percent in 2000, more than twice the rate for
comparable positions government-wide. Although the rate had decreased
to 9 percent in 2001, turnover at the SEC was still almost twice as
high as the rate government-wide. Further, as a result of this turnover
and inability to hire qualified staff quickly enough, about 250
positions remained unfilled in September 2001, which represents about
8.5 percent of the SEC's authorized positions. SEC officials said that
they could do more if they had more staff, but all cited the SEC's high
turnover rate as a major challenge in managing its workload. Likewise
industry officials agreed that many of the challenges that the SEC
faces today are exacerbated by its high turnover rate, which results in
more inexperienced staff and slower, often less efficient, regulatory
processes.
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\19\ Securities and Exchange Commission: Human Capital Challenges
Require Management Oversight (GAO- 01-947, September 17, 2001).
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Although the SEC and industry officials said that the SEC would
always have a certain amount of turnover because staff can
significantly increase their salaries in the private sector and some
staff only plan to stay at the SEC for a period of time, many said pay
parity with other financial regulators could enable the SEC to attract
and retain staff for a few additional years. The SEC estimated that a
new employee generally takes about 2 years to become fully productive
and that pay parity could help them keep staff a year or two beyond the
initial 2 years. Although industry officials said they were generally
impressed by the caliber of staff that the SEC hires and the amount of
work they do, they said that staff inexperience often requires senior
SEC officials to become more involved in basic activities. Industry
officials also said that certain divisions, such as Market Regulation,
could benefit from staff with a fundamental understanding of how
markets work and market experience. They said that such experience
could help speed rulemaking and review processes. However, SEC
officials said that they have a difficult time attracting staff with
market experience, given the Government's pay structure.
Some officials said that the SEC's turnover rate should decrease
after pay parity is implemented? Presently, the SEC professional staff
are paid according to Federal general pay rates. On January 16, 2002,
the President signed legislation that exempted the SEC from Federal pay
restrictions and provided it with the authority necessary to bring
salaries in line with those of other Federal financial regulators. That
legislation also mandated that we conduct a study to look at the
feasibility of the SEC becoming a fully self-funded agency. Although
the SEC now has the authority to implement pay parity, as of March 1,
2002, the SEC has not received an additional appropriation to fund its
implementation. In addition, the SEC has to take a number of steps to
effectively implement this new authority.
Although the SEC's workload and staffing imbalances have challenged
the SEC's ability to protect investors and maintain the integrity of
securities markets, the SEC has generally managed the gap between
workload and staff by determining what basic statutorily mandated
duties it could accomplish with existing resource levels. This
approach, while practical, under the circumstances, has forced the
SEC's activities to be largely reactive rather than proactive. For
instance, the SEC has not put mechanisms in place to identify what it
must do to address emerging and evolving issues. Although the SEC has a
strategic plan and has periodically adjusted staffing or program
priorities to fulfill basic obligations, the SEC has not engaged in a
much needed, systematic reevaluation of its programs and activities in
light of current and emerging challenges. Given the regulatory
pressures facing the SEC and its ongoing human capital challenges, it
is clear that the SEC could benefit from an infusion of funding and
possibly additional resources. However, a comprehensive, agency-wide
planning effort, including planning for use of technology to leverage
available resources, could help the SEC better determine the optimum
human capital and funding needed to fulfill its mission.
Closing Comments
A number of witnesses who have recently appeared before this
Committee and other Congressional committees to discuss Enron's failure
have stated that our Nation's system of capital markets is recognized
around the world as the best. I share that view. Our capital markets
enjoy a reputation of integrity that promotes investor confidence that
is critical to our economy and the economies of other nations given the
globalization of commerce. This reputation is now being challenged. The
effectiveness of our systems of corporate governance, independent
audits, regulatory oversight, and accounting and financial reporting,
which are the underpinnings of our capital markets, to protect the
public interest has been called into question by the failure of Enron.
Many of the issues that are being raised have previously surfaced from
other business failures and/or restatements of financial statements
that significantly reduced previously reported earnings or equity.
Although the human element factor, and the basic failure to always do
what is right, are factors that can override systems of controls, it is
clear that there are a range of actions that are critical to the
effective functioning of the system underlying our capital markets that
need attention. In addition, a strong enforcement function with
appropriate civil and criminal sanctions is also needed to deal with
noncompliance.
The results of the forum that we held last week on governance,
transparency, and accountability identified major issues in each of the
areas, which I have addressed in my remarks today, that endanger their
effective functioning to protect the public interest. As is usually the
case in issues of this magnitude and this importance, there is no
single silver bullet to quickly make the repairs that are needed to the
systems supporting our capital markets. The fundamental principles of
having the right incentives, adequate transparency, and full
accountability provide a good sounding board to evaluate proposals that
are advanced. A holistic approach is also important as the systems are
interrelated and weak links can severely strain their effective
functioning. I have framed a number of the key issues today for
Congressional consideration. As always, we look forward to working with
you to further refine the issues, and develop and analyze options and
take other steps designed to repair the system weaknesses that today
pose a threat to investor confidence in our capital markets.
In summary, Enron's recent decline and fall coupled with other
recent business failures pose a range of serious systemic issues that
must be addressed. Effectively addressing these issues should be a
shared responsibility involving a number of parties including top
management, boards of directors, various board committees, stock
exchanges, the accounting profession, standard setters, regulatory/
oversight agencies, analysts, investors, and Congress. In the end, no
matter what system exists, bad actors will do bad things with bad
results. We must strive to take steps to minimize the number of such
situations and to hold any violators of the system fully accountable
for their actions.
Mr. Chairman, this concludes my statement. I would be pleased to
answer any questions you or other Members of the Committee may have at
this time.
PREPARED STATEMENT OF ROBERT R. GLAUBER
Chairman and Chief Executive Officer
National Association of Securities Dealers, Inc.
March 5, 2002
Introduction
Chairman Sarbanes, Ranking Member Gramm, Members of the Senate
Banking Committee, thank you for this opportunity to testify today on
the vital, troubling, and timely issues of investor protection and
accounting highlighted by the collapse of Enron. It would be hard to
overstate the human tragedy for Enron's employees, pension-holders, and
investors caused by the failure of America's seventh largest company.
Yet it is my firm hope that significant good can come of the
collapse of Enron--in the form of better policies, oversight and
regulatory structures to help restore the public's trust in the
fairness of our markets. That is the purpose of today's hearing, and I
am privileged to contribute my thoughts and the NASD's experiences to
this Committee's thoughtful search for solutions.
Overview
Let me begin with a real quick overview of the NASD--because who we
are bears directly on both the substance of what I will be saying and
on the usefulness of the private sector self-regulatory model that we
embody.
The National Association of Securities Dealers, NASD, is not a
trade association, but rather, the world's largest self-regulatory
organization, or SRO. Under Federal law, every one of the roughly 5,500
brokerage firms, nearly 90,000 branch offices and almost 700,000
registered representatives in the U.S. securities industry comes under
our jurisdiction. To give you a sense of our scope and authority, it is
vital to know that every brokerage firm in the United States that does
business with the public must by law be a member of NASD. We have a
staff of over 2,000 employees in Washington, Rockville, and district
offices across the country and an annual budget exceeding $400 million.
For more than six decades, our mission and our mandate from
Congress has been clear: To bring integrity to the markets and
confidence to investors. We do this by licensing and setting
qualification standards for industry participants, maintaining a
massive registration database that includes qualification and
disciplinary histories of all brokers and firms, writing rules to
govern the conduct of brokerage firms and their employees, providing
investor education and outreach, educating our members on legal and on
ethical standards, examining them for compliance with the Federal
securities laws and NASD and Federal rules, investigating infractions,
and disciplining those who fail to comply.
The NASD's staffing and governance gives us independence from the
industry, but we use industry expertise and resources extensively to
accomplish our mission. The standards we set are not mere ``best
practices,'' but enforceable regulatory rules; violations may result in
significant fines or even expulsion from the securities industry.
History of Securities Self-Regulation
The NASD's history to a great degree is the history of securities
self-regulation in our country. The stock exchanges, options and
futures markets have self-regulatory responsibilities, but they are
centered on the trading that takes place within their respective
markets and relate only to the members of their markets.
Self-regulation of the securities markets has deep roots in the
United States.
The Securities Exchange Act of 1934 (Exchange Act or 1934 Act) is
the legal foundation for self-regulation of the exchange markets. In
that Act, Congress set up a system under which the New York Stock
Exchange, the American Stock Exchange, and other securities exchanges,
and through them their member seat holders, would form a regulatory
front line for the newly created governmental regulator, the Securities
and Exchange Commission (SEC).
Four years later, Congress felt that the market regulation focus of
the 1934 Act was not sufficient and passed the Maloney Act of 1938. The
Maloney Act authorized the formation and registration of national
securities associations, which would supervise the conduct of their
members subject to the oversight of the SEC.
In this way, Congress sought to ``bring about self-discipline in
conformity to law'' and to foster ``obedience to ethical standards''
that went beyond the law. Senator Maloney intended that the securities
industry ``handle the problems of technical regulation,'' with the SEC
``policing the submarginal fringe.'' The next year the National
Association of Securities Dealers became the first--and still the
only--registered national securities association.
From the creation in the 1930's, to strengthened SEC oversight of
self-regulation in the 1970's, the industry and the Government have
worked together successfully. The concept of self-regulation is now so
ingrained in our capital markets' regulatory structure and the markets
themselves are now so enormous in every sense of the word--the numbers
of investors, the types of products, volume, and dollar value of
trading--that it has become almost impossible to imagine their success
without self-regulation.
This evolution has not been without its false steps. In 1996, the
SEC criticized the NASD in part for putting its interests as the
operator of Nasdaq ahead of its responsibilities as the regulator of
the entire industry. The NASD's response was both decisive and
instructive. It acted almost immediately to carve out NASD Regulation
and the Nasdaq Stock Market (Nasdaq) as two distinct corporate
entities, with separate Boards, management, and staff. And since then,
we have taken this principle of independence even further, by spinning
off Nasdaq entirely--with the sale of our last 27 percent of the
company completed earlier this year.
While there were many other changes of less significance that
resulted from the SEC's report with respect to the NASD, the bottom
line was a much-strengthened role for the NASD's staff and a paring
back of many roles traditionally played by the industry. Nonetheless,
the active involvement of the industry in self-regulation has remained
the mainstay of its success. And during the more than six decades since
this system was established, investors worldwide have flocked to our
markets.
The NASD's Responsibilities
The NASD has a comprehensive regime of regulatory duties. We writes
rules to govern the conduct of our member firms, examine them for
compliance with these rules, and discipline members if they fail to
comply. Our market integrity services include professional testing and
training, licensing and registration; examination of our member firms;
investigation and enforcement; dispute resolution; and investor
education. We also monitor all trading on Nasdaq, the largest volume
market in the world, and other select securities and derivative
markets.
Our Rulemaking Process
After an initial NASD staff determination that a rule or rule
change is necessary to protect the public or strengthen market
integrity, we begin a rigorous process to vet the rule and solicit
industry and public input. The proposed rules or rule modifications are
the result of input from our Board, industry, the SEC, consumer groups,
the public, Congress, as well as arising from our own experience
tracking markets and regulatory trends.
The NASD's rules must be approved by the SEC prior to becoming
effective. Once a rule is finalized, our members are required to comply
and put into place supervisory systems designed to achieve compliance
with the new rule. NASD examiners, through routine cycle exams,
surveillance monitoring and examinations for cause, evaluate firm
compliance and recommend remedial actions by the firm, or disciplinary
action by the NASD where compliance does not meet our standards.
Enforcement
Tough and even-handed enforcement is a fundamental part of NASD's
mission. It not only ensures compliance and punishes wrongdoing, but
also benefits the vast majority of our members who obey the rules and
place investors first. For investors feel more confident using the
markets when they know a tough cop is patrolling the beat. This is a
fundamental aspect of our value to both the public and the industry.
On average, the NASD files more than 1,000 new disciplinary actions
annually, with sanctions ranging from censures to fines and suspensions
to expulsion from the securities industry. We supplement our
enforcement efforts with referrals to criminal authorities and the SEC.
In one important settlement alone this year, reached jointly with the
SEC, the NASD, and the SEC each imposed sanctions of $50 million
against a major investment bank for violating SRO rules by extracting
illegal paybacks from favored customers to whom it allocated ``hot''
IPO's.
While this role as writer and enforcer of rules is familiar
territory for this Committee, I would like to highlight some of the
aspects of the NASD with which you may not be as familiar and some of
the ways we carry out our regulatory functions.
For instance, we have created and we maintain a vast database of
well over one million current and former registered representatives
that enables us to provide the public with information on securities
firms and professionals. This Central Registration Depository (CRD) is
the largest such vehicle on the Internet. In 2001, we responded to over
2 million public disclosure inquiries. Using this same technology, we
developed and operate through a contract with the SEC and State
securities regulators the Investment Adviser Registration Depository
(IARD). We have registered some 10,000 investment advisers through
IARD.
It is also important to note that NASD Dispute Resolution is the
largest dispute-resolution forum in the securities industry, with a
docket that contains more than 90 percent of the cases in the industry.
And a point of particular importance to this Committee, considering
its focus on financial literacy, is that we have an active Office of
Individual Investor Education that brings increased attention and focus
to this area of burgeoning importance.
Why NASD Works: Some ``First Principles'' for Private Sector Regulation
Private sector regulators bring to bear a keen practical
understanding of the industry. They can tap industry expertise and
resources that are not readily available to governments. They foster
investor protection and industry involvement. And they foster higher
standards that go beyond simply complying with the law.
Self-regulation works because the brokerage industry understands
that market integrity leads to investor confidence, which is good for
business. The overwhelming majority of the NASD's members comply
willingly with the rules and the law. They view their own reputation
for fair dealing and high standards as a competitive asset in a
competitive industry.
Private sector regulators are uniquely qualified to identify and
respond to emerging regulatory issues and keep their members
appropriately informed. The NASD has developed a proactive program to
ensure that members are timely apprised of emerging industry regulatory
issues. Private sector regulators also are uniquely qualified to alert
the general public to emerging regulatory issues. In this regard, the
NASD has taken steps to reach out to the public through investor alerts
and a host of written in-person and Internet-based investor education
offerings.
All this explains how private sector regulation can work. But why
specifically does it work well in the securities industry?
The first essential ingredient of the NASD's success is
independence. At least half our Board of Governors are a nonindustry
representative. And our large, experienced professional staff is not
beholden to the industry.
Our governance structure relies on parties that have the right
incentives to insist upon market integrity and investor confidence.
Specifically, our Board includes representatives of the public,
corporate issuers, and institutional investors, as well as the
brokerage firms that make up our membership. The beauty of our system
is that all these interests want markets that are fair, efficient, and
safe. And no one stands to benefit from this more than the brokerage
industry--which knows well that market integrity leads to investor
confidence, which is good for business.
This leads to our next key attribute, which is assured funding from
that part of the private sector having the greatest interest in our
effectiveness. The right people pay for the NASD's services: Namely,
the brokerage firms that profit from the investor confidence that stems
from market integrity.
We are funded three ways: (1) through a gross assessment on firms
based on their revenue; (2) a regulatory fee on every transaction that
occurs on Nasdaq and on the InterMarket as our cost of regulating those
trades generally; and (3) user fees, including various application
costs and test fees, continuing education courses, and so forth. Every
registered representative must also pay a small assessment when he or
she registers.
This steady and sufficient funding means that we can afford the
sophisticated technology, techniques, and infrastructure it takes to
regulate a fast-changing, technology-intensive industry. NASD's
technology budget exceeds $150 million per year. No private sector
regulator can succeed without sufficient ways and means.
Another key to our success is that we have the combined ability to
write rules, examine for enforcement of these rules and enforce the
rules with teeth all under one roof. This consolidation of central
regulatory functions reinforces our authority, competence, and
credibility.
As was discussed in detail in the preceding section, the NASD is
empowered to discipline our members with sanctions tough enough to
punish violations and deter future misconduct. Last year, we brought
more than 1,200 disciplinary actions, resulting in over 800 expulsions
or suspensions from the industry. That is a powerful sanction--the
ability to bar someone from earning a livelihood in his or her chosen
field. In an average year we levy well in excess of $10 million in
monetary sanctions. Of course, with authority comes responsibility.
Just as our members are accountable to the NASD, so we are accountable
to the SEC. Strong oversight by Government regulators protects
investors by ensuring that someone is watching the industry watchdog.
What Desirable Features Congress Should Consider in Fashioning an
Oversight System For the Accounting Industry
There are strong policy reasons to move in the direction of private
sector regulator with strong SEC oversight for accounting. The
advantages of such a solution over a purely governmental solution
include the fact that when industry is involved, the regulator is able
to tap private expertise in a way the Government cannot. And with
industry assessed for the cost, the regulator can be better funded.
This way the professional staff of lawyers, examiners, administrators,
technologists, and analysts remain top notch and able to keep pace with
industry. This model provides the best of both worlds: Tough SEC
oversight of a well-funded, well-staffed, frontline private sector
regulator.
While we would never presume to prescribe in detail what a new
private sector regulator for the accounting industry should look like,
we can, based on our analysis of what has been successful in the
securities industry, illuminate the implications for such a body in the
accounting industry, should Congress decide to move in this direction.
First, the private sector regulator should be an independent
organization, with a sizable, professional staff, and sufficient
technology and infrastructure to stay apace of the accounting
profession. It should seek maximum industry input consistent with
maximum industry accountability. And it should consolidate as many of
the industry's central regulatory functions--especially in the areas of
licensing, registration, examination, and strong enforcement--under one
roof as is feasible. This will reinforce its authority, competence, and
credibility all at once.
Second, it should have a strong mandate from the Government that
sets its structure and empowers its enforcement arm with full authority
to discipline the industry. Any form of private sector regulation must
be empowered to effectively enforce the rules: The ability to levy
meaningful fines, place conditions on continued participation in the
industry, suspend, and where appropriate, banish those who misbehave
from the industry. This ``ultimate sanction'' is both a powerful
deterrent for would-be violators and an important investor protection.
Third, it should have a governance structure based on enlightened
self-interest--namely, the need for effective auditing to produce
numbers that investors can rely on and markets they can trust. This
means a Board with interested parties much the same as the NASD's:
Solid public companies that want investors to have confidence in their
financial statements; institutional investors; broker-dealers; and the
public--with accountants being a small minority.
Self-regulation does not mean that industry is left to its own
devices. Public participation on an SRO Board is important not only to
prevent any conflicts of interest, but also the appearance of such
conflicts.
Fourth, it should have assured funding from some of these same
self-interested parties, especially those with the biggest stake in the
success of the system that have the most to gain from thorough, fair,
and transparent accounting practices. The best candidates might be
issuers (with a small fee on new share registrations, 10-K or 10-Q
filings) and broker-dealers. And since they, of course, also have a
major stake in the credibility of their audits, another source of
funding could be examination fees charged to the accounting firms
themselves.
An effective private regulatory system requires infrastructure,
technology, and processes to provide quality, timely services. As we
all know, monitoring compliance with accounting standards and
principles in today's global economy is a complex and technology-
intensive process. The regulator for the accounting profession must be
equally up-to-date and technology-intensive.
And finally, it should be subject to strong, appropriate oversight
from the SEC to institutionalize accountability. Oversight by
Government regulators is essential to ensure the integrity of the
process. It also provides an appropriate appellate forum for
disciplinary actions.
Conclusion
Self-regulation in the securities industry has helped make the U.S.
capital markets the most successful and respected in the world. This
system was the legislative embodiment of the belief that additional
protections were needed to ``protect the investor and the honest dealer
from dishonest and unfair practices by the submarginal element in the
industry.'' These words are really the roots of the NASD's central
rule: ``A member, in the conduct of his business, shall observe high
standards of commercial honor and just and equitable principles of
trade.''
No one is under the illusion that the systemic flaws revealed by
Enron can be set right without significant Government involvement. Even
in the accounting industry, where self-regulation has suffered a bad
name, there is a vital role to be played by private sector regulation
which fully understands the industry but is not co-opted by it; which
commands respect with accountants and credibility with investors; and
which allows the SEC to focus its scarce resources where they are most
needed to police the honesty of the financial reporting that underpins
the success of the U.S. capital markets.
----------
PREPARED STATEMENT OF JOEL SELIGMAN
Dean and Ethan A.H. Shepley University Professor
Washington University School of Law in St. Louis
Public Member, American Institute of Certified Public
Accountants Professional Ethics Executive Committee
March 5, 2002
Nearly 70 years ago, Supreme Court Justice Harlan Stone memorably
observed at the dedication of the University of Michigan Law School
Quadrangle:
I venture to assert that when the history of the financial
era which has just drawn to a close comes to be written, most
of its mistakes and its major faults will be ascribed to the
failure to observe the fiduciary principle, the precept as old
as holy writ, that ``a man cannot serve two masters.'' More
than a century ago equity gave a hospitable reception to that
principle and the common law was not slow to follow in giving
it recognition. No thinking man can believe that an economy
built upon a business foundation can permanently endure without
some loyalty to that principle. The separation of ownership
from management, the development of the corporate structure so
as to vest in small groups control over the resources of great
numbers of small and uninformed investors, make imperative a
fresh and active devotion to that principle if the modern world
of business is to perform its proper function. Yet those who
serve nominally as trustees, but relieved, by clever legal
devices, from the obligation to protect those whose interests
they purport to represent, corporate officers and directors who
award to themselves huge bonuses from corporate funds without
the assent or even the knowledge of their stockholders,
reorganization committees created to serve interests of others
than those whose securities they control, financial
institutions which, in the infinite variety of their
operations, consider only last, if at all, the interests of
those whose funds they command, suggest how far we have ignored
the necessary implications of that principle. The loss and the
suffering inflicted on individuals, the harm done to a social
order founded upon business and dependent upon its integrity
are incalculable.\1\
---------------------------------------------------------------------------
\1\ 48 Harv. L. Rev. 1, 8 (1934).
The same year, 1934, that Justice Stone offered these observations,
the Securities and Exchange Commission (SEC) began operations. By 1940,
the SEC enforced six Federal securities laws.\2\
---------------------------------------------------------------------------
\2\ There are now seven Federal securities laws: The Securities Act
of 1933, 15 U.S.C. Sec. 77a; the Securities Exchange Act of 1934, 15
U.S.C. Sec. 78a; the Public Utility Holding Company Act of 1935, 15
U.S.C. Sec. 79; the Trust Indenture Act of 1939, 15 U.S.C. Sec. 77aaa;
the Investment Company Act of 1940, 15 U.S.C. Sec. 80a-1; the
Investment Advisers Act of 1940, 15 U.S.C. Sec. 80b-1; and the
Securities Investor Protection Act of 1970, 15 U.S.C. Sec. 78aaa. For
general description, see 1 Louis Loss & Joel Seligman, Securities
Regulation 224-273 (3d ed. rev. 1998).
---------------------------------------------------------------------------
In the years since the SEC began operations, the U.S. securities
markets have experienced an almost unimaginable growth and vitality.
The number of U.S. stockholders has increased from 1.5 million (or
1.2 percent of the population) in 1929 to 84 million (or 43.6 percent
of the adult population) in 1998.\3\ As long ago as 1980, 133 million
U.S. citizens indirectly owned shares through such intermediaries as
mutual funds or pension plans.\4\
---------------------------------------------------------------------------
\3\ Cf. Joel Seligman, The Obsolescence of Wall Street: A
Contextual Approach to the Evolving Structure of Federal Securities
Regulation, 93 Mich. L. Rev. 649, 654 (1995); N.Y. Stock Exch., Fact
Book, 55-56 (2000).
\4\ Seligman, supra n.3, at 658.
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When the stock market began its collapse in September 1929, the
aggregate value of all shares on the New York Stock Exchange (NYSE) was
approximately $90 billion.\5\ By 2000, NYSE capitalization had grown to
nearly $12.4 trillion.\6\ Perhaps most remarkably in 2000, over $2.3
trillion in new securities was sold in some 16,481 corporate
underwritings and 3,540 private placements.\7\
---------------------------------------------------------------------------
\5\ Joel Seligman, The Transformation of Wall Street 1 (rev. ed.
1995).
\6\ Securities Indus. Assoc., 2001 Securities Industry Fact Book at
48.
\7\ Id. at 12.
---------------------------------------------------------------------------
Underlying these remarkable numbers was the longest sustained bull
market in U.S. history. Focusing on year-end closing indexes, the Dow
Jones Industrial Average rose from 875 in 1981 to 11,497 in 1999,
paralleling similar surges in other leading composite indexes.\8\ To
put this in other terms, between 1981 and 1999, the New York Stock
Exchange stock market capitalization increased nearly 11 fold from $1.1
to $12.3 trillion.\9\
---------------------------------------------------------------------------
\8\ Id. at 54.
\9\ Id. at 48.
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With this unprecedented success there also appears to have come a
lulling of our institutional sensibilities. A widespread belief appears
to have evolved in the U.S. financial community that time honored rules
such as those that discourage conflicts of interest are quaint and
easily circumvented. Too frequently, in recent years, sharp
practitioners in business, investment banking, accounting, or law
appear to have challenged the fundamental tenets of ``full disclosure
of material information'' or ``fair presentation of accounting
results.'' A deterioration in the integrity of our corporate governance
and mandatory disclosure systems may well have advanced, not because of
a novel strain of human cupidity, but because we had so much success,
for so long, that we began to forget why fundamental principles of full
disclosure and corporate accountability long were considered essential.
No recent case better illustrates this deterioration than Enron.
Enron was an extraordinarily fast growing provider, primarily of
natural gas, electricity, and communication products and services,\10\
whose total assets quadrupled between 1996 and 2000 from $16.137 to
$65.503 billion.\11\ Its 2000 Form 10-K annual report filed with the
SEC was a consistently upbeat review of its many claimed successes,
only unusual because of Exhibit 21 to the certified financial
statements which was a 49 page list of subsidiaries. In 2001, Enron was
seventh on the Fortune 500 list, with revenues in 2000 of $100.8
billion.\12\
---------------------------------------------------------------------------
\10\ Enron Corp. Form 10-K Item 1--Business General.
\11\ Id., Item 6 --Selected Financial Data.
\12\ Fortune, April 16, 2001 at F-1.
---------------------------------------------------------------------------
Then, abruptly, essentially without warning, Enron melted down. A
November 8, 2001 Form 8-K stunningly stated: ``Enron intends to restate
its financial statements for the years ended December 31, 1999 through
2000 and the quarters ended March 31 and June 30, 2001. As a result the
previously issued financial statements for those periods and the audit
reports covering the year-end financial statements for 1992 to 2000
should not be relied upon.'' \13\
---------------------------------------------------------------------------
\13\ Item 5, Enron Corp. Form 8-K (November 8, 2001).
---------------------------------------------------------------------------
This Committee, I know, is already familiar with the Enron Special
Investigative Committee Report [Powers Report], chaired by University
of Texas Law School Dean William Powers. Let me not here revisit its
fact finding. I would like, however, to augment one type of fact
finding made by the Special Investigative Committee.
The Powers Report was critical of the required public disclosure of
the LJM partnerships which it characterized as systematically
inadequate.\14\ In Note 16 to the Enron Corporation 2000 Form 10-K,
related party transactions are described in these terms:
---------------------------------------------------------------------------
\14\ [T]hese disclosures were obtuse, did not communicate the
essence of the transactions completely or clearly, and failed to convey
the substance of what was going on between Enron and the partnerships.
The disclosures also did not communicate the nature or extent of
Fastow's financial interest in the LJM partnerships. This was the
result of an effort to avoid disclosing Fastow's financial interest and
to downplay the significance of the related-party transactions and, in
some respects, to disguise their substance and import. The disclosures
also asserted that the related-party transactions were reasonable
compared to transactions with third parties, apparently without any
factual basis. The process by which the relevant disclosures were
crafted was influential substantially by Enron Global Finance (Fastow's
group). There was an absence of forceful and of effective oversight by
Senior Enron Management and in-house counsel, and objective and
critical professional advice by outside counsel at Vinson & Elkins, or
auditors at Andersen. Id. at 17.
In 2000 and 1999, Enron entered into transactions with
limited partnerships (the Related Party) whose general
partner's managing member is a senior officer of Enron. The
limited partners of the Related Party are unrelated to Enron.
Management believes that the terms of the transactions with the
Related Party were reasonable compared to those which could
have been negotiated with unrelated third parties.
In 2000, Enron entered into transactions with the Related
Party to hedge certain merchant investments and other assets.
As part of the transactions, Enron (i) contributed to newly
formed entities (the Entities) assets valued at approximately
$1.2 billion, including $150 million in Enron notes payable,
3.7 million restricted shares of outstanding Enron common stock
and the right to receive up to 18.0 million shares of
outstanding Enron common stock in March 2003 (subject to
certain conditions) and (ii) transferred to the Entities assets
valued at approximately $309 million, including a $50 million
note payable and an investment in an entity that indirectly
holds warrants convertible into common stock of an Enron's
equity method investee. In return, Enron received economic
interests in the Entities, $309 million in notes receivable, of
which $259 million is recorded at Enron's carryover basis of
zero, and a special distribution from the Entities in the form
of $1.2 billion in notes receivable, subject to changes in the
principal for amounts payable by Enron in connection with the
execution of additional derivative instruments. Cash in these
Entities of $172.6 million is invested in Enron's demand notes.
In addition, Enron paid $123 million to purchase share-settled
options from the Entities on 21.7 million shares of Enron
common stock. The Entities paid Enron $10.7 million to
terminate the share-settled options on 14.5 million shares of
Enron's common stock outstanding. In late 2000, Enron entered
into share-settled collar arrangements with the Entities on
15.4 million shares of Enron common stock. Such arrangements
will be accounted for as equity transactions when settled.
The first paragraph is an exercise in obfuscation. What
transactions? How much money is involved? What risk is there to Enron?
Who is the senior officer of Enron? How much is he or she paid? Who are
the limited partners? What basis is there for management's belief that
the terms of these transactions ``were reasonable compared to those
which could have been negotiated with unrelated parties?'' The second
paragraph is more detailed but it is equally confusing. Why did Enron
enter into these transactions? Who is the Related Party? What risk does
Enron bear? \15\
---------------------------------------------------------------------------
\15\ The Powers Report concluded: Overall, Enron failed to disclose
facts that were important for an understanding of the substance of the
transactions. The Company did disclose that there were large
transactions with entities in which the CFO had an interest. Enron did
not, however, set forth the CFO's actual or likely economic benefits
from these transactions and, most importantly, never clearly disclosed
the purposes behind these transactions or the complete financial
statement effects of these complex arrangements. The disclosures also
asserted without adequate foundation, in effect, that the arrangements
were comparable to arm's-length transactions. We believe that the
responsibility for these inadequate disclosures is shared by Enron
Management, the Audit and Compliance Committee of the Board, Enron's
in-house counsel, Vinson & Elkins, and Andersen. Id. at 178.
---------------------------------------------------------------------------
There were other significant public disclosure issues that the
Powers Report did not address in the same detail as it did related
party transactions. The Report, for example, noted that the LJM2
entities had approximately 50 limited partners, ``including American
Home Assurance Co., Arkansas Teachers Retirement System, the MacArthur
Foundation, and entities affiliated with Merrill Lynch, J.P. Morgan,
Citicorp, First Union, Deutsche Bank, G.E. Capital, and Dresdner
Kleinworth Benson.'' \16\ Newspaper accounts have raised the quite
troublesome possibility that at least some of these limited partners
had been shown different financial statements than were publicly
disclosed.\17\
---------------------------------------------------------------------------
\16\ Id. at 73.
\17\ A Fog Over Enron, and the Legal Landscape, N.Y. Times, January
27, 2002. Cf. McGeehan, Enron's Deals Were Marketed to Companies by
Wall Street, N.Y. Times, February 14, 2002 at C1.
---------------------------------------------------------------------------
The Enron debacle has raised fundamental policy and regulatory
questions, notably including the following in corporate and securities
law:
(1) Perhaps most significant is the empirical question: Was Enron
an isolated, but serious, breakdown or are the problems exposed there
more widespread? By early February 2002, newspapers were reporting a
market wide dampening of stock prices because of uncertainty whether
the accounting, auditing, and corporate governance problems at Enron
would prove widespread.\18\ One article reported: ``Last year, a study
by Financial Executives International, a trade group for corporate
executives, found that public companies had revised their financial
results 464 times between 1998 and 2000, nearly as many restatements as
in the 20 previous years combined, and the problem probably worsened
last year.'' \19\
---------------------------------------------------------------------------
\18\ Berenson, The Biggest Casualty of Enron's Collapse of
Confidence, N.Y. Times, February 10, 2002 at Sec. 4 at 1.
\19\ Ibid.
---------------------------------------------------------------------------
Nonetheless, the hard empirical work to gauge the magnitude of
dysfunction
either at Enron or generally is far from complete. The more we learn
about incidence, types of dysfunction, and the causes of dysfunction,
the more intelligently we can consider remedies. We are still very far
away from a comprehensive analysis of Enron. Systematic review of other
company's SEC filings can reveal similar patterns of dysfunction, but
not all, particularly, if like Enron, a key problem is unreported off
balance sheet transactions.
The first and most urgent need in the wake of Enron is not
solutions, but facts.
(2) Will the type of problem illustrated by Enron prove self-
correcting, at least for the foreseeable future? Already there appear
to be underway SEC, Justice Department, and private investigations or
litigation. The SEC has now begun a series of regulatory initiatives,
including proposed changes in corporate disclosure rules, that, among
other points, significantly broaden the list of significant events that
require current disclosure on Form 8-K.\20\ Inevitably, without further
legislative or regulatory action, it is reasonable to anticipate
enhanced board review of transactions, more detailed and precise
disclosure in SEC filings, more demanding internal accounting controls
and outside audits, and more skeptical investment analyst reports.
---------------------------------------------------------------------------
\20\ SEC to Propose New Corporate Disclosure Rules, Press Rel.
2002-22 (February 13, 2002). This Press Release explained in part:
The Commission believes that markets and investors need more timely
access to a greater range of important information concerning public
companies than what is required by the existing reporting system.
Accordingly, the Commission intends to expand the types of information
that companies must report on Form 8-K. Some of the items that the
Commission is evaluating for inclusion in these reports include:
Changes in rating agency decisions and other rating agency
contacts.
Transactions in the company's securities, including
derivative securities, with the executive officers and directors.
Defaults and other events that could trigger acceleration
of direct or contingent obligations.
Transactions that result in material direct or contingent
obligations not included in a prospectus filed by the company with the
Commission.
Offerings of equity securities not included in a
prospectus filed by the company with the Commission.
Waivers of corporate ethics and conduct rules for
officers, for directors, and for other key employees.
Material modifications to rights of security holders.
The departure of the company's CEO, CFO, COO, or president
(or persons in equivalent positions).
Notices that reliance on a prior audit is no longer
permissible, or that the auditor will not consent to use of its report
in a Securities Act filing.
Definitive agreement that is material to the company. . .
Any loss or gain of a material customer or contract.
Any material write-offs, restructurings, or impairments.
Any material change in accounting policy or estimate.
Movement or de-listing of the company's securities from
one quotation system or exchange to another.
Any material events, including the beginning and end of
lock-out periods, regarding the company's employee benefit, retirement,
and stock ownership plans.
Given the significance of current disclosure of these events to
participants in the secondary markets, the Commission intends to
propose that companies file reports of these events no later than the
second business day following their occurrence. The Commission also is
considering whether some of these events require filing by the opening
of business on the day after the occurrence of the event.
---------------------------------------------------------------------------
It is too early to judge whether voluntary steps will suffice. We
need both to better understand the problems involved and what voluntary
steps will occur. There will be other steps from the self-regulatory
organizations such as the NYSE that also need to be taken into
account.\21\
---------------------------------------------------------------------------
\21\ See, e.g., SEC Review of Corporate Governance, Conduct Rules,
SEC Press Rel. 2002-23 (February 13, 2002).
---------------------------------------------------------------------------
A caveat is in order here. Voluntary steps often work well when
there is a mood of crisis or a fear of legislation or regulation. There
is a different type of uncertainty regarding whether voluntary steps
will endure after a crisis mood has abated.
(3) If structural or standard reform does prove necessary, there
appears to be broad support for focusing on accounting standard setting
and auditing regulation. In mid-January 2002 SEC Chairman Harvey Pitt
proposed a new industry organization that will oversee auditor
discipline.\22\ In response, the Public Oversight Board, shortly later,
voted to disband because of concern it was being ``shunted aside.''
\23\ Regardless of the fate of the POB the time seems ripe for a
systematic review of accounting standard setting by the FASB, auditing
oversight by the POB and other private and State agencies, and
accountant independence.\24\
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\22\ See Schroeder, SEC Proposes Accounting Disciplinary Body, Wall
Street Journal, January 17, 2002 at C1; Pitt Elaborates on Proposal for
New Board to Govern Accountants, Asks for Dialogue, 34 Sec. Reg. & L.
Rep. (BNA) 153 (2002).
\23\ In Protest, POB Votes to Disband; Panel to Consider SEC
Chief 's Urging Reversal, 34 Sec. Reg. & L. Rep. (BNA) 154 (2002).
\24\ See, e.g., former SEC Chairman Levitt Renews Call for
Additional Restrictions on Auditing Firms, 34 id. 155; Accounting
Debacles Spark Calls for Change: Here's the Rundown, Wall Street
Journal, February 6, 2002 at C1; Leonhardt, How Will Washington Read
the Signs? N.Y. Times, February 10, 2002 at Sec. 3 at 1.
---------------------------------------------------------------------------
The need for significant reform of the accounting profession has
been particularly stressed in recent Congressional hearings.\25\
---------------------------------------------------------------------------
\25\ Former SEC Chairman Roderick M. Hills, for example, testified
on February 12, 2002 to the Senate Committee on Banking, Housing, and
Urban Affairs:
. . . The system itself needs a major overhaul. The head of NYU's
Accounting Department, Paul Brown, put it well:
``It is the old adage of a F.A.S.B. rule. It takes 4 years to write
it, and it takes 4 minutes for an astute investment banker to get
around it.''
Second, it is increasingly clear that the accounting profession is
not able consistently to resist management pressures to permit
incomplete or misleading financial statements, and the profession has
serious problems in recruiting and keeping the highly qualified
professionals that are needed.
Third, the audit committees of too many boards are not exercising
the authority given to them or the responsibility expected of them. . .
The financial papers produced dutifully each year by publicly-
traded companies have become a commodity. Companies produce them
largely because they are required to do so. Few CEO's regard this work
product as having any intrinsic value. Accounting firms compete for
business more on price than on the quality of their personnel or
procedures.
If a company does take an interest in the structure of its balance
sheet and profit and loss statement, it is far more likely to be caused
by a desire to be innovative in how they report their profits than in
the quality of the auditor's work. They hire bankers and consultants to
design corporate structures that will give them a stronger looking
balance sheet and, perhaps, keep the profits and losses of related
companies off of their financial papers.
Senate Committee on Banking, Housing, and Urban Affairs, Hearing on
``Accounting and Investor Protection Issues Raised in Enron and Other
Public Companies,'' February 12, 2002 (Testimony of Roderick M. Hills)
at 1-2.
---------------------------------------------------------------------------
It is worth disaggregating several specific issues.
The off balance sheet transactions that Enron employed were
made in accordance with generally accepted accounting standards.
This has appropriately focused attention on the quality of the
existing accounting standard setting organization, the Financial
Accounting Standards Board (FASB). Long before Enron, the political
and financial weaknesses of the FASB were much discussed. As former
SEC Chairman David Ruder has stated:
Despite its attempts to seek the views of the business
community, the FASB faces difficulty in obtaining financing
from business, which often
objects to FASB standards that affect business interests. The
FASB is
financed through sales of its work product and through
contributions by accounting firms and businesses. When
businesses do not like the FASB's standards or its process for
creating then, they sometimes withdraw financial support, or
fail to provide it in the first place. The FASB continually
faces difficulties in financing its operations. The accounting
profession is supportive, but generally speaking business is
not. Institutional investors and investment bankers, who
benefit greatly from financial statement disclosures,
contribute little to the FAF, creating a classic free rider
problem.
I believe the solution to the financial pressures on the FASB would
be to provide a system of financing . . . FASB should be financed by
payments by preparers and users of financial statements. If a voluntary
system cannot be established, Congress should enact legislation
creating financing for the FASB.\26\
---------------------------------------------------------------------------
\26\ Senate Committee, supra n. 25 (Testimony of David S. Ruder) at
5- 6.
After the bankruptcy of Enron in December 2001, SEC Chairman Harvey
Pitt published How to Prevent Future Enrons, Wall Street Journal,
December 11, 2001 at A18, which stated in part:
Private-sector standard setting that responds
expeditiously, concisely and clearly to current and immediate needs. A
lengthy agenda that achieves its goals too slowly, or not at all, like
good intentions, paves a road to the wrong locale.
An effective and transparent system of self-regulation for
the accounting profession, subject to our rigorous, but nonduplicative,
oversight. As the major accounting firm CEO's and the American
Institute of Certified Public Accountants recently proposed, the
profession, in common with us, must provide assurances of comprehensive
and effective self-regulation, including monitoring adherence to
professional and ethical standards, and meaningfully disciplining firms
or individuals falling short of those standards. Such a system has
costs, but those who benefit from the system should help absorb them.
See also Pitt Renews Call for Modernization of Disclosure,
Regulatory Processes, 33 Sec. Reg. & L. Rep. (BNA) 1630 (2001).
---------------------------------------------------------------------------
Paul A. Volcker, now Chair of the International Accounting
Standards Committee Foundation, similarly has testified:
. . . [P]roblems, building over a period of years, have now
exploded into a sense of crisis. That crisis is exemplified by
the Enron collapse. But Enron is not the only symptom. We have
had too many restatements of earnings, too many doubts about
``pro forma'' earnings, too many sudden charges of billions of
dollars to ``good will,'' too many perceived auditing failures
accompanying bankruptcies to make us at all comfortable. To the
contrary, it has become clear that some fundamental changes and
reforms will be required to provide assurance that our
financial reporting will be accurate, transparent, and
meaningful.\27\
---------------------------------------------------------------------------
\27\ Senate Committee, supra n. 25 (Testimony of Paul A. Volcker,
February 14, 2002) at 1.
Congress or the SEC should systematically review the process and
substance of accounting standard setting. It is urgently necessary to
restore and strengthen the fundamental premise that financial
statements will provide a ``fair presentation'' of an entity's
financial position. This both involves addressing specific disclosure
items such as off balance sheet transactions, stock options, and
derivatives and strengthening the independence of accounting standard
setting. The key here, as elsewhere, is money. You cannot expect a
Government agency or private entity to be truly independent without an
assured source of funds. Congress should explore means to legislate a
---------------------------------------------------------------------------
user or accounting firm fee system that will provide such independence.
Enveloping Generally Accepted Accounting Principles is the SEC
mandatory disclosure system. The mandatory disclosure system
deserves to be under sharp question. How could financial reporting
practices sufficient to bankrupt the seventh largest industrial
firm in the country so long go undisclosed? Is this simply an
isolated instance of bad disclosure practices or is Enron
suggestive of more systematic failure?
The SEC has begun to grapple with the latter, more disturbing
possibility. In December 2001 the Commission issued a cautionary
Release on ``pro forma'' financial information,\28\ rapidly followed by
a similar statement regarding the selection and disclosure of critical
accounting policies and practices,\29\ and in January 2002 by a
consequential and broad new interpretation of the pivotal management
discussion and analysis disclosure item.\30\
---------------------------------------------------------------------------
\28\ Sec. Act Rel. 8039, 76 SEC Dock. 896 (2001).
\29\ Sec. Act Rel. 8040, 76 SEC Dock. 983 (2001).
\30\ Sec. Act Rel. 8056, ____ SEC Dock. ____ (2002).
This Commission statement delineated additional disclosure that
should occur concerning (1) off balance sheet arrangements, (2)
commodity contracts, including those indexed to measures of weather,
commodity prices, or quoted prices of service capacity, such as energy
and bandwidth capacity contracts; and (3) related party transactions.
The Commission statement was premised on the assumption that Item
303(a) of Regulation S-K already requires disclosure of ``known
trends'' or ``known uncertainties'' that could result in a registrant's
liquidity or capital resources increasing or decreasing in a material
way.
---------------------------------------------------------------------------
More needs to be done. The Commission and Congress should carefully
review whether SEC oversight of the Generally Accepted Accounting
Principles and the context of its mandatory disclosure system has
unacceptably deteriorated.
The Commission also needs to seriously and patiently review whether
we today have the right construct of disclosure requirements,
proceeding item by item, and whether changes in timing and delivery of
data would be appropriate given evolving changes in technology and
international securities trading.
At its core Enron involved an audit failure. The outside
auditor both appeared to operate with significant conflicts of
interest and to have been too beholden to a highly aggressive
corporate management.
Several aspects of the Enron audit failure deserve particular
attention.
First, the Public Oversight Board, primarily responsible for
overseeing the SEC's auditors, has been much criticized. Former SEC
Chairman Harold Williams, for example, recently stated:
The Public Oversight Board was created by the profession
during my Chairmanship as an effort at self-regulation. We
expressed concern at the time whether the peer review process
administered by the profession would be adequate. But as
believers in the principle of self-regulation, we concluded
that the Board should have the opportunity to prove itself. In
my opinion, the events over the intervening years have
demonstrated that it does not meet the needs and is not
adequate. Under the peer review system adopted in 1977, the
firms periodically review each other. To my knowledge, there
has never been a negative review of a major firm. However, the
peer review is not permitted to examine any audits that are
subject to litigation. The reviews focus on the adequacy of
quality control procedures and do not examine the audits of
companies to see if the peer would have arrived at a different
conclusion. Peer review has proved itself insufficient.
Particularly as the Big Eight has become only the Big 5, peer
review in its present form becomes too incestuous. A system
needs to be established which is independent of the accounting
profession, transparent and able to serve both effective
quality control and disciplinary functions.
Further, the Board is not adequately funded and is beholden
for its funding to the very people it is supposed to oversee. I
suggest that the SEC consider a requirement that a percentage
of the audit fees of public companies be assessed to pay for
independent oversight, whether it is the Public Oversight Board
or a successor body, so that its funding is assured.\31\
---------------------------------------------------------------------------
\31\ Senate Committee, supra n. 25 (Testimony of Harold M.
Williams) at 3.
The former SEC Chairman David Ruder would go further and replace
the POB with ``a new body which will be separate from the AICPA and
whose board will be composed entirely of public members who have no
connection to the accounting profession.'' \32\
---------------------------------------------------------------------------
\32\ Senate Committee, supra n. 25 (Testimony of Ruder) at 4. Ruder
explains in ibid:
The POB has functioned well in the past, and there is much to learn
from its organization and operations. However, although the POB's
powers have been strengthened, it does not have sufficient budget to
allow it to function effectively. It does not have the power to force
accounting firms to provide the documents necessary to complete
investigations, nor does it have the power to promise that documents
received will be protected against discovery in private litigation. It
is forced to rely upon the accounting profession itself to engage in
enforcement activities. Most important, its connection to the AICPA
creates an appearance of control by that body.
---------------------------------------------------------------------------
I believe at this time a new auditing self-regulatory organization
is necessary. It should replace not just the POB, but also a Byzantine
structure of accounting disciplinary bodies which generally have lacked
adequate and assured financial support; clear and undivided
responsibility for discipline; and an effective system of SEC
oversight. The success of such a new SRO will be in careful attention
to detail. I would recommend:
A legal structure similar to that in Sections 15A and 19 of
the Securities Exchange Act which apply to the securities
associations and other securities industry self-regulatory
organizations and addresses such topics as purposes, powers, and
discipline.\33\
---------------------------------------------------------------------------
\33\ 6 Louis Loss & Joel Seligman, Securities Regulation 2692-2723,
2787-2830 (3d ed. 1990).
---------------------------------------------------------------------------
A clear scope provision articulating which auditors should be
subject to the new SRO and a mandate that they be subject to the
SRO.
A privilege from discovery of investigative files to
facilitate auditing discipline during the pendency of other
Government or private litigation.
Crucially the new SRO should be permitted, subject to SEC
oversight, to adopt new auditing standards that can evolve over
time. These rules would be limited by SEC rulemaking and, of
course, Congressional legislation.
As with the accounting standard setting body a pivotal
decision involves funding. To effectively operate over time any new
auditing SRO must have an assured source of funding. The most
logical basis of such funding may prove to be a Congressionally
mandated fee on covered auditing firms.
The new SRO will need to draw on the expertise of the
accounting profession to ensure technical proficiency. A
supervisory board with a minority of industry representatives and a
majority of public representatives may prove to be an appropriate
balance. The chair of such a board, however, should be a public
member.
I believe the most significant issue may prove to be who
conducts periodic examinations and inspections. To paraphrase the
classical adage: Who will audit the auditors? I would urge serious
consideration be devoted to replacing peer review with a
professional examination staff in the new SRO. Peer review has
been, to some degree, unfairly maligned. But even at its best it
involves competitors reviewing competitors. The temptation to go
easy on the firm you review lest it be too critical of you is an
unavoidable one. While the inspection processes of the New York
Stock Exchange and the NASD Reg are not panaceas, then suggest a
workable improvement.
Finally, it may prove particularly wise to statutorily
replicate Sec. 15(b)(4)(E) of the Securities Exchange Act which can
impose liability on a broker-dealer who has ``failed reasonably to
supervise.'' Particularly in firms with as many offices as the
leading auditing firms, a clearly delineated supervision standard
strikes me as vital to effective law compliance.
Second, a separate, not mutually exclusive approach, would be to
require mandatory rotation of auditors at specific intervals such as 5
or 7 years.\34\
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\34\ Former SEC Chairman Harold Williams has advocated this
approach:
I would urge the Commission to consider a requirement that a public
company retain its auditor for a fixed term with no right to terminate.
This could be for 5 years or perhaps the Biblical seven. After that
fixed term, the corporation would be required to change auditors. As a
consequence of such a requirement, the auditor would be assured of the
assignment and, therefore, would not be threatened with the loss of the
client and could exercise truly independent judgment. Under such a
system the client would lose its ability to threaten to change auditors
if in its judgment the assigned audit team was inadequate. It would
also reduce the client's ability to negotiate on fees, and almost
certainly the audit would cost more. The required rotation of auditors
would also involve the inefficiency of the learning curve for the new
auditor. I view all of these potential costs acceptable if it
reinforces the auditor's independence and makes the work more
comprehensive. The client could be given a right to appeal to a
reconstituted independent oversight organization if it believes that it
is not well served by its auditor and needs some relief. Senate
Committee, supra n. 56 (Testimony of Williams) at 2.
---------------------------------------------------------------------------
Third, particular attention has been devoted to the wisdom of
separating accounting firm audit services from consulting. One early
result of Enron has been an acceleration of this process by voluntary
means in the Big 5 accounting firms.\35\ Congress or the SEC should
consider whether a statute or regulation should require such separation
and, if so, how best to define which consulting services and which
accounting firms should be subject to the new law or rule.
---------------------------------------------------------------------------
\35\ Former Chairman David Ruder thoughtfully explained:
One of the substantial worries regarding the Andersen audit of
Enron has been that Andersen not only audited Enron, but also was paid
approximately the same amount for nonaudit services. It has been
reported that in the year 2000 Andersen was paid audit fees of
approximately $25 million and nonaudit fees of approximately $27
million. Comparisons of the amounts of audit fees to nonaudit fees for
a range of companies and auditors have revealed ratios of nonaudit to
audit fees ranging as high as nine to one. The expressed general
concern is that an audit cannot be objective if the auditor is
receiving substantial nonaudit fees.
The accounting profession seems to have recognized that management
consulting services, which involve accounting firms in helping
management make business decisions, should not be performed for an
audit client. Three of the Big 5 accounting firms (Andersen, Ernst &
Young, and KPMG) have now separated their management consulting units
from their audit units by contractual splits and spinoffs, and a fourth
(PricewaterhouseCoopers) has announced its intention to split off its
management consulting unit in a public offering. (Wall Street Journal,
p. 3, January 31, 2002) The fifth firm should also do so, or at least
refrain from offering management consulting services to audit clients.
Senate Committee, supra n. 25 (Testimony of Ruder) at 2.
---------------------------------------------------------------------------
Fourth, a key SEC reform of the 1970's, the Board of Directors
audit committee, has also been sharply criticized for its
ineffectuality. Former SEC Chairman Roderick Hills, during whose term
in 1977, the New York Stock Exchange adopted the requirement of the
independent audit committee was both detailed in his delineation of
shortcomings and in his proposed solutions:
Audit committees may consist of people who satisfy the
objective criteria of independence, but their election to the board
is too often the whim of the CEO, who decides each year who will
sit on the audit committee and who will chair it.
Audit committees too often seek only to reduce the cost of the
audit rather than to seek ways to improve its quality. They do not
play a sufficient role in determining what the fair fee should be.
Audit committees seldom ask the auditor if there is a better,
fairer way to present the company's financial position.
Audit committees seldom play a role in selecting a new audit
firm or in approving a change in the partner in charge of the
audit. They may well endorse an engagement or the appointment of a
new team, but they are not seen as material to the selection
process.
Audit committees seldom establish themselves as the party in
charge of the audit.
Congress may wish . . . to require that:
Corporations of a certain size with publicly-traded stock have
an effective, independent audit committee in order to avoid a
finding that there is a material weakness in the corporation's
internal controls.
Corporations of a certain size have an independent nominating
committee with the authority to secure new directors and appoint
all members of the audit committee.
Audit committees be solely responsible for the retention of
accounting firms and be responsible for the fees paid them.\36\
---------------------------------------------------------------------------
\36\ Senate Committee, supra n. 25 (Testimony of Hills) at 5, 8.
I believe former Chairman Hills proposals should be seriously
considered.
(4) A separate principal culprit at Enron was a dysfunctional
corporate management, broadly potentially including senior executives,
the board, board committees, internal accounting systems, the outside
auditor, and both internal and outside legal counsel.\37\ The genius of
U.S. corporate law, if genius there be, is its redundant systems of
corporate accountability. The Board is intended to monitor the
principal executives. Outside accountants and outside legal counsel are
supposed to buttress this accountability system as are a series of
legal devices, most notably including board and executive potential
liability for false and misleading filings with the SEC and State
corporate law negligence liability.
---------------------------------------------------------------------------
\37\ As former SEC Chairman David Ruder testified:
The primary fault in the Enron failure seems to be poor management.
From all accounts it appears that Enron became overly aggressive in its
efforts to dominate the energy trading markets, engaged in highly
leveraged off balance sheet financing, engaged in extremely aggressive
accounting, overstated its earnings, failed to disclose the true nature
of its corporate and financial structure, and eventually lost the
confidence of its creditors and trading counter parties. Enron
management appears to be primarily to blame. . . .
. . . the Enron problems represent a failure in corporate
governance. One striking aspect of this failure is Enron's apparent
lack of respect for the accounting system that underlies financial
reporting. Enron seems to have purposely attempted to avoid disclosure
of its true finances. Instead it should have utilized the accounting
system as a means of assisting it to make sound management decisions
and as a source of information helping it to provide the securities
markets with a truthful statement of financial condition. Senate
Committee, supra n. 25 (Testimony of Ruder) at 6 -7.
Similarly former Chairman Hills observed:
Finally, it must be said on this point that unless one has been
subjected to a serious corporate meltdown, you cannot possibly
appreciate the enormous discretion that management has under GAAP to
present its financial position. By changing depreciation schedules, by
using different estimates or by adopting different strategies or
assumptions, a company can make enormous changes in its annual income.
Management too often makes these ``top-level'' adjustments without
adequate disclosure to the public about how much their current earnings
depend on such adjustments. A corporate meltdown in which I was
involved 3 years ago was caused by top-level adjustments that accounted
for 40 percent of the company's total income and led to a corporate
admission that billions of dollars of income had been improperly
reported. Senate Committee, supra n. 25 (Testimony of Hills) at 3.
---------------------------------------------------------------------------
The overlapping accountability systems can individually fail. What
made Enron unusual is that they all appeared to fail simultaneously.
I am skeptical that similar simultaneous dysfunction will prove
widespread.
I am also mindful that poorly designed new regulatory solutions
could stultify the type of product innovation and risk-taking that has
been consequential to the recent growth of the U.S. economy. I am also
aware that corporate governance has largely been addressed by State
corporate law.
At the Federal level, I anticipate that reforms related to the
dysfunction in Enron management will be indirect, based on the more
effective use of the mandatory disclosure system and litigation, rather
than direct such as proposals for the SEC to audit each registered firm
or select directors. Among other proposals that should be thoughtfully
reviewed will be:
First, increasing the size of the SEC staff to increase the number
of filings reviewed and enforcement investigations conducted.\38\
---------------------------------------------------------------------------
\38\ Cf. Norris, Will SEC's Needs Be Met? Not by Bush, N.Y. Times,
February 8, 2002 at C1.
---------------------------------------------------------------------------
Second, considering whether to strengthen private enforcement of
the Federal securities laws by reviewing whether the Private Securities
Litigation Reform Act of 1995 has deterred or needlessly delayed
meritorious lawsuits.\39\
---------------------------------------------------------------------------
\39\ See 10 Louis Loss & Joel Seligman, Securities Regulation 4636-
4669 (3d ed. rev. 1996).
---------------------------------------------------------------------------
Third, considering whether it would be wiser to permit private
aiding and abetting actions against attorneys and auditors and reverse
through legislation the 1994 U.S. Supreme Court decision in Central
Bank,\40\ which held that such actions could not be implied from the
key Federal securities law fraud remedy, Securities Exchange Act Rule
10b-5.\41\
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\40\ Central Bank of Denver, N.A. v. First Interstate Bank of
Denver, N.A., 511 U.S. 164 (1994).
\41\ 9 Louis Loss & Joel Seligman, Securities Regulation 4479-4488
(3d ed. 1992 & 2001 Ann. Supp.).
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(5) One step removed from Enron, but strongly suggested by its
failure are serious questions of the integrity of investment analysts.
As former SEC Chairman Arthur Levitt, Jr. emphatically testified in
February 2002:
. . . For years, we have known that analysts' compensation is
tied to their ability to bring in or support investment banking
deals. In early December, with Enron trading at 75 cents a
share, 12 of the 17 analysts who covered Enron, rated the stock
either a hold or buy.
Two years ago, I asked the New York Stock Exchange and the
National Association of Securities Dealers to require
investment banks and their analysts to disclose clearly all
financial relationships with the companies they rate. Last
week, we finally saw a response from the self-regulators. But
it is not enough. Wall Street's major firms--not its trade
group--need to take immediate steps to reform how analysts are
compensated. As long as analysts are paid based on banking
deals they generate or work on, there will always be a cloud
over what they say.\42\
---------------------------------------------------------------------------
\42\ Senate Committee, supra n. 56 (Testimony of Arthur Levitt,
Jr.) at 2.
Congress should broadly investigate whether investment banks have
adequately maintained ``Chinese walls'' between the retail brokerage
and underwriting and whether, more fundamentally, securities firms that
underwrite should be separated from retail brokerage.\43\ These are not
new questions \44\ but they have been revived by Enron. I am very
skeptical that separation here will prove wise. But to put the matter
bluntly, the quality of investment advice has raised fundamental
questions.
---------------------------------------------------------------------------
\43\ Wayne, Congress's Scrutiny Shifts to Wall Street and Its Enron
Role, N.Y. Times, February 19, 2002 at A1.
\44\ See, e.g., 6 Louis Loss & Joel Seligman, Securities Regulation
2977-2980 (3d ed. 1990). (Proposed segregation of brokerage and
underwriting in 1930's), 8 Louis Loss & Joel Seligman, Securities
Regulation 3618-3631 (3d ed. 1991) (Chinese Wall).
---------------------------------------------------------------------------
An alternative approach worth considering would be a new form of
adviser liability for recommendations without a reasonable basis.
Increased SEC inspection cycles to review the basis of adviser
recommendations is also now in order.
Conclusion
There will be other proposals, both within the framework of
corporate and securities law and without, no doubt, that should receive
serious consideration. At its core Enron was a triumph of aggressive
and of financial chicanery over time honored concepts such as ``fair
presentation'' of financial information and ``full disclosure'' of
material information. After thoughtful and diligent investigation, I
anticipate at least one inevitable result. Our traditional commitment
to avoiding or fully disclosing conflicts of interest will be
systematically reinvigorated.
----------
PREPARED STATEMENT OF JOHN C. COFFEE, JR.
Adolf A. Berle Professor of Law, Columbia University School of Law
March 5, 2002
Introduction
I want to thank the Committee for inviting me to appear today.
Because I realize that you are covering a broad range of issues and
have only limited time to listen to any individual witness, I believe
that my contribution will be the most useful if I focus on just two
issues: (1) What powers, duties, and standards should Congress include
in any legislation that establishes a self-regulatory body to oversee
the auditing profession? and (2) How should Congress respond to the
evidence that conflicts of interest do bias the recommendations and
research of securities analysts?
If we focus only on Enron, it cannot prove by itself that there is
a crisis or that either auditors or securities analysts have been
compromised by conflicts of interest. By itself, Enron is only an
anecdote--bizarre, vivid, and tragic as it may be. But Enron does not
stand alone. As I elaborated in detail in testimony before the Senate
Commerce Committee on December 17, 2001 (and thus will not repeat at
any length here), Enron is part of a pattern. As the liabilities faced
by auditors declined in the 1990's and as the incentives auditors
perceived to acquiesce in management's desire to manage earnings
increased over the same period (because of the opportunities to earn
highly lucrative consulting revenues), there has been an apparent
erosion in the quality of financial reporting. Assertive as this
conclusion may sound, a burgeoning literature exists on earnings
management, which indicates that earnings management is conscious,
widespread, and tolerated by auditors within, at least, very wide
limits.\1\ Objective data also shows a decline in the reliability of
published financial results. To give only the simplest quantitative
measure, from 1997 to 2000, there were 1,080 earnings restatements by
publicly-held companies.\2\ Most importantly, there has been a
significant recent increase in the number of earnings restatements.
Earnings restatements averaged 49 per year from 1990 to 1997, then
increased to 91 in 1998, and soared to 150 in 1999 and 156 in 2000.\3\
Put simply, this sudden spike in earnings restatements is neither
coincidental nor temporary.
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\1\ I summarize much of this literature and the absence of any
meaningful effort at internal self-discipline in a recent article. See
Coffee, The Acquiescent Gatekeeper: Reputational, Intermediaries,
Auditor Independence and the Governance of Accounting (2001). This
article, written well before the Enron story broke, is available on the
Social Science Research Network (SSRN) at www.ssrn.com at id=270994.
\2\ See George Moriarty and Philip Livingston, ``Quantitative
Measures of the Quality of Financial Reporting,'' 17 Financial
Executive 55 (July 1, 2001).
\3\ Id. 715 of these restatements involved Nasdaq listed companies;
228 involved New York Stock Exchange companies; the rest were listed
either on the American Stock Exchange or were traded in the over-the-
counter market. Premature revenue recognition was found to be the
leading cause of restatements.
---------------------------------------------------------------------------
Worse yet, the accounting profession is conspicuous by its lack of
any meaningful mechanism for internal self-discipline. This void
contrasts starkly with the governance structure of the broker-dealer
industry, where the National Association of Securities Dealers (NASD)
administers a vigorous and effective system of internal discipline.
Because both brokers and auditors ultimately serve the same
constituency--for example, investors--this disparity is unjustifiable.
Put simply, American corporate governance depends at bottom on the
credibility of the numbers. Only if financial data is accurate can our
essentially private system of corporate governance operate effectively.
Today, there is doubt about the reliability of reported financial
data--and also about the independence and objectivity of the two
watchdogs who monitor and verify that data: Namely, auditors and
securities analysts.
What should Congress do about the crisis? While there is a case for
raising the liabilities that auditors and analysts face, I am fully
aware that many are skeptical of private enforcement of law through
class and derivative actions. Essentially, this asks a third watchdog--
the plaintiff 's attorney--to monitor the failings of the first two
(auditors and analysts), and plaintiff 's attorneys may have their own
misincentives. Also, it may still be too early to ask Congress to
revisit the Private Securities Litigation Reform Act of 1995 (the
PSLRA). Thus, both in my December appearance before the Senate Commerce
Committee and again today, I urge Congress to give fuller consideration
to public enforcement through the creation or strengthening of self-
regulatory organizations (SRO's). An SRO already exists with
jurisdiction over securities analysts (for example, the NASD), but one
needs to be created from whole cloth in the case of auditors. Thus, my
comments will focus first on the creation of a new SRO for auditors and
then how to strengthen the oversight of analysts.
An SRO for Auditors: Some Suggested Standards
The governance of accounting is today fragmented and indeed
Balkanized among (1) State boards of accountancy, (2) private bodies,
of which there are essentially seven, and (3) the SEC, which has broad
antifraud jurisdiction, but less certain authority under Rule 102(e) of
its Rules of Practice.\4\ Disciplinary authority is particularly
divided within the profession. The Quality Control Inquiry Committee
(QCIC) of the SEC Practice Section of the American Institute of
Certified Public Accountants (AICPA) is delegated responsibility to
investigate alleged audit failures involving SEC clients arising from
litigation or regulatory investigations, but it is charged only with
determining if there are deficiencies in the auditing firm's system of
quality control. The Professional Ethics Executive Committee (PEEC) of
the AICPA is suppose to take individual cases on referral from the
QCIC, but as a matter of ``fairness'' PEEC will automatically defer, at
the subject firm's request, any investigation until all litigation or
regulatory proceedings have been completed. In short, the investor's
interest in purging corrupt or fraudulent auditors from the profession
is subordinated to the firm's interest in settling litigation cheap,
uninfluenced by any possible findings of ethical lapses.
---------------------------------------------------------------------------
\4\ 17 CFR Sec. 201.102. The SEC's authority under Rule 102(e) was
clouded by the D.C. Circuit's decision in Checkosky v. SEC, 139 F.3d
221 (D.C. Cir. 1998) (dismissing Rule 102(e) proceeding against two
accountants of a ``Big 5'' firm). The SEC revised Rule 102 in late 1998
in response to this decision (see Securities Act. Rel. No. 7593
(October 18, 1998), but its authority in this area is still subject to
some doubt that Congress may wish to remove or clarify.
---------------------------------------------------------------------------
Little in this system merits retention. Legislation is necessary to
create a body that would have at least the same powers, duties and
obligations as the NASD. In truth, however, the legislation that
created the NASD in 1938 (the Maloney Act) is not an ideal model, given
its general lack of specific guidance. Rather, model legislation should
have the following elements:
1. Rulemaking Power. The SRO should be specifically authorized to
(1) address and prohibit conflicts of interest and other deficiencies
that might jeopardize either auditor independence or the public's
confidence in the accuracy and reliability of published financial
statements, and (2) establish mandatory procedures, including
procedures for the retention of accountants by publicly-held companies
and for the interaction and relationship between the accountants and
audit committees. This is a broad standard--and deliberately so. It
could authorize the SRO to require that auditors be retained and/or
fired by the audit committee and not by the company's management. In
addition, the SRO should be authorized to affirmatively mandate the
adoption and use of new or improved quality control systems, as they
from time to time become accepted.
2. Mandatory Membership. All outside auditors preparing or
certifying the financial statements of publicly-held companies or of
companies conducting registered public offerings would be required to
be members in good standing, and suspension or ouster from the SRO
would render an auditor unable to certify the financial statements of
such companies.
3. SEC Supervision. SEC approval of the initial registration of
such an SRO and of all amendments to its rules would be mandated, just
as in the case of the NASD. The SEC would also have authority to amend
the SRO's rules in compliance with a statutory ``public interest''
standard. Finally, the SEC should have authority to sanction, fine, or
suspend the SRO and to remove or suspend its officers or directors for
cause.
4. Enforcement Powers. The SRO should have the same authority to
impose financial penalties or to suspend or disbar an auditor from
membership, or to suspend, disbar, fine, or censure any associated
professional. Such fines and penalties should not require proof of
fraud, but only a demonstration of negligent or unethical conduct.
Subpoena authority should also be conferred, and a failure to cooperate
or to provide evidence should be grounds for discipline or dismissal.
5. Duties of Supervisory Personnel. A common response of
organizations caught in a scandal or a criminal transaction is to blame
everything on a ``rogue'' employee. Yet, such ``rogues'' are often
responding to winks and nods from above (real or perceived) or to an
organizational culture that encourages risk-taking (Enron is again
symptomatic). The Federal securities laws impose duties on supervisory
personnel in brokerage firms to monitor their employees, and a parallel
standard should apply to supervisory personnel in auditing firms.
6. Governance. The SRO should have at least a supermajority (say,
66\2/3\ percent) of ``public'' members, who are not present or recently
past employees or associated persons of the auditing industry.
7. Prompt Enforcement. The practice now followed by PEEC of
deferring all disciplinary investigations until civil litigation and
regulatory investigations have been resolved is self-defeating and
unacceptable. It might, however, be possible to render the findings and
disciplinary measures taken by the SRO inadmissible in private civil
litigation.
Securities Analysts
What Do We Know About Analyst Objectivity
A number of studies have sought to assess the impact of conflicts
of interest upon the objectivity of securities analyst recommendations.
Additional evidence was also recently collected at hearings held in
June 2001 by the Subcommittee on Capital Markets, Insurance and
Government Sponsored Enterprises of the House Financial Services
Committee. This data is probably more germane, and merits greater
reliance, than the well-known statistic that an alleged 100:1 ratio
exists between the ``buy'' recommendations and ``sell'' recommendations
made by securities analysts. Although the actual ratio may be somewhat
less extreme than 100:1,\5\ the real problem with this statistic is
that it is not necessarily the product of conflicts of interest. That
is, analysts employed by brokerage firms (as all ``sell-side'' analysts
are) have a natural incentive to encourage purchase or sale
transactions. For this purpose, ``buy'' recommendations are more useful
than ``sell'' recommendation, because all clients can buy a stock, but
only existing holders can sell as a practical matter.
---------------------------------------------------------------------------
\5\ A December 2000 Thomson Financial Survey reported that 71
percent of all analyst recommendations were ``buys'' and only 2.1
percent were sells. Apparently, only 1 percent of 28,000
recommendations issued by analysts during late 1999 and most of 2000
were ``sells.'' This study also finds that the overall ``buy'' to
``sell'' ratio shifted from 6:1 in the early 1990's to 100:1 by
sometime in 2000. Of course, this shift also coincided with the Nasdaq
bull market of the 1990's.
---------------------------------------------------------------------------
Other data better illustrates the impact of conflicts of interest
on analysts. Among the most salient findings from recent research are
the following:
1. Conflict of Interests. Several studies find that ``independent''
analysts (for example, analysts not associated with the underwriter for
a particular issuer) behave differently than analysts who are so
associated with the issuer's underwriter. For example, Roni Michaely
and Kent Womack find that the long-run performance of firms recommended
by analysts who are associated with an underwriter was significantly
worse than the performance of firms recommended by independent
securities analysts.\6\ They further find that stock prices of firms
recommended by analysts associated with lead underwriters fall on
average in the 30 days before a recommendation is issued, while the
stock prices of firms recommended by analysts not so associated with
underwriters rose on average over the same period. Finally, the mean
long-run performance of buy recommendations made by analysts on
nonclients is more positive than the performance of recommendations
made on clients--at least for 12 out of 14 brokerage firms.
---------------------------------------------------------------------------
\6\ See R. Michaely and K. Womack, Conflict of Interest and the
Credibility of Underwriter Analyst Recommendations, 12 Review of
Financial Studies 653 (1999).
---------------------------------------------------------------------------
Still another study by CFO Magazine reports that analysts who work
for full-service investment banking firms have 6 percent higher
earnings forecasts and close to 25 percent more buy recommendations
than do analysts at firms without such ties.\7\ Similarly, using a
sample of 2,400 seasoned equity offerings between 1989 and 1994, Lin
and McNichols find that lead and co-underwriter analysts' growth
forecasts and particularly their recommendations are significantly more
favorable than those made by unaffiliated analysts.\8\
---------------------------------------------------------------------------
\7\ See S. Barr, ``What Chinese Wall,'' CFO Magazine, March 1,
2000.
\8\ H. Lin and M. McNichols, Underwriting Relationships and
Analysts' Earnings Forecasts and Investment Recommendations, 25 J. of
Accounting and Economics 101 (1997).
---------------------------------------------------------------------------
2. Pressure and Retaliation. In self-reporting studies, securities
analysts report that they are frequently pressured to make positive buy
recommendations or at least to temper negative opinions.\9\ Sixty-one
percent of analysts responding to one survey reported personal
experience with threats of retaliation from issuer management.\10\
Similarly, former Acting SEC Chairman Laura Unger noted in a recent
speech that a survey of 300 chief financial officers found that 20
percent of surveyed CFO's acknowledged withholding business from
brokerage firms whose analysts issued unfavorable research.\11\ This is
a phenomenon that is almost certain to be underreported.
---------------------------------------------------------------------------
\9\ J. Cote, Analyst Credibility: The Investor's Perspective, 12 J.
of Managerial Issues 351 (Fall 2000).
\10\ D. Galant, ``The Hazards of Negative Research Reports,''
Institutional Investor, July 1990.
\11\ Laura Unger, ``How Can Analysts Maintain Their Independence?''
Speech at Northwestern Law School (April 19, 2001).
---------------------------------------------------------------------------
This data should not be overread. It does not prove that securities
research or analyst recommendations are valueness or hopelessly biased,
but it does tend to confirm what one would intuitively expect: Namely,
conflicts of interest count, and conflicted analysts behave differently
than unaffiliated or ``independent'' analysts.
The Regulatory Response
In light of public criticism regarding securities analysts and
their conflicts of interest, the National Association of Securities
Dealers (NASD) proposed Rule 2711 (Research Analysts and Research
Reports) in early February 2002.\12\ Proposed Rule 2711 is lengthy,
complex and has not yet been adopted. Nonetheless, because its adoption
in some form seems likely, a brief analysis of its contents seems
useful as an introduction to what further steps Congress should
consider.
---------------------------------------------------------------------------
\12\ See File No. SR-NASD-2002-21 (February 8, 2002).
---------------------------------------------------------------------------
Basically, Rule 2711 does seven important things:
(1) It places restrictions on investment banking department's
relationship with the ``research'' or securities analyst division of an
integrated broker-dealer firms.
(2) It restricts the prepublication review of analyst research
reports by the subject company and investment banking personnel.
(3) It prohibits bonus or salary compensation to a research analyst
based upon a specific investment banking services transaction.
(4) It prohibits broker-dealers from promising favorable research
or ratings as consideration or an inducement for the receipt of
business or compensation.
(5) It extends the ``quiet period'' during which the broker-dealer
may not publish research reports regarding a company in an IPO for
which the firm is acting as a manager or co-manager for 40 calendar
days from the date of the offering.
(6) It restricts analysts ability to acquire securities from a
company prior to an IPO or to purchase or to sell for a defined period
before or after the publication of research report or a change in a
rating or price target.
(7) It requires extensive disclosure by an analyst of certain stock
holdings or compensation or other conflict of interest relationships.
All of these prohibitions are subject to substantial exceptions
and/or qualifications, and it is debatable whether some can be
effectively monitored. Only time and experience with proposed Rule 2711
can tell us whether its exceptions will overwhelm the rule.
Nonetheless, Rule 2711 represents a serious and commendable effort to
police the conflicts of interest that exist within broker-dealer firms
that both underwrite securities and provide securities research and
recommendations. In this light, the most important question is: What
else can or should Congress do? Are these topics or areas that Rule
2711 has not addressed that Congress should address? These are
considered below:
Congressional Options
The overriding policy question is whether conflicts of interest
relating to securities research should be prohibited or only policed.
As I will suggest below, this question is not easily answered, because
there are costs and imperfections with both options:
1. Radical Reform: Divorce Investment Banking From Securities
Research. Congress could do what it essentially did a half century ago
in the Glass-Steagall Act: \13\ namely, prohibit investment banking
firms that underwrite securities from engaging in a specified activity
(here, providing securities research to all, or at least certain,
customers). Arguably, this is what Congress and the SEC have already
proposed to do with respect to the accounting profession: For example,
separate the auditing and consulting roles performed by accountants.
Here the conflict might be thought to be even more serious because the
empirical evidence does suggest that the advice given by conflicted
analysts is different from the advice given by independent analysts.
---------------------------------------------------------------------------
\13\ See the Glass-Steagall Act of 1933, 12 U.S.C. Sec. 36 et. seq.
(separating commercial and investment banking).
---------------------------------------------------------------------------
But this divestiture remedy is here even more problematic than in
the case of the original Glass-Steagall Act. Put simply, securities
research is not a self-sufficient line of business that exist on a
freestanding basis. To be sure, there are a limited number of
``independent'' securities research boutiques (Sanford C. Bernstein &
Co. is probably the best known and the most often cited example) that
do not do the underwriting, but still survive very well. Yet this is a
niche market, catering to institutional investors. Since May 1, 1975
(Mayday) when the old system of fixed commissions was ended and
brokerage commissions became competitively determined, commission have
shrunk to a razor-thin margin that will not support the costs of
securities research. Instead, securities research (for example, the
salaries and expenses of securities research) is essentially subsidized
by the investment banking division of the integrated broker-dealer
firm. The problematic result is at the same time to subsidize and
arguably distort securities research.
This point distinguishes the securities analysts from the
accountant. That is, if the auditor is prohibited from consulting for
the client, both the auditing and the consulting function will survive.
But, in particular because the costs of securities research cannot be
easily passed on to the retail customer, a Glass-Steagall divorce might
imply that the number of securities analysts would shrink by a
substantial fraction.\14\ A cynic might respond: Why seek to maximize
biased research? Yet if the number of analysts were to fall by,
hypothetically, one half, market efficiency might well suffer, and many
smaller firms simply would not be regularly covered by any analyst.
Hence, the divestiture approach may entail costs and risks that cannot
be reliably estimated.
---------------------------------------------------------------------------
\14\ I recognize that the number of ``buy side'' analysts employed
by institutional investors might correspondingly increase, but not, I
think, to a fully compensating degree. Moreover, ``buy side'' analysts
do not publish their research, thus implying increased informational
asymmetrics in the market.
---------------------------------------------------------------------------
2. Piecemeal Reform: Policing Conflicts. Proposed Rule 2711
represents an approach of trying to police conflicts and prevent
egregious abuse. The practical ability of regulators to do this
effectively is always open to question. For example, although proposed
Rule 2711 generally prohibits investment banking officials from
reviewing research reports prior to publication, it does permit a
limited review ``to verify the factual accuracy of information in the
research report'' (see Rule 2711(b)(3) ). It is easy to imagine veiled
or stylized communications that signal that the investment banking
division is displeased and will reduce the analyst's compensation at
the next regular salary review. Such signals, even if they consist only
of arched eyebrows, are effectively impossible to prohibit. Still, at
the margin, intelligent regulation may curtail the more obvious forms
of abuse. Although proposed Rule 2711 addresses many topics, it does
not address every topic. Some other topics that may merit attention are
discussed below, but they are discussed in the context of suggesting
that Congress might give the NASD general policy instructions and ask
it to fine tune more specific rules that address these goals:
1. An Anti-Retaliation Rule. According to one survey,\15\ 61
percent of all analysts have experienced retaliation--threats of
dismissal, salary reduction, etc.--as the result of negative research
reports. Clearly, negative research reports (and ratings reductions)
are hazardous to an analyst's career. Congress could either adopt, or
instruct the NASD to adopt, an anti-retaliation rule: No analyst should
be fired, demoted or economically penalized for issuing a negative
report, downgrading a rating, or reducing an earnings, price, or
similar target. Of course, this rule would not bar staff reductions or
reduced bonuses based on economic downturns or individualized
performance assessments. Thus, given the obvious possibility that the
firm could reduce an analyst's compensation in retaliation for a
negative report, but describe its action as based on an adverse
performance review of the individual, how can this rule be made
enforceable? The best answer may be NASD arbitration. That is, an
employee who felt that he or she had been wrongfully terminated or that
his or her salary had been reduced in retaliation for a negative
research report could use the already existing system of NASD employee
arbitration to attempt to reverse the decision. Congress could also
establish the burden of proof in such litigation and place it on the
firm, rather than the employee/analyst. Further, the Congress could
entitle the employee to some form of treble damages or other punitive
award to make this form of litigation viable. Finally, the Congress
could mandate an NASD penalty if retaliation were found, either by an
NASD arbitration panel or in an NASD disciplinary proceeding.
---------------------------------------------------------------------------
\15\ See Galant, supra note 10, and Cote, supra note 9.
---------------------------------------------------------------------------
2. A No-Selling Rule. If we wish the analyst to be a more neutral
and objective umpire, one logical step might be to preclude the analyst
from direct involvement in selling activities. For example, it is today
standard for the ``star'' analyst to participate in ``road shows''
managed by the lead underwriters, presenting its highly favorable
evaluation of the issuer and even meeting on a one-to-one basis with
important institutional investors. Such sales activity seems
inconsistent with the much-cited ``Chinese Wall'' between investment
banking and investment research.
Yet from the investment banking side's perspective, such
participation in sales activity in what makes the analyst most valuable
to the investment banker and what justifies multimillion dollar
salaries to analysts. Restrict such activities, they would argue, and
compensation to analysts may decline. Of course, a decline in salaries
for the super-stars does not imply a reduction in overall coverage or
greater market inefficiency.
Although a ``no-selling'' rule would do much to restore the
objectivity of the analyst's role, one counter-consideration is that
the audience at the road show is today limited to institutions and high
net worth individuals. Hence, there is less danger that the analyst
will overreach unsophisticated retail investors. For all these reasons,
this is an area where a more nuanced rule could be drafted by the NASD
at the direction of Congress that would be preferable to a legislative
command.
3. Prohibiting the ``Booster Shot.'' Firms contemplating an IPO
increasingly seek to hire as lead underwriter the firm that employs the
star analyst in their field. The issuer's motivation is fueled in large
part by the fact that the issuer's management almost invariably is
restricted from selling its own stock (by contractual agreement with
the underwriters) until the expiration of a lock-up period that
typically extends
6 months from the date of the offering. The purpose of the lock-up
agreement is to assure investors that management and the controlling
shareholders are not ``bailing out'' of the firm by means of the IPO.
But as a result, the critical date (and market price) for the firm's
insiders is not the date of the IPO (or the market value at the
conclusion of the IPO), but rather the expiration date of the lock-up
agreement 6 months later (and the market value of the stock on that
date). From the perspective of the issuer's management, the role of the
analyst is to ``maintain a buzz'' about the stock and create a price
momentum that peaks just before the lock-up's expiration.\16\ To do
this, the analyst may issue a favorable research report just before the
lock-up's expiration (a so-called ``booster shot'' in the vernacular).
To the extent that favorable ratings issued at this point seem
particularly conflicted and suspect, an NASD rule might forbid analysts
associated with underwriters from issuing research reports for a
reasonable period (say, 30 days) both before and after the lock-up
expiration date. Proposed Rule 2711 stops well short of this and only
extends the ``quiet period'' so that it now would preclude research
reports for this first 40 days after an IPO. Such a limited rule in no
way interferes with the dubious tactic of ``booster shots.''
---------------------------------------------------------------------------
\16\ This description of the analyst's role (and of the
underwriter's interest in attracting ``star'' analysts) essentially
summarizes the description given by three professors of financial
economics, Rajesh Aggarwal, Laurie Krigman, and Kent Womack, in their
recent paper, Aggarwal, Krigman, and Womack, Strategic IPO
Underpricing, Information Momentum, and Lockup Expiration Selling
(April 2001) (available on SSRN).
---------------------------------------------------------------------------
4. Summary: The most logical and less overbroad route for Congress
to take with regard to securities analysts and their conflicts is to
pass legislation giving the NASD more specific guidance and
instructions about the goals that they should pursue and then instruct
the NASD to conduct the necessary rulemaking in order to fine tune this
approach. NASD penalties might also properly be raised. This approach
spares Congress from having to adopt a detailed code of procedure,
avoids inflexibility and rigid legislative rules, and relies on the
expertise of the SEC and the NASD, as paradigms of sophisticated
administrative agencies.
ACCOUNTING REFORM AND
INVESTOR PROTECTION
----------
WEDNESDAY, MARCH 6, 2002
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:10 a.m. in room SD-538 of the
Dirksen Senate Office Building, Senator Paul S. Sarbanes
(Chairman of the Committee) presiding.
OPENING STATEMENT OF CHAIRMAN PAUL S. SARBANES
Chairman Sarbanes. Let me call this hearing to order.
Because of the nature of the Senate schedule and the time
constraints that some Members have, I am going to invite the
panel of two people to come on up. We will just do one panel
because, otherwise, I am afraid that we are just going to run
over.
So if we could just take the other two witnesses and put
them on either end, I think Senator Gramm and I will be able to
work that within the time constraints. As you well know, you
never can control the Senate schedule from 1 day to the next.
Today, the Committee continues its examination of auditing
standards, corporate financial reporting, and investor
protection. As almost all of our previous witnesses have
pointed out, Enron is but one example of underlying weaknesses
within our system. In fact, The Wall Street Journal noted
yesterday, and I quote them:
It is hard to deny that the boom of the 1990's produced
some faster and looser behavior by business. John Goble, the
former head of Vanguard, recently pointed out that U.S.
companies restated their earnings 607 times in the past 3
years, more than in the entire previous decade. Granted a
company's income statement is not everything, but it ought to
be more than fiction.
Accounting abuses and lagging standard setting are not new
problems. Neither are attempts to solve those problems through
private studies.
The debate about purchase versus pooling for business
combinations in the 1960's led ultimately to the creation of
the Financial Accounting Foundation--Financial Accounting
Standards Board structure, after a report written by a group
headed by former SEC Commissioner Francis Wheat.
The Commission on Auditors' Responsibilities, headed by
former SEC Chairman Manny Cohen, was created in 1977, after the
Penn Central failure and the equity funding and foreign bribery
scandals of the 1970's. Its job--in words that are actually
still appropriate--was to: ``Develop recommendations regarding
the appropriate responsibilities of independent auditors . . .
[and] consider whether a gap may exist between what the public
expects or needs and what auditors can and should reasonably
expect to accomplish.''
The failures at Penn Square Bank, Continental Illinois,
Drysdale Government Securities, and Baldwin United, among
others, in the 1980's, led to the creation of a National
Commission on Fraudulent Financial Practices, led by former SEC
Commissioner James Treadway.
An SEC request that the Public Oversight Board ``examine
whether recent changes in the audit process serve and protect
the interests of investors'' led to creation in 1998 of the
Panel on Audit Effectiveness, Chaired by Shaun O'Malley, former
Chairman of Price Waterhouse. The O'Malley Report was issued in
August 2000.
Unfortunately, only a fraction of the recommendations made
by these reports have been adopted.
So, we have some veterans of this process here with us this
morning and we are looking forward to hearing from them.
Mr. O'Malley, I will yield to Senator Gramm for a moment
for a statement, and then we will go to you first, since you
did the most recent study of audit effectiveness. And then we
will branch out across the panel with Mr. Seidler, Mr. Wyatt,
Mr. Longstreth, and Professor Briloff.
Senator Gramm.
STATEMENT OF SENATOR PHIL GRAMM
Senator Gramm. Mr. Chairman, I will be brief. First, I want
to again, as I have on all the other occasions that we have
held hearings in this area, commend you. I think of all the
Congressional hearings held on issues related to Enron and
similar problems, that yours have been the most productive.
Chairman Sarbanes. Potentially, the most productive.
[Laughter.]
Senator Gramm. Well, I think that they have been the most
productive in terms of focusing on the real role of Congress,
which is forward-looking in terms of what we can do to improve
the system. I think it is a compliment that you are due to be
paid.
Second, let me thank all of our witnesses today. We are in
the midst of, I think, excellent hearings. Accounting is not as
simple as I thought it was after I completed my two mandatory
courses as a sophomore in college. I knew it was burdensome
when I had to do the old practice sets, which made me decide
that I did not want to be an accounting major.
We have talked about real issues in accounting and in
dealing with our changing financial structure as we have looked
at how you account for mergers and acquisitions, as we have had
a long and heated debate about how you account for stock
options, it is clear that this is a complicated issue.
The principles are simple. The applications are
complicated.
On this Committee, we are going to try, once we have
gathered all the facts we can and gotten the input we can, try
to see what we can do to improve the situation, recognizing
that for every change, there are costs and benefits.
One of the principles that I have tried to live by as a
lawmaker is, ``Do no harm.'' I think what we have to do is to
figure out what we can do that will clearly be beneficial,
where the benefits in terms of economic growth and job
creation, the ultimate test of a capital market, exceed the
costs. And so, your input in that, given your vast experience
and your involvement in these debates over these many years, is
much appreciated.
Chairman Sarbanes. Thank you very much.
Mr. O'Malley, I should have also mentioned, is the retired
Chairman of Price Waterhouse. As I said, he Chaired the Panel
on Audit Effectiveness, and was the President of the Financial
Accounting Foundation in the early 1990's.
Mr. O'Malley, we are pleased to have you here this morning.
We would be happy to hear from you.
STATEMENT OF SHAUN F. O'MALLEY
CHAIRMAN, 2000 PUBLIC OVERSIGHT BOARD PANEL ON
AUDIT EFFECTIVENESS (O'MALLEY COMMISSION)
FORMER CHAIRMAN, PRICE WATERHOUSE
PAST PRESIDENT, FINANCIAL ACCOUNTING FOUNDATION
Mr. O'Malley. Thank you very much, Mr. Chairman.
I would just like to ask, I notice my game clock here says
5 minutes, and I was told that we would have up to 10 minutes.
Chairman Sarbanes. Yes. This thing is set in a way----
Senator Gramm. We lied.
[Laughter.]
Chairman Sarbanes. Five to 10 minutes, if you could.
Mr. O'Malley. All right.
Thank you very much. I should say also by way of
introduction, I spent 36 years working in the accounting
profession, the vast majority of them as an auditor.
Like everyone, I am shocked by the Enron debacle. As I
explain in more detail in my written statement, it appears that
Enron represents a breakdown in every one of the safety nets
that guard our corporate reporting process--corporate
management, the board of directors and audit committees, law
firms, auditing firms, securities analysts, commercial and
investment banks, credit-rating services, the Financial
Accounting Standards Board, and the SEC--all seem to have
failed in some respect and their combined failure led to the
largest bankruptcy in corporate history.
There have been a number of proposals concerning reform of
the accounting profession. I would like to assist in your
consideration of these proposals by sharing with you the
recommendations of the Panel on Audit Effectiveness, which I
Chaired from 1998 to 2000.
The Panel was appointed by the POB at the request of the
Securities and Exchange Commission, to review, to evaluate, and
to recommend improvements in the way independent audits are
conducted and to assess the effects of recent trends in
auditing on the public interest. The almost 2 years of work by
the Panel involved a massive undertaking, a description of
which may be found in my written statement.
In the end, the Panel published a report that set forth our
findings and our recommendations for hundreds of changes in the
way audits are conducted. Of the more than 250 pages of this
report, the Panel spent three full chapters discussing a host
of recommendations designed to improve audit quality.
Let me emphasize that.
At the end of the day, enhancing audit quality has to be
the primary goal of our response to the problems at Enron. It
is a matter of concern to me that in the context of proposed
reforms that target the accounting profession, so little is
being said in the media about whether or how the various
proposed solutions will improve audit quality. Yet that is the
issue upon which we must ultimately focus our attention if
something positive is to come out of these unhappy events.
The recommendation of the Panel made prior to Enron's
collapse bears some similarity to proposals discussed by the
SEC and in Congressional hearings. I will describe the thrust
of the Panel's recommendation in the context of three themes.
First, the need for improved audit quality. Second, the call
for the separation of audit and nonaudit functions. And third,
proposals for change in the governance of the accounting
profession.
First, our recommendations for improved audit quality. The
Panel made some 150 specific recommendations toward furthering
the quality and reliability of audits. Some of the most
important of these recommendations were: One, that auditors be
required to adopt new forensic-type procedures and an overall
new approach to detecting fraud; Two, that the Auditing
Standards Board issue clearer, more definitive auditing
standards; Three, that auditors be required to attain a much
deeper understanding of an issuer's business and internal
controls, and that accounting firms take to heart the
importance of the investing public of quality audits and that
firms emphasize this importance in every way possible, from
communications by top management to compensation and
advancement decisions.
Let me comment on what I believe to be the boldest of these
initiatives, which is that auditors be required to approach
their audits with more of an eye toward the detection of fraud
by a company's management.
The Panel recommended that auditing standards be enhanced
to require auditors in planning and performing certain phases
of their exam to presume the possibility of dishonesty at
various levels of the company's management, including the
possibility of collusion.
The Panel also recommended a number of specific forensic
measures to be taken during any audit, with the principal
objective of detecting material financial statement fraud. An
auditor's ability to investigate fraud will always be limited.
The Panel believed, however, that this dramatic shift in
approach would not only help auditors to discover material
fraud, but would also more likely deter fraud from occurring in
the first place.
I was heartened to see that last week, the Auditing
Standards Board issued an exposure draft which would, if
adopted, replace the current audit standard relating to fraud.
I am reviewing the proposal to determine whether it will
accomplish what the Panel sought to achieve in its
recommendation.
Let me now turn to the topic of auditor independence and
the scope of services issue. Because of the fundamental
importance of auditor independence to the quality of and
confidence in public
audits, the Panel dedicated a full chapter of its report to
auditor independence and specifically, to accounting firms'
provision of nonaudit service to clients. Of the 126 publicly-
related audit engagements studied by the Panel, the Panel
identified 37 of those engagements in which services other than
audit and tax had been provided. The Panel's reviewers did not
find any instances in which providing those services to audit
clients had a negative effect on audit effectiveness. Indeed,
the Panel found that on roughly a quarter of such engagements,
nonaudit services actually had a positive impact on the
effectiveness of the audit.
Based on an independent survey, we found that many people
remain concerned that the performance of nonaudit services for
audit clients creates at least the appearance of an impairment
to auditor independence. And considering this thorny issue, the
Panel did not reach a unanimous recommendation as to whether or
not a ban on nonaudit services to clients was advisable, and if
so, which services should be in or out. However, since that
time, the SEC by rule has banned the provision of many nonaudit
services to audit clients. And recently, all five of the major
firms have agreed to end the performance of two types of
nonaudit services to clients: First, financial information
systems design and implementation; and second, internal audit
out-sourcing.
These types of engagements generate substantial fees for
accounting firms, and as the Panel found, create at least a
perceived threat to auditor independence.
The net result of the action by the SEC and the decisions
by the firms is that substantial amounts of so-called
consulting dollars are off the accounting firms' table.
Going forward, I am not confident that the lines drawn in
the political or legislative process with regard to permissible
scope of services will most effectively enhance the quality of
public audits. I believe some expert entity, like the now-
defunct Independent Standards Board, could develop a framework
to identify independence threats and provide guidance on
appropriate safeguards.
I would strongly urge that whoever is charged with
oversight of this issue, utilize the framework and methodology
developed by the ISB, a clear guide to appropriate regulation.
I also believe that audit committees should take it upon
themselves to review nonaudit engagements with the company's
auditor using certain guiding principles such as those
recommended in the Panel's report.
Let me now discuss the issue of governance of the
accounting profession.
The profession's combination of public oversight and
voluntary self-regulation is extensive, Byzantine, and
insufficient. The Panel found that the current system of
governance lacks sufficient public representation, suffers from
divergent views among its members as to the profession's
priorities, implements a disciplinary system that is slow and
ineffective, lacks efficient communication among its various
entities and with the SEC, and lacks unified leadership and
oversight.
In light of these significant shortcomings, the Panel
recommended the formation of a strong, unifying oversight body
to help ensure the effective working of the profession's
standard setting, monitoring, disciplinary, and special review
functions.
In the Panel's opinion, the experience and expertise of the
Public Oversight Board could have served as a sound foundation
for such an organization, a body to whom the SEC, the State
boards, the auditing profession, and the public would look for
leadership.
Unfortunately, the POB has all but disbanded. There are,
however, many similarities between our Panel's proposals and
those considered by the SEC and the Congress.
I am in favor of the creation of an organization to oversee
the accounting profession, whether it is created by regulation
or by legislation. If carefully structured to ensure effective
oversight, disciplinary proceedings and rulemaking in an
unpoliticized environment, such an organization could serve the
same purpose we had in mind for an expanded POB.
There are important considerations in structuring a new
entity.
First, it must be decided whether the new organization will
assume an oversight role similar to that proposed by the panel,
or whether it will assume some or all of the responsibilities
of existing bodies. In this regard, if the new body is created
by statute, the Congress should provide statutory
confidentiality protection for the materials, interviews, and
findings developed as part of the new organization's peer
review, investigatory, and disciplinary functions.
I believe the Auditing Standards Board remains the
appropriate entity for establishing audit standards. But a new
organization should oversee its activities and ensure that the
ASB continually reexamines and addresses emerging auditing
issues on a timely basis. And although today, the FASB is beset
with political pressure that directly hampers the accounting
standard setting process, in my view, the FASB remains the
right entity for determining accounting standards.
A second consideration is that any new oversight
organization must remain independent from the profession, but
mindful of current issues and trends affecting the profession.
There should be an appropriate balance of members from outside
the profession, public members, and the profession.
Third, Congress should ensure that the oversight
organization is sufficiently staffed and funded to carry out
its sizable mandate. If a new organization assumes review
responsibilities currently undertaken as part of the peer
review system, it will have to do the job that is now done by
hundreds of experienced employees, managers, and partners
assigned by the firms.
Finally, in view of the various efforts at the State level
in the wake of Enron, I believe if a new oversight organization
is created, Congress should ensure that national accounting
firms are subject to a clear and consistent set of regulations
and do not find themselves guided by multiple, conflicting sets
of rules.
Our capital markets are not broken. They may have been bent
a little, but they are wonderfully resilient and have stood the
test of time. I believe that much can and should be done by the
accounting profession, and by the other participants in our
safety net, to restore confidence in our capital markets and
protect the investing public. And, I believe that Congress can
play a constructive role in holding the type of hearings that
have been undertaken by this Committee and, if necessary, once
all the facts are gathered, by crafting legislation in the
public interest. I do want to urge caution in whatever
legislative proposals are advanced, because I fear that a
hastily-crafted package could potentially harm, rather than
help, the cause of audit reform.
I appreciate the opportunity to give you my views, and I
will be pleased to assist this Committee in whatever manner
would be most helpful.
Mr. Chairman, that concludes my remarks and I am sorry that
I went a minute over here on my time.
Chairman Sarbanes. We are very pleased to have you, sir.
We will next hear from Lee Seidler, a General Partner and
Senior Managing Director of Bear Stearns. Actually, he is now
Managing Director Emeritus, as I understand it. And as I
mentioned earlier, was the Deputy Chairman of the Commission
headed by former SEC Chairman Manny Cohen.
Mr. Seidler was a Professor of Accounting at New York
University's Graduate School of Business Administration for 20
years. He is the author of a number of books on accounting and
taxation. And he served on the audit committees of a number of
companies where he has been a member of the board of directors.
And so, we are very much looking forward to his perspectives
this morning.
We would be happy to hear from you, Dr. Seidler.
STATEMENT OF LEE J. SEIDLER
DEPUTY CHAIRMAN OF THE 1978 AICPA
COMMISSION ON AUDITORS' RESPONSIBILITIES
MANAGING DIRECTOR EMERITUS, BEAR STEARNS
Mr. Seidler. Thank you, Mr. Chairman and Senator Gramm, for
inviting me to testify today.
I should mention that from time to time I act as an expert
witness for the Enforcement Division of the SEC. My title of
Managing Director Emeritus of Bear Stearns calls for no work,
no pay, but it does entitle me to free lunch at the partners
table on occasion.
[Laughter.]
I will be presenting a summary of my written testimony, and
I would request that my written testimony be placed in the
record.
Chairman Sarbanes. The full written testimony will be
included in the record.
Mr. Seidler. Mr. Chairman, you read the charge to the Cohen
Commission. I would like to read a couple of sentences that
follow, which are our conclusions:
The charge suggests the possibility that a gap exists
between the performance of auditors and the expectations of the
users of financial statements. The Commission concludes that
such a gap does exist. However, the principal responsibility
does not appear to lie with the users of financial statements.
In general, users appear to have reasonable expectations of the
abilities of auditors and the assurances they can give. The
burden of narrowing the gap falls primarily on auditors and
other parties.
We said that in 1978. And in 1978, we also said:
The public accounting profession has failed to react and
evolve rapidly enough to keep pace with the speed of change in
the American business environment.
And unfortunately, a quarter of a century later, I have to
repeat that. It is identical.
As you said earlier, most of our recommendations were not
taken. I would like to mention a few that I would consider the
most critical that were not taken, then move to a suggested
action on your part.
First of all, the Commission recommended that we stop
auditing financial statements and instead, convert into an
audit function. That is that the auditor be essentially the
auditor of the auditor of the company and that the audit be
essentially a continuous function. From that flowed our
recommendation, which was revolutionary in those days, that all
published quarterly reports be reviewed by auditors. And that
was ultimately taken. However, if we move ahead 25 years, it
would seem to flow that now all quarterly reports ought to be
audited as part of an integrated audit with the year-end
financial statements.
Second, we recommended that auditors evaluate the financial
statements as a whole. Commission member Leroy Layton called
that the smell test.
Then, and now, auditors have to evaluate the cumulative
effect of uncorrected misstatements and decide what that is on
the financial statements as a whole, and I will talk a bit more
about that. We said, take a positive look. Evaluate the
cumulative effect of the selection application of all the
accounting principles and decide if the total picture presented
by the financial statements is there. No steps have been taken
on that at all.
Auditors today, and then, opine that the accounting
principles used by the company are acceptable. Then, as now, if
a company changes an accounting principle as between one
alternative to another acceptable alternative, the auditor and
the company must opine that the new accounting principle is
preferable.
The Cohen Commission said, we see no reason to opine on
preferability only when a change is made. So, we suggested that
the auditor always ought to opine that when there are
alternative accounting principles, the principles selected by
the company are preferable. No action has been taken on that
suggestion, either.
And I would add that, certainly, a lot of the disclosures
in Enron and some other cases have suggested another form of
accounting principles, barely acceptable accounting principles,
where transactions have been structured to fit under a line. I
think if a preferability requirement were put in, that would
eliminate the notion of just squeezing in under the line of
acceptability.
Materiality is an accounting concept that most people do
not know about. Materiality, however, is the very strongest
accounting principle. Every statement issued by the Financial
Accounting Standards Board, and by its predecessors, the APB,
includes the following statement:
The provisions of this statement need not be applied to
immaterial items. In other words, if the decision is made that
an item is not material, it does not have to be accounted for
correctly. No matter how egregious, no matter how authoritative
the particular standard is, if it is not material, it does not
have to be accounted for
correctly.
In my written testimony, I describe some of the bizarre
accounting used by Waste Management, audited by Arthur
Andersen, taking it from the SEC release. And that accounting
was ultimately, although totally egregious, would have been
spotted by one of my Accounting 101 students, was simply
decided to be not material and therefore, was permitted to go
through.
The problem, however, is that there is no workable
definition of materiality. There is a legal or legalistic
definition, but really is not one that accountants can apply on
a day-to-day basis.
The Cohen Commission in 1978 noted that in 1975, the FASB
had issued a discussion memorandum on materiality. That is the
predecessor to going to work on a statement. Unfortunately,
since then, not a single piece of paper has emerged from the
FASB on materiality. The SEC issued a slight clarification
recently, but still, there is no definition.
I propose a simple standard that would resolve many of
these problems. I said earlier that uncorrected misstatements
in financial statements have to be aggregated and the
conclusion has to be that they are not material.
I raise this simple question--why have any uncorrected
misstatements in financial statements? If the auditors find an
error in the financial statements, why not correct it, no
matter what it is, no matter how large it is?
In the old days, if you will, precomputer days, making a
correction near the end of the audit meant changing lots of
schedules and changing the statements that have been produced.
Today, I have a $149 accounting program in my laptop computer.
If there is a set of financial statements in there and I put in
a journal entry, one correcting entry, in about a hundredth of
a second, new financial statements are created and it is all
corrected. Therefore, there seems to be absolutely no logic in
doing anything other than saying, when an auditor finds an
error, correct it. Forget about the materiality.
I will also tell you that, in my experience in testifying
for the SEC, materiality was the major issue, and usually the
major issue on uncorrected misstatements found by the auditors.
This would eliminate that major problem.
I won't dwell on the last one extensively, and that is to
eliminate nontraditional management consulting because there
seems to be a great deal of agreement that consulting outside
the traditional realm of accounting should be eliminated.
I will say that my conclusion is not based on empirical
evidence, but as it was said by my companion here, it is the
fees that are the real problem, the huge fees from consulting
which make it much more difficult for an auditor to be the one
who lost the Enron account or the Waste Management account. And
I would like to take as much fee temptation away.
I will offer a note of caution, however.
Smaller businesses, nonpublic businesses, benefit greatly
from the advice of their auditors. And in carving out any
restriction on consulting, I would hope that you would take
caution with the smaller businesses.
I would point out that and I am, for example, on the board
of a small public company, too small to afford an investment
banker, and we have received some time ago a buy-out offer. Our
audit partner came to the board and actually gave the best
advice about how to deal with this particular buy-out.
I would suggest that any advice, consulting, that can be
given by the audit staff, by the audit partner, should not be
precluded.
My conclusion is that the profession hasn't acted in 25
years, as you say. The question is, where do we go? I suggest
my solution reluctantly.
I am a CPA. My father was a CPA. I taught for 23 years. In
a largely unregulated profession, I believe now we need to
create a regulatory body and I would suggest a body in the
image of the NASD, which has done an excellent job of
regulating the securities industry. And I would propose that in
that body, we do not have to create a new group from scratch. I
propose taking the standard setting portions of the AICPA--that
is, the Auditing Standards Board, the Accounting Standards
Executive Committee, along with the SEC practice section--and
move those into the new statutory self-regulatory organization.
I would also suggest taking the Financial Accounting
Standards Board and moving that into the same organization. I
think by doing that, we would create a body which has both the
standard setting and the regulatory ability, and would be able
to act much better to create change.
I would also say be careful not to interfere with the State
societies when you do this because some of the State societies,
particularly New York State Society of Certified Public
Accountants, are far more creative than the American Institute
of CPA's. I would like to allow them to continue in their way.
In finishing, I would like to make a plea or just a
recommendation that is not within your legislative purview, and
that concerns accounting education.
Twenty-five years ago, the Cohen Commission pointed out
that there is no graduate professional education in accounting.
Accountants have to go to undergraduate school, basically.
There is no graduate professional schools, no graduate
professional degrees
offered. And we said that was robbing the accounting profession
of some of the best manpower, those people who go through
undergraduate and opt for graduate school later on.
Twenty-five years later, with the number of students
following that career perhaps tripling, the accounting
profession, unlike law, medicine, architecture, compute
science, business, physical and social sciences, and even
pharmacy, does not offer a graduate degree.
The accounting profession is essentially starving for
manpower. It reminds me of the story of the farmer who, in
order to save money, decided to cut down on feeding his cow a
little bit every day. It was going very successfully, he
finally got the feed down to zero, and the cow fouled the whole
thing up by dying.
[Laughter.]
The accounting profession is doing about the same thing in
its manpower. And I urge you--you cannot legislate it, but
perhaps you can recommend to the State boards of accountancy,
that they try to increase the accounting education
requirements.
In conclusion, I would just like to read a very brief
statement which came from Senator Francis T. Maloney, who
sponsored the 1938 Maloney Act Amendment of the Securities
Exchange Act of 1934, which created the NASD. He said: ``This
Act is designed to effectuate a system of regulation in which
the members of the industry will themselves exercise as large a
measure of authority as their natural genius permit.'' I hope
you can do the same thing for the accounting profession.
Thank you.
Chairman Sarbanes. Thank you very much. It is very helpful
testimony.
We will now hear from Arthur Wyatt, retired Managing
Director of Arthur Andersen, Professor Emeritus of Accountancy
at the University of Illinois, his alma mater. Mr. Wyatt has
served as President of the American Accounting Association, has
been a member of the Financial Accounting Standards Board,
Chairman of the International Accounting Standards Committee.
I ought to mention that both Mr. O'Malley and Professor
Wyatt are members of the Accounting Hall of Fame, which is
located at Ohio State University.
Actually, that group includes Arthur Andersen himself, who
had a very distinguished career, as I have noted here on a
couple of occasions. And Charles Bowsher, former Comptroller
General of the United States, who will be before the Committee,
not next week, but the week after next.
Mr. Wyatt, we would be happy to hear from you, sir.
STATEMENT OF ARTHUR R. WYATT, CPA
FORMER CHAIRMAN, AMERICAN INSTITUTE OF
CERTIFIED PUBLIC ACCOUNTANTS' ACCOUNTING
STANDARDS EXECUTIVE COMMITTEE
FORMER CHAIRMAN, INTERNATIONAL ACCOUNTING
STANDARDS COMMITTEE
FORMER PARTNER, ARTHUR ANDERSEN & CO.
PROFESSOR OF ACCOUNTANCY EMERITUS
UNIVERSITY OF ILLINOIS
Mr. Wyatt. Thank you, Mr. Chairman, Senator Gramm, Senator
Miller. I am pleased to be before you today. I have some brief
prepared remarks----
Senator Gramm. Arthur, would you pull that microphone up a
little bit?
Mr. Wyatt. Yes. And I would respectfully request that the
full text of my written testimony previously submitted to you
be entered into the public record.
Chairman Sarbanes. Without objection, it will be included
in the record in full.
Mr. Wyatt. Before dealing with the specific issues raised
in your invitation to appear here today, however, it may be
helpful to provide some background on the evolution of the
large public accounting firms over the last 35 years. My
observation is that over this period, the attitude of the
leadership of the large accounting firms has gradually shifted
from an emphasis on the quality of accounting and auditing
services provided to clients, to emphasis on growing top-line
revenues. The impact of this attitudinal change within the
firms has been significant, in my view.
No longer is technical expertise and leadership the obvious
avenue to progress within the firms. Rather, expansion of
clients served and expansion of client services are viewed as
the primary drivers. And obviously, the loss of a client is a
negative in one's career path.
Since many decisions required of audit firm managers and
partners are judgmental in nature, rather than clearly
prescribed by external forces, such judgments are, at the
margin, sometimes influenced by perceptions of the attitudes of
leaders of a given firm.
If those perceptions by audit firm personnel are that the
loss of a client is damaging to one's career path, the
judgments made may be more in the direction of keeping the
client than to achieving fair presentation in financial
statements.
I believe the leadership in the various firms needs to
evaluate how well their existing organizational structures and
reward policies are serving what has to be their primary
focus--the delivery of high-quality, professional accounting
and auditing services to their audit clients.
While these observations may not be very helpful in
considering legislative initiatives, I believe they are crucial
for the major accounting firms to address if the firms wish to
survive in the private sector as respected reporters on the
financial situation and results of operations of business
enterprises.
The evolution of the drift toward increased emphasis on
commercialization and reduced emphasis on professionalism led
the large accounting firms to expand the range of services
provided to their audit clients.
Many of these services are logically best provided by the
audit firms--tax return preparation and tax planning,
evaluation of the accounting alternatives for planned
transactions, assistance with
financial statement preparation for regulatory purposes, audits
or reviews of prospective acquirees in business combinations,
are some examples. Indeed, any additional services that are
directly related to assuring the fairness of presentation of
client financial statements are proper activities for audit
firms to undertake.
On the other hand, as the range of services provided
broadened, some were clearly creating potential for conflicts
with the basic audit services. For example, rendering internal
audit services for audit clients was never a sound idea.
Likewise, services related to the design of financial reporting
systems places the auditor in an awkward position if the system
does not function as anticipated.
Actuarial services, executive searches, advice on specific
investment decisions, and many more services of this nature
that evolved over the years to generate increased revenues, but
either have little relationship to the annual audit or may
create conflicts of interest, should no longer be permitted by
audit firms for their audit clients.
Drawing lines in this area will not be an easy task. Given
the current environment, it is certainly possible that some
regulations or legislation will suggest scope-of-service
restrictions that will damage the auditor's ability to develop
the best possible basis for expressing an opinion on the
fairness of presentation of the client's financial statements.
The initiatives in this area need to be undertaken, but
they must be undertaken with care so that they do not frustrate
the auditor's ability to complete top-quality audit services.
Now some comments on accounting standard setting.
Too often, the Financial Accounting Standards Board, FASB,
has departed in its final standards from the concepts that it
has represented will guide its decisions, generally because
interested parties have not only raised objections to
conclusions tentatively expressed, but also have effectively
lobbied against adoption of those decisions the Board has
signaled.
If the accounting standard setting process is to achieve
its objectives of providing guidance on appropriate accounting
for transactions and events of an entity, the process must be
recognized by all participants as being primarily an
intellectual process and not primarily a political process.
The Board often receives negative comments from industry
constituents, from auditing firm representatives, from Members
of Congress, as well as others. When these comments become part
of an organized campaign to undermine the direction a standard
is taking and recommend alternative conclusions that are not
conceptually sound, the mission of the Board is frustrated. Now
this is particularly true when the interveners are Senators and
Representatives, who, as part of their commentaries, threaten
some type of legislation to frustrate the direction that the
Board is moving.
While Senators and Representatives have a legitimate
interest in the workings of the Board, they need to recognize
that their interventions may well lead to Board decisions that
are not in the best interests of investors and the broad
business community.
Standards that are conceptually sound need not run hundreds
of pages to thwart those who would attempt to subvert the
intent of the standards. Each standard issued by the Board
should contain in the clearest English possible the objective
or intent the Board intends to achieve by issuing the standard.
Each standard issued by the Board should contain a clear
statement that any one who is applying the standard should
review carefully its application to satisfy himself or herself
that the objective specified by the Board has in fact been best
achieved through the application that has been adopted.
With regard to audit committees, at least the audit
committee chairman, and preferably all audit committee members,
should have experience in evaluating the business risks and
should be sufficiently conversant with accounting issues to
raise appropriate questions with an ability to evaluate
responses received.
Audit committees should be especially curious about the so-
called audit adjustments proposed by auditors, but not made by
company accounting personnel.
Audit committees should pressure company accountants and
the auditors to resolve any open adjusting entries, either by
the company accepting the entry for recording or the auditor
concluding that the proposed entry should never have been on
the schedule in the first place.
The audit committee concept is a sound one. Through efforts
of the New York Stock Exchange and the SEC, improvements in
committee composition and mission should continue to evolve.
Honest managements and responsible auditing firms should
welcome audit committee involvement when such committees are
constituted properly, with knowledgeable individuals willing to
gain an understanding of the underlying business risk issues
and raise questions on appropriate accounting and disclosure
matters.
My experience with disciplinary mechanisms, as well as my
knowledge base in this area, is sparse. The current mechanism
under the auspices of the American Institute of Certified
Public Accountants, however, is clearly not working.
Over the years, the Securities and Exchange Commission has
been a generally effective agency working toward improvements
in financial reporting. Even so, its resources have probably
been far too limited to achieve the optimum level of success in
its diverse objectives.
I would be inclined to provide increased funding to the
SEC, to have it become and assume the principal role in
overseeing the
effectiveness of the financial reporting process. Creation of a
new agency to undertake this responsibility seems unnecessary
in view of the record established by the SEC over the past 65
years.
Thank you, Mr. Chairman. I very much appreciate this
opportunity and would be pleased to respond to questions.
Chairman Sarbanes. Thank you, sir. Very helpful testimony.
We will now hear from Professor Briloff who is the Emanuel
Saxe Distinguished Professor Emeritus at Baruch College of the
City University of New York. He holds a doctorate from NYU
Graduate School of Business Administration, and is a Certified
Public Accountant in the State of New York. Professor Briloff
has practiced public accountancy since 1944, almost 60 years.
He is the author of a number of books and hundreds of articles
bearing on many of the topics that are before the Committee.
Professor Briloff, we are pleased to have you with us this
morning. We would be happy to hear from you now.
STATEMENT OF ABRAHAM J. BRILOFF
EMANUEL SAXE DISTINGUISHED PROFESSOR EMERITUS
BERNARD M. BARUCH COLLEGE, CUNY
Mr. Briloff. Thank you, Mr. Chairman. I appreciate the
opportunity to appear before you today.
About the only light moment for the next 10 minutes might
be derived from the quotation that you read from The Wall
Street Journal, which reminded me of the old quip going way
back, that financial statements are very much like bikini
bathing suits--what they reveal is interesting, what they
conceal is vital.
[Laughter.]
I would like for my prepared statement----
Chairman Sarbanes. Professor Briloff, you are going to have
to try to keep that microphone close to you. Otherwise, the
system doesn't work so well.
Mr. Briloff. I would like for my prepared statement to be
included in the record: ``Accountancy and Society: The Covenant
and the Desecration.''
Chairman Sarbanes. The full statement will be included in
the record, without objection.
Mr. Briloff. Mr. Chairman and Members of the Committee on
Banking, everyone who is privileged to enter into a profession
is presumed to have entered into a covenant, a covenant with
the forbears of his or her profession who have created a status
and stature of that calling. And by definition, since a
profession demands service to society, there is also the
covenant with society.
The profession of accountancy has a very special covenant
because, in the infancy of the securities laws, about 1934 or
1935, by a 3 to 2 vote, mind you, the accounting profession,
and the private-sector of the accounting profession, was given
the responsibility, the franchise of auditing the financial
statements of publicly-owned companies, the registrants with
the SEC.
That is a most valuable franchise bestowed on my profession
by the action of the Securities and Exchange Commission some 65
years or so ago. It is that covenant which I say is being
violated.
Now the responsibility of the auditing profession, of the
accounting profession to society, Mr. Chairman and Members of
the Banking Committee, goes beyond just the financial
statements, beyond the debits and credits, beyond the balance
sheets and the income statements and the statements of cash
flows.
It goes to reviewing the entire process of corporate
governance and accountability, the totality of governance and
accountability, because some agency has to be there to make
certain that the corporate engine, the catalyst for the
American capitalistic system, American capitalism, is
functioning optimally. That is the role and the responsibility
of the accounting/auditing profession, which we should be
charged to fulfill.
If we reflect for just a brief moment on the effectiveness
of the corporate operations impacts on the individuals more
directly, more intimately, more regularly, more continuously,
than does Government. That which we eat and drink, where we
live, how we live, how we carry on our activities, our
mobility, all are dictated and directed by corporate activities
and corporate decisionmaking.
Certainly, our economic present and our economic future are
critically impacted by the way in which our corporate
enterprise and our American capitalistic system is functioning,
again, with corporations as the catalyst. So it is beyond the
mere financial statements toward which I look at in terms of
the canvas of the auditor's role and responsibility.
Now to assure the effectiveness of that corporate
enterprise, where, mind you, as things have worked out, we have
that power-without-property syndrome, as Adolf Berle described
it, whereby enormous resources have been delegated by the
owners of those resources to managements which, in turn, or
who, in turn, exercise the power.
It is to assure the effective exercise of that power that
we have created the system of corporate governance and
accountability which, if it were to function optimally, would
assure the fulfillment of that American corporate enterprise.
That system with management at its center then moves outwards
to the board of directors, to the management committee, to the
independent audit committee, to the independent auditors, to
the Securities and Exchange Commission, to the Congress, to the
courts, including at various points the professions of the
journalists and the lawyers.
All are embraced by what might be termed the system of
corporate governance and accountability. It is when that system
breaks down and where the auditors fail to fulfill their
responsibility that we run into the Enron syndrome.
Now some benchmarks to history which were provided by Mr.
O'Malley, Professor Seidler, Professor Wyatt and by repeating
them, it is saddening. We have had all of these things
occurring heretofore. They are all so self-evident. Why hasn't
the situation been improved in order to accomplish what
everyone recognized over the years as being essential?
In 1976, there was the staff study prepared for the
Committee under Senator Lee Metcalf called the Accounting
Establishment, which described the apparatus which prevailed.
And we then had hearings under Senator Metcalf in 1977, from
which there then evolved the AICPA's Division for Firms, where
they were going to be doing all of this self-discipline and
self-regulation, especially with the Public Oversight Board to
be overseeing all of this.
Why should it not have been accomplished?
Following that, fortunately, we do have the independent
audit committee proposals, which are very, very vital. We then
have the S&L crisis in the 1980's. We have the Foreign Corrupt
Practices Act in 1977. We have Title III of the Private
Securities Litigation Reform Act of 1995. All of those were
supposed to correct the problems which we then recognized. And
here we are in 2002, seeing the problems, even more critical,
even more serious than had prevailed heretofore.
Where do we go from here? That is the reason I know that
you invited me to appear before you today.
First, I mean this reasonably seriously, we do not need any
new promulgations from the Financial Accounting Standards
Board. I maintain that we have a surfeit of accounting rules
because the Board does not promulgate standards. They
promulgate rules. And the moment they promulgate rules, the
firms go back to their Ouiji boards or their computers and they
develop programs--how can we circumvent those rules if we want
to circumvent those rules, as we saw in the cases of leases, as
we saw in the cases of business combinations.
Thirty-two years ago, Mr. Chairman, Members of the
Committee, I testified before Senator Hart on the very matter
of business combinations. I spoke against pooling.
Some months ago, the FASB aborted pooling, requiring
purchase accounting. And I say to you in all seriousness, Mr.
Chairman, Members of the Committee, and others who are here,
the rules that they now have for purchase accounting makes the
situation even more grievous than that which prevailed before
the FASB promulgations aborting pooling because of the
presumptions that are implicit in purchase accounting in the
nonamortization of goodwill. But I want to pass from that.
Where do we go from here?
Very quickly, Mr. O'Malley referred to the introduction of
the
forensic accounting procedures. I say, amen. We know what to do
when we are involved in the pathological process of a post-
mortem after a fraud has been discovered.
Arthur Andersen did an extraordinarily beautiful job when
they did the post-mortem in the Cendant situation, identifying
all that Ernst & Young should have done. They did an
extraordinary job. And after I completed my analysis of that
and congratulating
Arthur Andersen, lo and behold, Sunbeam surfaced where Arthur
Andersen, as the auditor of Sunbeam, replicated some of the
matters that were found with respect to Ernst & Young.
So, we know what to do. Let's do it.
Second, consistent with what Mr. O'Malley indicated, an
agency under the SEC maintain a registry of firms who have
committed themselves to the audit of registrants with the SEC,
who, by demonstrating their quality, and the system of checks
and balances within the firms, have demonstrated that they are
qualified to be there. And such an agency would be in the
position of disciplining and possibly delicensing or removing
them from the registry.
Third, this involves a sea change. I do not want to deceive
you.
As a part of the proxy material where the shareholders vote
to approve the designation of auditors, the shareholders should
direct that the auditors, on their own initiative, prepare the
financial statements which would best replicate or reflect
economic reality as the auditors see it, without hindrance.
Now the sea change comes about in this fashion. If you look
at the auditor's opinion, they do not say, we prepared the
financial statements. They do not say, these are our financial
statements. No, they say these are management's financial
statements, which, somehow or other, have gone above the
threshold of GAAP.
Now maybe that is not as high a threshold as we would like.
It may not be as close to economic reality as it could be. But,
yet, it passes. On their initiative, clearly and overtly, that
it is there, the auditor's statements.
Then I come to the sine qua non, which I know is most
difficult to accomplish, but yet, so very important. For those
firms who have qualified to be the auditors of publicly-held
enterprises and applied for that listing, I propose that the
statements be developed by the independent auditors on their
initiative, clearly and overtly that its their, the auditors
statements--absolute--repeat, absolute, underscored--
divestiture of all nonaudit services.
I want the auditors of publicly-owned enterprises to be
something of a priesthood, as I have indicated in different
contexts, one where they recognize, as I indicated in the
opening remarks, the importance of their role. By doing so and
emphasizing the transcendent import of the audit, the firm's
personnel would realize how important that audit is. The whole
chain of command would be oriented toward the independent
audit, and it would have a salutary effect because the
downsizing would permit the tone at the top, which we would
presume to be the kind that Professor Wyatt had in mind and
that Mr. Treadway had in mind when he spoke of the tone at the
top, when he spoke of where the profession should be, would be
filtered down.
So instead of rainmaking being the sine qua non within the
firm, it would be the quality of the audit.
Then, I concluded my prepared statement by saying, what if
we continue to fail by saying, okay, another committee to be
designated by the AICPA. Yet another commission like the Cohen
Commission. Another period of study.
I say, nonsense.
If we fail, then I respectfully suggest that the SEC
pronounce, we do not require certification of the financial
statements by independent auditors. Rely on the financial
statements from management, reviewed by the independent audit
committee, with whatever counselors they might want to select.
But then add at the end,
caveat emptor, because to me the worst deception is to continue
to pretend that the public is getting a safe product when we
know, as we have heard from all the testimony going over 25, 30
years, that there is a quagmire under us.
Thank you. I do not know how many minutes I have exceeded,
and if I have, I am sorry.
Chairman Sarbanes. Thank you very much, Professor Briloff.
We will turn to our concluding panelist, Bevis Longstreth.
I am pleased to welcome him back before the Committee. Mr.
Longstreth is a retired Partner at Debevoise & Plimpton in New
York. He was an SEC Commissioner in the early 1980's, a Member
of the Board of Governors of the American Stock Exchange, and
he has written frequently on corporate governance, banking, and
securities law.
Bevis, we are very pleased to have you here. We would be
happy to hear from you.
STATEMENT OF BEVIS LONGSTRETH
MEMBER OF THE O'MALLEY COMMISSION
FORMER COMMISSIONER OF THE
SECURITIES & EXCHANGE COMMISSION, 1981-1984
RETIRED PARTNER, DEBEVOISE & PLIMPTON
Mr. Longstreth. Thank you, Senator. It is a pleasure to be
here.
I agree with so much that has been said. But I will try to
say a few things and perhaps put specific points on a few of
the observations that have already been made.
I want to say that I am not an altruist in my interest in
this subject. I serve on the board of two very large money
management firms. We have a great stake in the trustworthiness
of financial statements.
I am going to talk about reforming the audit profession,
which is our theme. My thesis on that is simple. I think the
profession needs reforms in two major respects. First, an
effective rule that prevents the delivery of most nonaudit
services to audit clients. And second, an effective system of
self-regulation.
Despite the SEC's tortured process which gave birth to a
new rule, 2-01, just a year ago, the threat to an auditor's
independence from performing nonaudit services allowed by that
rule remains palpable. And despite the enlarged charter that
the Public Oversight Board was given after extensive
negotiations led by the SEC, the POB being until recently the
most promising vehicle for some kind of at least partially
effective self-regulation, the truth is an effective system
does not exist and cannot be achieved without legislative
reform.
So let me start--what is wrong with the new SEC rule beyond
its hideous complexities?
In many respects, it can be criticized, but I just want to
talk about one. The SEC adduced strong evidence that providing
to one's audit client nonaudit services of any kind or kinds,
if large enough in terms of fees paid, may impair independence.
Despite this powerful predicate that the SEC established
for rulemaking, the rule adopted fails absolutely in addressing
this concern. It is a giant omission and it touches upon one of
the two fictions that I want to address today.
Fiction number one is the profession's claim, and it has
been a consistent claim for decades, that payments by an audit
client to its auditor for consulting and other nonaudit
services, no matter how large, will never impair independence.
Appearances, that is a problem, but in fact, don't worry
about it.
Now it defies common sense to claim that large payments for
nonaudit services, which management could easily purchase or
threaten to purchase from service vendors other than the
auditor, do not function as a powerful inducement to gain the
auditor's cooperation on how the numbers are presented.
I was delighted to hear Mr. Seidler make the same point.
Audit account partners are expected by their firms to
establish close relationships with the managements they serve.
They are expected to cross-market to management as full a range
of nonaudit services as possible, and that is a natural thing
to do if they are allowed to do it. They are compensated by
their firm on the basis, among others, of how much revenue they
produce from their audit clients. Their stake in maximizing
revenue from these clients through cross-marketing is as
natural and compelling as any financial reward could be.
To claim that these incentives have no adverse impact on
both the fact and the appearance of independence is a fiction,
pure and simple.
One basic problem with nonaudit fees which exists
regardless of their magnitude, but grows more serious as the
fees grow larger, is a basic conflict of interest. The conflict
derives from the fact that in performing both audit and
nonaudit services, the audit firm is serving essentially two
different sets of clients--management, in the case of nonaudit
services, which typically are commissioned by and performed for
management, and the audit committee, in the case of audit
services, which now are by rule commissioned by the audit
committee and performed for that committee, the shareholders
and all those who rely on the audited financials in deciding
whether to invest.
So the audit committee is a fiduciary in respect to each of
these two very distinct client groups, duty-bound to serve each
with undivided loyalty. It is obvious, and a matter of common
experience, that in serving these different clients, the firm
will be regularly subjected to conflicts of interest. And these
conflicts will tear at the heart of independence.
What is independence? It is the absolute freedom to
exercise undivided loyalty to the audit committee and the
investing public. That is what we are trying to protect; to
assure the auditor has the absolute freedom to be independent.
When other loyalties tug for recognition, and especially
when they come from those in a position to enlarge or shrink
one's book of business, on which depends one's partnership
share, and the share of one's staff, the freedom necessary to
meet one's professional responsibilities as an auditor is
challenged.
So there is a big hole in the rule.
To plug the hole, I suggest a simple exclusionary rule
covering most nonaudit services. And I am not suggesting
Congress should get into the business of writing that rule. But
I am suggesting the rule needs to be written by an SRO or by
the SEC, and the SRO is the other subject that I will come to
shortly.
An exclusionary rule would define the category of services
to be barred as including everything other than the work
involved in performing an audit and other work that is integral
to the function of an audit.
In general, the touchstone for deciding whether a service
other than the straightforward audit itself should be excluded
is whether the service is rendered principally to the client's
audit committee acting on behalf of investors to facilitate or
improve the quality of the audit and the financial reporting
process, or is rendered principally to provide assistance to
management in the performance of its duties.
The exclusionary rule could include a carefully
circumscribed exception to permit certain types of nonaudit
services to be rendered by the audit firm to its client, where
special circumstances are found by the audit committee to
justify so doing. The rule would be refined and enforced by a
legislatively empowered SRO, which is the subject of my second
recommendation for reform.
Beyond the two-client problem I have described, and the
conflict, there are many additional arguments for exclusion and
they are summarized in my written testimony, which I hope can
be included in the record.
Chairman Sarbanes. Without objection, the full statement
will be included in the record.
Mr. Longstreth. I want to mention just one argument here
because it seems so compelling to me.
Independence is given important meaning in many situations
analogous to auditing, where potential conflicts, while not
always certain to impair independence, nonetheless are
prohibited in the interest of avoiding the problem. And here's
the example.
Consider the independence necessary for a director to serve
on an audit committee of a public corporation. For a director
to be independent for that purpose, as now generally defined by
bodies that have looked at this, a blue ribbon committee,
actually, that looked at it--Shaun's committee was not blue
ribbon, but I think it was a great committee. I served on it.
Chairman Sarbanes. Well, you have bestowed a blue ribbon
it.
[Laughter.]
Mr. Longstreth. But the blue ribbon committee said, for a
director to be independent enough to serve on the audit
committee, he must not accept any compensation from the
corporation for any service other than the service of being a
director. Now, he may be extremely valuable in serving that
corporation in some other way. And management may really feel
frustrated that they cannot hire him for that purpose. But they
cannot because it would impair his independence.
The common-sense parallel to the auditor is both exact and,
in my view, compelling. Compensation for services other than
the audit function can threaten independence.
Now the second fiction I want to address, fiction number
two, is the profession's three-fold claim that: First, the
profession has the ability and motivation to regulate itself
voluntarily; second, it has done so effectively over the past
several decades; and third, there is no need for a
legislatively empowered regulatory body led by persons
independent of the profession. And if you haven't heard this
argument enough yet, you are going to hear it in spades as the
possibility of legislation on this subject increases.
The present system of voluntary self-regulation is
completely unsatisfactory. If one looks closely at that system,
what one sees is a bewildering maze of overlapping committees,
panels and boards piled one on top of the other. They are
characterized by complexity and ineffectiveness in matters of
central importance to any effective system of regulation.
And since I am out of time, I am going to jump over----
Chairman Sarbanes. Take a couple of minutes to finish up.
Mr. Longstreth. Okay. There are very specific reasons why
only a legislatively empowered SRO can have a chance at
effectiveness.
The NASD is such an animal and it has not had an
unblemished record of effectiveness. It had a chance and it has
gotten better, and it is doing now, I think, a very important
job, which the SEC simply does not have the resources to do
itself. So, we need to
replicate some thing like that. But the specific reasons, which
are
rooted in issues of antitrust law, self-incrimination and so
on, are laid out in my testimony.
I won't go through that now because it is somewhat
technical. But it is critically important to realize that
voluntary action will never do the job. And the big element
that is missing from volunteerism are these protections against
abusing the right against self-incrimination, the protections
against violating the antitrust laws, the ability to throw
people out of the profession if they do not cooperate, give
evidence, turn over documents, testify before the SRO, and so
forth.
So it is an easy conclusion to reach when you understand
the details. It has to be legislatively empowered.
Now, I just want to make one more point. We have had a lot
of history. I am going to go back even further than the others,
if I may, because I think there is an important historical
analogue that gives meaning to the opportunity you have now on
the back of Enron, as momentum builds, to actually do an
important legislative job.
Senator Gramm has returned, I want to say something because
I was impressed with your statement at the outset of this
hearing. You said your first rule was to do no harm, and I
applaud that.
I am not a fan of lots of legislation, take a law kind of
thing, to solve every ill. But in regard to audit reform, I
hope that you and all the others in the Senate will seize the
opportunity that only lawmakers have right now to prevent
further harm.
I think, as you have heard--if you look at the sweep of
history--the harm from bad financials has been increasing,
there is a problem, and it can only be solved by the
legislature, by lawmakers.
But the analogue I wanted to make was to the Great
Depression and the fact that, with the huge losses of
depositors, the Congress recognized the need that the public
had to feel that the money they put in banks was safe. It had
to be safe and they had to feel it was safe. And the result of
that was many laws, maybe too many laws. But the FDIC was
created and that law and the safety net for deposits that it
provided has been around a long time.
The problem is that since the 1930's, money has migrated
out of bank deposits and into the capital markets, from bank
deposits to money market mutual funds and, increasingly, to
equities. And with this shift in how the public saves its
money, saves its retirement funds, should come a shift by
lawmakers in fashioning the kinds of protections that public
investors need.
I am not suggesting a safety net under equities. That would
do more harm than good. But what I am suggesting is a system
that you can help create, indeed, must be the absolute
essential element in creating, a system assuring that, when our
corporations present their financial condition to the world,
what they present is worthy of public trust.
The auditors are the last line of defense. Security
analysts, you can fuss with them, but you are never going to
fix their conflicts entirely. But auditors are not
entrepreneurs. They are the last line of defense. Their job is
to vouch for, render trustworthy the financial statements of
the corporations they serve in this way, and the public that
they serve in this way.
We know in recent years with disturbing frequency the
numbers are fudged, earnings are managed, and sometimes, on the
slippery slope, they become false and misleading deliberately.
So legislative action is needed now because, with these
growing numbers of audit failures, culminating, but not ending,
with Enron, the public's trust and confidence has really been
badly shaken, just as in the Depression. But now, it is
shaken--the public is shaken as investors, not as depositors,
and the loss of trust is directed to the reliability of
financial statements, not to the bank deposit.
I hope that the hearings will convince Congress that it can
and must restore the public's confidence in the financial
statements by taking the steps I have outlined to create an
effective SRO with independent leadership, which is critical.
Now there has been consideration given to rotation of
auditors, and I think that is worth studying.
I thank you for the extra time and I will stop now.
Chairman Sarbanes. Well, thank you very much. This has been
an extremely helpful panel, not only for your testimony, but
also the evident care and effort that went into the prepared
statements that have been fully included in the record and
which will be subject to careful study.
Senator Gramm has another conflicting engagement. I will
yield to him to do his questioning first, and next to Senator
Miller, and then I will pick up myself.
Senator Gramm. Mr. Chairman, let me try to be brief, given
your generosity.
First, I want to thank each of you for outstanding
presentations.
I believe there is a growing consensus on this Committee
that we need to strengthen this independent accounting standard
setting board. And so, I want to pose a question to each of you
that is counter to the principle that I am moving toward, or at
least raising a concern about it.
I think maybe I am the only person who has this concern.
The concern basically is, there is a growing recommendation
that we need more people who are not CPA's on this accounting
board. There is a growing recommendation that we have more
independent people involved in the process. There is a growing
recommendation that we give this board unchecked substantial
increases in power.
Mr. Wyatt brought up setting standards and talked about
political involvement, and I can comment on it because I have
consistently taken the view that while some of the proposals of
FASB are proposals that I have never been able to understand,
not that I think I lack the analytical powers. It is just--the
issue about stock options and how they should be treated is an
example. But I have consistently taken the position that
whatever they decided, it was infinitely superior to anything
Congress could decide.
So, I agree with part of the point Mr. Wyatt makes, but not
all of it. I have always taken the position that, whether I
agreed with the board or not, I did not want to get in their
business.
That is the do-no-harm part.
But here's the point. If we create this board and we give
it increased power, which I believe we are going to and that I
am going to support, does anybody have concern about it losing
touch with the reality of the accounting profession? Does
anybody have concerns about when we give it financial
independence and so it doesn't have to go out and get people to
contribute to its support, that we could lose the kind of
feedback and input from grassroots accounting that at least I
believe is important?
I guess the oldest example of the concern that I am raising
goes back to Plato's Republic. The ancient Greek philosophers
believed that the solution was to produce perfect men, and then
they would be given authority. Our founders understood there
has only been one perfect man and that you had to do checks and
balances.
But the whole thesis of this board, it raises the question,
and I will get to the question, that was raised in response to
the concern about Plato's Republic--who is to guard the
guardians? Where are the checks and balances? I understand the
need for independence. But where are the checks and balances?
And do any of you all have a concern that, if we go too far in
isolating and insulating this board, that we could create a
problem in that direction?
Let me just start over here on the left and we will just go
down, if you could give me your response.
Mr. Longstreth. When you talk about the board, you are
talking about the FASB. Is that right?
Senator Gramm. I'm talking about this new successor board
that we will give subpoena power, that we are going to give
lots of power to. We are going to give them a permanent funding
source.
Mr. Longstreth. Okay.
Senator Gramm. And we are going to give them a lot of
power. The concern I have is, that I am raising is, does
anybody have concern about the loss of--that they might cease
being responsive to the profession, that they might lose touch
with people who are actually doing audits every day?
Mr. Longstreth. Yes, I understand. Well, I think the checks
and balances that you would build into it would start with very
clear oversight by the SEC, just as we have now with the NASD.
Of course, you would have constant Congressional oversight
because it would be created by Congress and it could be changed
or eliminated by Congress. You would have limited terms for the
leadership. And I hope that they would be appointed by people
who are public officials charged with public responsibility.
Senator Gramm. You do not want that, believe me.
[Laughter.]
Mr. Longstreth. You do not?
Senator Gramm. No, I do not think so.
Mr. Longstreth. Well, it is worth a debate.
Chairman Sarbanes. Like the Chairman of the Fed, Chairman
of the SEC, that panel that appoints the group.
Mr. Longstreth. That is what I was talking about, yes. That
is right. Sort of like the Chrysler board that was created.
That was an ad hoc board, but it had the comptroller general,
it had the chair of the Federal Reserve Board.
I think there should be a committee of public officials who
are responsible to the public, the investing public, in a
certain way, who would, as a committee, fill the slots and fill
the vacancies. They would include, it would seem obvious, the
chair of the SEC or the SEC itself, the Fed, the comptroller
general, and maybe someone else. And it could have some
private-sector people, too.
It seems to me that those are the classic checks and
balances we have--limited terms, appointment by other people,
oversight by the SEC, including sanctioning powers of the SEC.
They can sanction the NASD, and in fact did a few years ago.
The same formula.
Chairman Sarbanes. Mr. Seidler.
Mr. Seidler. I do share your concern. I think one example
we have is FASB, which, although it has accountants on it, sits
in bucolic Connecticut, almost isolated from the rest of the
world and has produced almost other worldly pronouncements in
certain cases.
I foresaw in my proposal that the membership of the Board,
of the SRO, which I call the National Financial Reporting
Board, contain a significant number of practicing professional
accountants.
I won't get into the majority/minority issue, but I think
we have to look back in history to the old Accounting
Principles Board, which did a far better job and contained
frequently the top technical partners in the firms who were, as
Professor Wyatt has said, also the managing partners of their
firm. So, I would like to see substantial representation from
practicing or very recently retired practicing.
Chairman Sarbanes. Can I invite you to get into the issue
of whether substantial means majority or minority?
Mr. Seidler. Well, I would think it would be minority
because I can see three groups represented. First would be
public people. There would have to be people with an overview,
I think. Second, I would like to see the financial community
represented. And third, the professional accountants, depending
on the number that one had and, possibly, at least one member
from industry.
Industry has exhibited a great self-interest in the
standards----
Senator Gramm. What do you mean by industry?
Mr. Seidler. Representatives like a CFO from a major
company.
Senator Gramm. Okay.
Mr. Seidler. Industry has been showing its self-interest.
Nevertheless, the preparer community has to have some say over
the structure. So, no, I do not see a majority of practicing
professionals, but I see a significant minority.
Mr. O'Malley. I would agree with that, Senator. I think
history shows us that the failure of the self-regulatory model
that we have identified in our panel's report suggests that the
tilt toward public interest ought to be weighed, if it is 4-3
or something like that.
I do think you need some very knowledgeable, practicing
public accountants who are very much involved in the process
because I would fear that if you had too much, if you had a 6-3
or something like that, you could potentially lose sight of
what the real issues are to these people out in the field, and
that is very important. But at the same time, I am saying,
whatever the body is, whether it is created by legislation or
by regulation, it ought to have that tilt toward the public
interest, for appearance, as much as for the importance of
operating it.
Senator Gramm. You could have a majority that are
accountants, but require a super-majority to act. I mean there
are a lot of ways that you could do it.
Mr. O'Malley. True.
Mr. Wyatt. Yes, Senator. I share the concern. I think that
we are dealing with a highly technical subject and we need as
participants on the board those people who are most expert in
dealing with the issues and have a background of having dealt
with them. So, I probably would favor a slight majority from
the practicing profession, but I could live with a strong
minority.
The challenge would be to get people who do not have such
expertise to agree to involve themselves in an activity which
they had not prepared themselves for in their careers. Getting
good people under those circumstances is a challenge.
Senator Gramm. Would you all see this as a full-time board?
Mr. Wyatt. You bet.
Senator Gramm. So, you would want it to be highly
compensated and this would be their only source of income?
Mr. Seidler. No, I would demur from that. I am not certain
that it should be a full-time board. The FASB are full-time
people and they have been divorced from practice and I think
that has shown up. I could see a board which functioned to a
great extent as a board of directors with a staff under them. I
would like to permit practicing technical partners from
accounting firms to serve while they are still practicing in
their firms.
Mr. Briloff. Senator Gramm----
Senator Gramm. Grab that microphone, if you will,
Professor.
Mr. Briloff. The question that you ask--forgive me--is what
I sometimes refer to as a plumbing problem. Let's first try to
think in terms of the overall architecture and if we move
consistent with what Mr. O'Malley or Professor Longstreth might
have suggested, Professor Wyatt, and think in terms of creating
an SRO, I believe that then the personnel and the functioning
would fall into place very, very effectively.
The only single standard I would urge, separated absolutely
in funding and operationally from the American Institute of
Certified Public Accountants because it has become a trade or
industry association. It is not any longer a professional
organization.
Senator Gramm. Thank you, Mr. Chairman.
Chairman Sarbanes. First, let me say by way of preface to a
line of questioning that I want to develop, I feel very
strongly, and have for quite a long time, almost since I came
to Congress, that the SEC is not given sufficient resources to
meet its responsibilities.
We constantly brag about the integrity of the American
securities capital markets, how important that is to the
functioning of our economic system, that they are the best in
the world--and I still believe they are. But the SEC plays an
important role in making that possible. Its workload has just
grown at a geometric progression. Its staff resources hardly
match that.
We passed a package last year that was pressed very hard by
industry to reduce trading fees because it was said that they
were bringing in a lot more money than the SEC budget, which
was the initial rationale for it. We linked that with providing
pay parity to SEC employees with the other Government
regulators, not pay parity with the private sector, which still
remains a difficult problem. But in any event, pay parity with
the Government sector.
I think all of us here when we passed that bill, assumed
that it would go into place as a package. Well, lo and behold,
the fee reduction went into place, but the budget submission
from the Administration did not implement pay parity.
The SEC currently has a significant number of unfilled
positions because of the budget shortfall. Most people have
testified that they think they should have additional personnel
over and above what they now have, so that you really do need a
significant infusion. Their budget is $460 million--that is the
request this year, roughly speaking, for all of the SEC's
functions.
So, I have been in touch with the Administration. I have
just written to the President again, urging him to send a
supplemental request to the Congress because, obviously, and I
want to move to this in a moment, we are probing what structure
we have, what systemic and structural changes we should make to
significantly lessen the risks of these things occurring again.
But while that process is developing, it seems clear to me that
immediately, additional resources to the SEC would enable it to
move ahead and exercise the authorities it now has in order to
meet its responsibilities. We continue to press for that. I
take it all the panelists agree with the observation that we do
need to provide an additional infusion of resources into the
SEC to meet its responsibilities. Is there anyone who would
dissent from that?
[No response.]
Fine. Thank you very much.
Now let me explore the possible structure. Some of these
will be advanced as a devil's advocate. I just want to explore
the possibilities. One possibility I guess would be to say,
well, the SEC is going to do it all. This would be a major
expansion--not what I am talking about here in terms of the
budget request I am putting to the Administration. But this
would have to be a very significant expansion in personnel and
budget and the SEC then would, in effect, set the standards,
monitor the standards, really be at the top and carry it on
through.
Now the magnitude of this and what it involves may be to
some extent illustrated by the testimony we had from Bob
Glauber just yesterday, the Chairman and Chief Executive
Officer of the NASD, and I want to quote it for a minute:
The National Association of Securities Dealers is not a
trade association, but, rather, the world's largest self-
regulatory organization, or SRO. Under Federal law, every one
of the roughly 5,500 brokerage firms, nearly 90,000 branch
offices, and almost 700,000 registered representatives in the
U.S. securities industry come under our jurisdiction. To give
you a sense of our scope and authority, it is vital to know
that every brokerage firm in the United States that does
business with the public must by law be a member of NASD. We
have a staff of over 2,000 employees in Washington, Rockville,
and district offices across the country and an annual budget
exceeding $400 million.
For more than six decades, our mission and our mandate from
Congress has been clear: To bring integrity to the markets and
confidence to investors. We do this by licensing and setting
qualification standards for industry participants, maintaining
a massive registration database that includes qualification and
disciplinary histories of all brokers and firms, writing rules
to govern the conduct of brokerage firms and their employees,
providing investor education and outreach, educating our
members on legal and on ethical standards, examining them for
compliance with the Federal securities laws and NASD and
Federal rules, investigating infractions, and disciplining
those who fail to comply. And, of course, violations may result
in significant fines or even expulsion from the securities
industry.
What is your perception of the idea that we should just
have the SEC do it? No one has suggested that here. I just want
to get some benchmarks.
Mr. Longstreth. I think that is a completely acceptable
alternative. I really do not know whether it is preferable to
an SRO for the audit profession.
The truth is that if you go back to the creation of the
first SRO, which James Landis, I think, was responsible for as
Chair of the SEC, it was the New York Stock Exchange. And as
Joel Seligman's book thoroughly and persuasively points out,
the New York Stock Exchange, on all issues of fundamental
economic importance to its members, beat back reform efforts by
the SEC for decades.
The most critical issue was fixed commission rates. The SEC
only acted in the face of imminent legislative action to force
it to act on May Day of 1975.
So the record was not good from 1933 to 1975 on major
economic issues. And it remained very bad with the NASD on the
major economic issue right up until the present because
billions of dollars of investors' money was lost because there
was basically some price-fixing going on which the NASD
ignored. That led to the reforms that Senator Rudman led and
which made things better. But the record is not great for SRO's
in regard to major economic things.
Now what is a ``major economic thing'' for the audit
profession? Well, it could be nonaudit services. That is why I
emphasize the importance of the leadership and the way in which
the leadership is appointed, to make sure that they really are
there on the SRO Board to represent the public interest.
I think having the SEC do it is a viable alternative and
one that ought to really work on the question of why isn't that
approval a good idea? Maybe you will be led to conclude it is
not or that there is a better idea, which is a well-established
SRO. That is my view.
Chairman Sarbanes. Mr. Seidler.
Mr. Seidler. I do not think it would be a good idea. I
think that the SEC has demonstrated over most of its lifetime
the ability to essentially guide and direct--not always
perfectly, sometimes quite imperfectly--the various bodies
under its jurisdiction.
With respect to accounting, there hasn't been an SRO, as a
practical matter. The SEC's input, frequently by direction,
frequently by indirection, has pushed the various accounting
standard setting bodies in the direction that the Commission
wanted to move. I think the Commission has enough problems in
getting resources and I greatly doubt that, given enough
resources, it would suddenly undertake for its first time a
production function, which is what this would be.
So, I would much prefer to take a model, and I guess that
is because I have always tried to copy something that works
reasonably well, take a model that does work reasonably well,
and that is an SRO under the direction of the SEC.
Chairman Sarbanes. Right.
Mr. O'Malley.
Mr. O'Malley. My own sense is they ultimately are
responsible anyway. The SEC will be over any SRO or any other
organization that is set up to respond to these concerns. My
own sense is that I would talk to them first and see whether
they can feel they can do it best this way or with an SRO. I
don't have any particular preference. I just want to make sure
that all the issues--whether it is discipline, standard
setting--all of these issues get somehow covered by an
oversight body, whether it is created by SRO or created under
the SEC, with continued Congressional oversight of the SEC,
would be acceptable to me.
As long as we get these subjects taken care of in the
group, I do not care how it is constructed, to be honest with
you, Senator.
Chairman Sarbanes. Right.
Mr. Wyatt.
Mr. Wyatt. I think I would prefer to have the standard
setting be independent and everything else be under the aegis
of the SEC.
The FASB and the SEC work together very, very closely
currently and I would see them continuing to do so. But I think
that having an independent body removes to some extent the
political influence, and I think that is important.
Chairman Sarbanes. Professor Briloff.
Mr. Briloff. I would not want to have the responsibility
that we are here talking about directly under the SEC. The SEC
is the over-arching body for the administration of the nexus of
securities laws, not only the 1933 and 1934 Acts.
I would look to the SEC as possibly saying to the
accounting profession, under the FCPA 1977 Act, you are
required to implement the internal control procedures. Under
the 1995 Act, you are required to do that even more fully. Go
out and do it.
I would look to the SRO for that registry and the
disciplinary process that we have been talking about, with the
SEC there as the others have indicated, as the over-arching
body, just to see that all of these bodies are functioning
optimally.
Chairman Sarbanes. All right. That is at one end of the
spectrum. Now at the other end, we have had this system of
voluntary effort, which I think everyone indicates has
obviously had significant deficiencies in it. It really is
falling short.
I am struck by the quality of the reports by the various
commissions, yours, Mr. O'Malley, and much earlier, the Cohen
Commission. And yet, our inability to implement or put into
place most of the recommendations.
We get a problem and we do a commission, we do a very good
study, we get very able people to draw these conclusions. And
then the recommendations are out there and a few get put into
place. But in terms of instituting some system or structure
that really addresses the problem, we seem to be unable to do
that.
Mr. O'Malley. Senator, we were very aware of that problem
and I think attendant to it. We thought that if the POB, which
was our proposal, was so strengthened and empowered to carry
out this mission, that one of the things that we would require
them to do, was to regularly report on whether these
recommendations had been implemented, and if not, why not, and
to publicize that information in our annual report, so that the
public, the Congress, and everybody would know exactly whether
or not the profession was responding to these proposals.
That had been agreed upon. And I am not sure that was in
the charter, but the POB agreed that was an appropriate way to
go. They would oversee whether these recommendations were being
implemented and report publicly on the status of that.
Chairman Sarbanes. First of all, I take it that you all
think it would need to be done by statute and not by regulation
by the SEC. Is that correct?
Mr. O'Malley. I am neutral, Senator. I do not know which
would be better. If the SEC can do the job, as far as I am
concerned, that is fine. If an SRO can somehow do it better,
that is fine.
Chairman Sarbanes. Of course, they have been unable to do
it up to this point. That is one of the problems, I think.
Mr. Wyatt made the point that, and I think it is a very
well taken point, that you had Members of Congress who had
intervened with FASB as they were prepared to do some standard.
I would just make the observation that that wasn't a
spontaneous intervention. It is not as though Members of
Congress sit around and try to keep tabs on what FASB is doing
and then decide that they want to intervene. They are
intervening because they are hearing from elements of the
industry who are resistant to what FASB is thinking of doing.
And the same thing with the SEC.
Levitt was thinking of instituting certain things, and then
there was a big outcry about that, both from the industry and
from the Congress. But the Congress was really, at least those
who moved ahead, were reflecting what they were hearing from
the industry.
So it seems to me that we have to get a change in attitude
at the top within the accounting profession in terms of where
their responsibilities lie. One of the challenges is, how do we
achieve that?
Mr. Seidler. Could I comment on that?
Chairman Sarbanes. Let me just say one thing about the NASD
because I want to come back and ask you to what extent you
think they have done a good job and should constitute some
example or benchmark that we should look to as we think about
this problem.
Mr. Glauber, in his testimony, said:
On average, the NASD files more than 1,000 new disciplinary
actions annually, with sanctions ranging from censures to fines
and suspensions to expulsions from the securities industry. We
supplement our enforcement efforts with referrals to criminal
authorities and the SEC. In one important settlement alone this
year, reached jointly with the SEC, the NASD, and the SEC each
imposed sanctions of $50 million against a major investment
bank for violating SRO rules by extracting illegal paybacks
from favored customers to whom it allocated ``hot'' IPO's.
Is the NASD a model to which we should pay some attention
as we address the issues that we are confronting here?
If I could get quick answers from everyone.
Mr. Longstreth. Yes, I think it is. It is a model which has
been vastly improved through the Rudman recommendations and
changes. NASD Regulation now, I think, is much better
structured to represent the investor interest as opposed to the
interest of the brokerage community.
But just to answer the earlier question which is relevant
to this question, I do not think the SEC has the power to
create the kind of SRO that you would want to create to assure
effectiveness. Maybe I am wrong about that, but I do not think
it does.
Of course, you could empower it. And I would think if you
are going to have an SRO, one way to do it is to tell the SEC
largely what to do, and the other is to empower them to do it
in their own best judgment, with some broad principles.
I do think that the NASD is vastly improved. But any SRO
serving the fundamental economic interest of its members is
going to have a struggle between that self-interest and the
public interest. However, as long as one recognizes that and
works against it through publicity, transparency, and so on, it
seems to me that an SRO can be an effective tool.
Chairman Sarbanes. Mr. Seidler.
Mr. Seidler. I think Mr. Wyatt referred to the impact
perhaps of greed on the accounting profession, going into too
much consulting. I worked on Wall Street for a large part of my
career. The greed in the accounting profession, by comparison
to the greed on Wall Street, looks like Little Red Riding Hood.
The NASD has dealt with a group of people who are intent on
making a great deal of money and overall, has done a very good
job of controlling that.
If you see the size of the problem, the number of people
they have dealt with, they have, I think, done quite an
effective job with a very, very difficult problem.
I was in charge of Bear Stearns internal audit department
for some time and also sat on the operating committee, and
therefore, saw the interface with the NASD. Was it perfect? No.
Did they always control this perfectly? Probably not. But they
did constantly cause us to change, to operate, to see what they
were doing, and to respond.
In general, I felt that this model was quite effective and
I would see it applying, in some sense, easier to apply it to
the accountants than it would be to a bunch of my partners in
Bear Stearns.
Chairman Sarbanes. Mr. O'Malley.
Mr. O'Malley. Senator, you mentioned discipline and I think
that was one of the keys in our report, the total lack of
discipline in the existing organization of the profession.
I do not know what the best answer is for making sure that
there is discipline and that the justice is swifter than it had
been in the 8 or 9 years that it takes today.
But I think, if I can just say, on accounting standards, we
think that should be essentially an independent body, but with
oversight by this new body, whatever the organization is. And
the same thing with auditing standards. That should be put
together by experts that are relatively independent. This
oversight group would be appointing the chairman, approving
other appointments, and overseeing in the sense that they would
be telling them you are not moving fast enough or addressing
this problem. But those two standard setting bodies should be
relatively independent in setting the standards, but with
oversight from this body. The key for this body is going to be
the discipline because that to me brings back my favorite
subject, and that is improving audit quality.
If you put some teeth in the discipline, I think it is
going to help overall in the improvement of audit quality.
Chairman Sarbanes. Well, who is doing the monitoring of the
standards under your scenario?
Mr. O'Malley. Monitoring would be this group. But the
standard setting itself would not be done by this group.
Chairman Sarbanes. Does everyone agree with that or can you
bring the standard setting into the group as well?
Mr. Seidler. We have, for example, NASDR under the NASD. I
would see the SEC practice section perhaps being like NASDR.
I would see the FASV as another subsidiary of this board.
The auditing standard setting as yet another subsidiary, each
one developing its own standards but under the direction,
selection of leadership, control----
Chairman Sarbanes. Monitoring.
Mr. Seidler. Monitoring--of the overall board.
Chairman Sarbanes. So the overall board would have under it
the sub-boards or sub-groups that established the standards and
also, whatever group did the monitoring of the standards and
the disciplining. Is that correct?
Mr. Seidler. That is correct.
Chairman Sarbanes. All right.
Mr. Wyatt.
Mr. Wyatt. Yes.
Chairman Sarbanes. Why don't you speak now and then we will
come back to Professor Briloff. I know he has something to
offer to this discussion.
Mr. Wyatt. Let me start by saying, I am not as familiar
with the NASD as obviously the fellow on my right is. But a
structure that would permit the expertise needed to set
accounting standards and auditing standards to function
properly, the failure we have had, I believe, is more in the
area of disciplinary action.
The AICPA disciplines, I do not know, hundreds, maybe
thousands, of practicing accountants every year, but they are
single practitioners. They haven't done anything with the
bigger firms, I suspect, partly at the risk of losing the
revenue from all of the members of those firms who are members
of the institute. I don't know, but that is my perception. That
has to change.
Chairman Sarbanes. Professor Briloff.
Mr. Briloff. The only comment I want to make is that I
would like to have the standards themselves left to those
within the profession. I believe that is part of their
professional undertaking. However, this SRO would act as a
mandate under the Congress or the SEC to make certain that the
profession has, in fact, fulfilled the responsibilities vested
in it, whether by the Congress or by some mandate from the SEC.
What I am driving at here is, as I indicated earlier, and
forgive me for repeating, we have the Foreign Corrupt Practices
Act and Title III of the 1995 Act, which the profession has
blithely essentially ignored. If there were an SRO, it would
direct the profession to take cognizance of it and to then make
certain that the profession is responding meaningfully and
effectively to what the legislation anticipated.
Chairman Sarbanes. Now, I am struck by the fact that under
the current arrangements, the standard setting bodies, both
FASB and the international, because we do have this
international dimension now developing, and I think we need to
keep an eye on that. But they are funded by basically going
around with a tin cup. So, you go to the very people who are
going to be most intimately affected by the standards. You ask
them for money to support the operation, and if they do not
like what they think the standard
setting body is going to do, they are obviously either
unwilling or reluctant to give money.
It was dramatized when Volcker was soliciting a number of
the largest corporations to give contributions for the
International Accounting Standards Foundation, to fund that
work. And amongst the companies that was on the list that was
solicited was Enron. Then, internally, within Enron--Paul
Volcker knew nothing about this. They were passing memos back
and forth trying to decide whether to make a contribution. And
the big question was, what kind of influence could this get
them in whatever standards were going to be set.
What are your views on how we should fund this SRO, so you
are not dependent upon the voluntary contribution of the people
in the industry that are being affected, either by the
standards or by the monitoring or disciplinary action?
Mr. Longstreth. The NASD's $400 million budget is paid, I
believe, through members--the catch is that everybody who hangs
out a shingle as a broker-dealer or registered representative,
has to be a member.
Chairman Sarbanes. And they have to pay a fee.
Mr. Longstreth. They have to pay a fee.
Chairman Sarbanes. Right.
Mr. Longstreth. I guess that adds up --you said $400
million--almost as much as the SEC.
Chairman Sarbanes. Right.
Mr. Seidler. I would see every company's securities that
are publicly-traded having to pay a certain amount and every
auditor or auditing firm that was registered to audit such
companies also paying a mandated fee.
Mr. O'Malley. Something like that, some kind of a fee
structure.
At present, the FASB is funded--each of the major
accounting firms contribute something like a million dollars to
the FASB, and then industry essentially makes up the rest of
the FASB's budget.
So in the final analysis, it is going to be the companies
that are registered that are going to pay the cost, whether it
is through fees or through indirectly the charges they pay to
the auditing firms.
Chairman Sarbanes. Yes.
Mr. Wyatt.
Mr. Wyatt. I would disagree with my colleague. The FASB's
budget, the last I saw, was approximately two-thirds from the
sale of publications.
Chairman Sarbanes. Right.
Mr. Wyatt. And one-third from these contributions from
accounting firms and industry.
Chairman Sarbanes. Of course, the International Standards
Board, the Europeans have indicated, the EU, that by 2005, they
expect to adopt the standards of the International Accounting
Standards as their accounting standards in the EU countries,
which I regard as a significant development because this is a
very significant economic actor, the EU community. Its economy
combined is almost equivalent to the United States. When they
do that, they won't be able to charge for materials because the
EU is taking the position that the materials--since these are
requirements that you have to meet, you ought to get the
materials without paying for them, in order to abide by them.
Mr. Wyatt. Different mindset over there.
Chairman Sarbanes. Yes.
Mr. Wyatt. I think that the defect in the FASB structure
currently is that the trustees fundamentally are
representatives of the groups that are paying in the money. The
trustees of the foundation should not be representatives of
those organizations, but should be people from the public who
have independent interest. I think that is where part of the
problem with the FASB has rested.
Chairman Sarbanes. Professor Briloff, did you want to add
anything to this point?
Mr. Briloff. Very little at this point. Any one of these
funding mechanisms would work, either charging for those who
are registered, the registrants, or the firms.
Again, forgive my applying that notion of ``a plumbing
problem.'' I want to resolve the matters in principle, spelled
with an ``l-e,'' and everything else will fall into place.
Chairman Sarbanes. Yes.
Mr. Seidler.
Mr. Seidler. Mr. Chairman, if I could add one caveat.
There are many smaller public accounting firms that have
several public companies whose securities are traded. Their
main practice is private, but they have a few.
In recent years, with the increasing problems of dealing
with new pronouncements and so on, there has been a tendency
for them to drop that business, to find that it is just too
difficult to handle. I would hate to see those smaller
accounting firms stifled by a new structure.
So to the extent that it is possible, it would be useful to
keep the structure, particularly fees, in such a way as to not
force out this body of smaller accounting firms. Some of them
are very excellent in specialties, sometimes better than the
major firms.
Chairman Sarbanes. Well, that is an interesting point. We
will have to wrestle with it. But it seems to me that there is
a significant break between accounting firms that take on
publicly-listed companies because the nature of their
responsibilities at that point, very significant dimensions are
added to it, as opposed to just handling private companies. In
fact, we had a discussion in here yesterday with a panel about
that very subject.
The American Institute of Certified Public Accountants is
putting out an alert now to all their key people about the
terrible things that may happen here in the Congress as we
wrestle with this problem and how they have to start contacting
their Representatives and their Senators to begin to build a
groundswell in the other direction.
One of the points they make is that the very small
accounting firms with private clients are going to be impacted
by all of this. Of course, the level at which we are thinking
has this kind of differentiation point between private and
public. But once you start representing companies that are
listed on the exchanges, which then gets you into questions of
the integrity of the capital markets and the reliability of the
information, and all the rest of that flows from that, it seems
to me that you are dealing in a different realm.
Now, we will have to look at that. The danger, I think, is
any exception becomes the loophole that is then exploited and
is broadened and widened, you see. And all of a sudden, you
have undercut what you are trying to do. But I think it is a
reasonable point and it is one we will have to consider.
I think then we will draw it to a close.
Everyone seems now to agree that at least some of the
consulting activities that accounting firms are doing, while
also doing auditing, ought not to be done. Now some take the
position that they should not do any of those activities at
all. Professor Briloff has held that position today. Others
have held it before the Committee in the course of our
hearings. Others say, well, certain things should be precluded,
but not everything. And then the question is, how do you define
that?
In the Superior Bank failure in Chicago, which this
Committee has been looking at, the accounting firm established
the internal financial process of the company, of the bank, by
which they would value residuals. Then in the auditing
function, approve the company's valuation of the residuals
developed by their process. Now, of course, it turned out they
were grossly overvalued and it was one of the reasons why the
bank collapsed and it is now going to cost the insurance fund
probably somewhere around $500 million. Who should draw this
line in the structure we are talking about?
Mr. O'Malley. Senator, could I respond to that?
I think, and this is a little historic, the SEC, working
with the profession, set up the Independent Standards Board.
And that Board, Chaired by William Allen, who was a former head
of the Delaware Chancery Court, set up a structure for
resolving independence issues. They listed what the basic
principles of independence were. They listed all the threats to
independence, and they set up a system for evaluating and
addressing the threats and then taking some services and
saying, they clearly should be off the table, others should
not.
The basic principle is that you shouldn't be self-auditing.
You shouldn't be able to audit your own work. And that would
address the issue you raised in the Superior Bank situation.
The other is that you cannot be part of management. You
cannot replace management or then you clearly are not
independent both in form or in appearance or in substance.
So the SEC, when it announced its rulemaking initiative,
essentially ended the life of the Independent Standards Board,
which it had set up just 2 years before. And this group did a
lot of valuable work. I said in my written statement, I would
hope, however we resolve this issue, that the principles they
set up, which were a clear and positive guide for regulating
independence, be utilized by the new body going forward and
making these decisions.
And I would emphasize, I do not think we ought to have
legislation that says you can do this service and you cannot do
that service. This body should make those decisions and they
should do it based on a sound conceptual framework.
Chairman Sarbanes. Should you have legislation that didn't
try to set the specific line, but try to provide some broader
guidance to where they might go?
Mr. O'Malley. That would be totally acceptable to me. If we
had a conceptual framework that said you cannot audit yourself,
you cannot be part of management, that addresses any threat.
Chairman Sarbanes. A general statement.
Mr. O'Malley. Yes, exactly.
Chairman Sarbanes. But then to be developed out.
Mr. O'Malley. Exactly. That would be my approach.
Mr. Longstreth. I would agree with that.
Chairman Sarbanes. Okay. Yes.
Mr. Longstreth. Shaun and I have talked a lot about this
subject together. I just want to add one comment to what he
said, most of which I agree with.
I think I have read all of the ISB stuff. The big hole in
the SEC rule which I described, namely, that it fails to
acknowledge that large, nonaudit fees, for whatever kind of
nonaudit services might be involved, can have an impact on
independence.
But the SEC did not say so and neither, as far as the ISB
got, did the ISB. I do not think there is any recognition there
of that fundamental, common sense observation. The point at
which large amounts of money are paid to you for services that
management could send elsewhere, could retain other people put
at risk for one's professional reputation, which can be
subordinated to the amount of fees being paid and the annuity
that those fees can represent.
The prospect of fees, in the case of Enron, who paid
Andersen $27 million in 2001. So $27 million this year. But you
can look forward to that kind of payment far into the future.
That is a principle I would add to the two very important
principles that Shaun mentioned as being developed by the ISB.
Mr. O'Malley. I would only add to that point that, to me,
it doesn't matter what service you are being paid for. If you
are being paid--whether it is auditing or another service--
there is an inherent conflict in the relationship to begin
with. If you are being paid $20 million to do an audit and you
are going to be doing the audit for some years, it is no
different than if you are being paid another $5 million for
another service.
To me, the inherent conflict is there. I think it is up to
the structure of this oversight board to make sure that the
audit committees are deeply involved in any nonaudit service
decisions, as long as we have eliminated self-auditing and
acting as management.
Chairman Sarbanes. But this could be a handy benchmark. If
the nonaudit services, in terms of recompense, dwarf or
overwhelm the audit service, even if they are for services that
we generally have said, do not create your problem, they are
okay services. But somehow, the size and the magnitude of them
grows to the point that the recompense dwarfs the other, then
you may have created a problem. Perhaps some kind of percentage
test or something at least avoids that more extreme or
egregious situation.
Mr. O'Malley. I agree. I saw the one case that was cited. I
do not know what the company was, where the auditors were paid
$3 million for the audit and $60 some million. And to me, I
would imagine that would be eliminated by this agreement not to
do major financial systems design and implementation. That is
where the big dollars are. They have taken that off the table
entirely. But I agree with you. In that instance, if I were on
the audit committee, I would be saying, wait, wait a minute on
this. Let's see if we can get some other proposals.
Chairman Sarbanes. Let me ask you about auditor rotation,
if I could, or term-limited auditors, or however you want to
describe it. Actually, we have received some interesting
testimony, including from former chairmen of the SEC who have
really advanced the 5 or 7 year rotation for auditors. I would
just be interested to get your quick reactions to that.
Mr. Seidler. The Cohen Commission examined it and concluded
considering economic and noneconomic costs and benefits, that
the costs were greater than the benefits and said not to have
rotation. On the other hand--that was 25 years ago. That was 25
years before audit fees grew and before we had some cases that
we had recently where we see the influence of the fee and the
influence of a simple question--would you like to be the audit
partner who lost the XYZ audit, getting greater and greater.
The one factor in favor of rotation is, when the auditor
says, no, you cannot do it, and risk giving up the fee, he's
not giving up this year's fee, he's giving up the stream of
future fees. If there were auditor rotation, he would be giving
up a finite stream of future fees, if it were a 5 year or 7
year rotation.
I was silent on it because I could not come to a
conclusion. But there is no question that if we did have
rotation, that evil would be cut tremendously. On the other
hand, changing auditors involves a lot of other evils, one of
them being, as we discovered, most frauds occur in the early
years of the audit. It does take a while to learn about the
business. So it is almost a toss-up.
Mr. O'Malley. I would say, I am 6 years out of doing
audits, but I am still opposed to auditor rotation, Senator,
and I think for good reason. One of the keys to being a good
auditor and we heard this today, is looking at the whole
business, understanding the whole business, the culture, the
systems, the people, what is going on.
To do that, you have to be in place for a period of time. I
think the way to deal with this, and some companies already do
that, they require the auditors to repropose regularly for the
audit, to submit a proposal to be continued as auditors.
Sometimes that is done in competition with other firms where
they are reproposing and other firms are proposing against
them. I think it is the responsibility of the audit committee
to satisfy itself that you are getting the kind of service that
you need and then deciding whether to go ahead. That decision
to reappoint auditors should be taken very seriously. I think
in my experience on audit committees, it was taken very
seriously. I would be against rotation of auditors.
Mr. Briloff. Mr. Chairman, at one time I was very much
opposed to the rotation of auditors for various reasons. But I
am now very much in favor of it, particularly as we look upon
these audit fiascoes, we all too frequently find the incestuous
relationships that prevail. Namely, members of the auditing
firm becoming CFO's or importantly positioned as management
people within the firm that had been the subject of the audit.
So there is too much of that buddy system. We had it in Enron.
I saw it in the CUC situation in Cendant.
Therefore, I am in favor of the rotation now. And that
brings to mind an observation made by Jack Seidman, one of the
profession's greats, who made it probably 35, 40 years ago, who
referred to the fact that Mrs. Seidman was a most meticulous
housekeeper. But he said, when she expects company to be
coming, she is especially so. The house is even more
effectively kept.
[Laughter.]
So it is that if a firm expects that they will be
superceded 2 or 3 years down the line, they try as much as they
can to make sure that they are leaving with a clean slate.
Chairman Sarbanes. Thank you.
Mr. Longstreth. I would like to second the point that was
just made. One way of thinking about it is that the centerpiece
of such self-regulation as has existed has been the peer
review, where one of the Big 5 reviews another Big 5's audit.
That has not been thought of as a great success in the
sense that there has never been much of a problem found. That
is because what goes around comes around. There are only five
firms and it is not likely that, unless something terribly bad
is found, that they are going to slam their colleagues.
So the most effective peer review we could have would be a
peer review that results basically from a new auditor coming in
through rotation with the old auditor having a sure knowledge
that a new auditor is coming in. I think the balance that Dr.
Seidler put on this on the pros and cons leading him, I guess,
to not making a clear decision in his own mind at this point is
where I am, too.
I think there are some powerful arguments to consider this
now, given the growing risks that we face through nonaudit
services. It is one possible solution anyway, to the problem of
trying to limit nonaudit services that ought not to be limited
because there is so much synergy involved in using the auditor.
It deserves a lot of close study, but I am not in a
position to come out one way or the other at this point.
Chairman Sarbanes. Well, this has been an enormously
helpful panel and we appreciate it very much.
This hearing stands adjourned.
[Whereupon, at 12:35 p.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF SHAUN F. O'MALLEY
Chairman, 2000 Public Oversight Board Panel on
Audit Effectiveness (O'Malley Commission)
Former Chairman, Price Waterhouse
Past President, Financial Accounting Foundation
March 6, 2002
Thank you for inviting me to testify before the Committee about the
important decisions facing the accounting profession, its regulators,
and the Congress.
I am Shaun O'Malley. I spent 36 years working in the accounting
profession, the last 7 of those as Chairman of Price Waterhouse until
my retirement in 1995. Since that time, I have served on various
corporate and nonprofit boards and audit committees. In 1998, I was
asked to serve as Chairman of the Panel on Audit Effectiveness, which
was appointed by the Public Oversight Board (POB) at the request of the
Securities and Exchange Commission. The Panel was asked to conduct a
comprehensive review and evaluation of the way independent audits are
conducted and to assess the effects of recent trends in auditing on the
public interest.
The Panel was formed in the wake of a number of high profile
restatements, which were followed by massive declines in market values
of the companies involved. Concerns were raised at that time about the
overall reliability of financial statements and, in particular, about
the role of auditors. On August 31, 2000, the Panel issued a report in
which we made a number of significant recommendations aimed at
improving audit quality.\1\ I will address what I believe to be the
Panel's key recommendations later in my statement.
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\1\ The Panel on Audit Effectiveness, Report and Recommendations,
August 31, 2000 (``Report'').
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The Enron debacle has been the catalyst for a reexamination of
current methods of corporate reporting and audit oversight. While my
testimony will focus primarily on the latter, I first want to comment
on the specific issues highlighted by the Enron failure.
Failures in the Corporate Reporting Safety Nets
There exist numerous safety nets in the corporate reporting
process--corporate management, the board of directors and audit
committee, law firms, auditing firms, securities analysts, capital
providers and intermediaries such as commercial and investment banks,
credit rating services, the Financial Accounting Standards Board, and
the Securities and Exchange Commission. Most, if not all, seemed to
have failed in the case of Enron. We need to examine what caused these
shortcomings and decide how to remedy them.
As far as I can tell from Congressional testimony and press
coverage to date, the overriding cause of the Enron failure can best be
identified as ``systems breakdowns.'' Practically every element of our
system of safeguards failed until it was too late to repair the damage.
The list of breakdowns is a long one. It includes:
The apparent willingness of a number of Enron employees to set
aside their responsibilities and to manipulate the numbers, subvert
control systems, and mask the true status of Enron's financial
condition and performance.
The apparent willingness of certain senior management
personnel to promote off balance sheet activities for personal gain
at the expense of the shareholders, employees, and creditors.
The apparent failure of Enron's Board of Directors and of its
audit committee to
understand what was happening inside the company; their
corresponding willingness to accept, without more penetrating
inquiries, management and auditors' assurances that accounts were
properly stated; and their willingness specifically to waive the
company's own ethics rules in order to permit some of the now-
infamous off balance sheet transactions involving company insiders.
The apparent failure of the auditors to detect irregularities
and/or their apparent willingness to support transactions and
related accounting and disclosures that do not stand up to
scrutiny.
The unexplained waiver by the SEC of important disclosure
requirements for Enron on two occasions, and the Commission's
failure to review Enron's financial statements for several years
despite an announced step-up in annual report reviews and despite
Enron's huge growth and its position as one of the top 10 U.S.
companies as measured by revenues.
The failure of the FASB and the SEC to promulgate timely
accounting and disclosure requirements in the face of ever-changing
and increasingly complex business transactions, the growth in the
use of derivatives, and the increased use of off
balance sheet partnerships and special purpose entities.
The apparent affirmation of some of the special entity off
balance sheet transactions by the attorneys retained by Enron's
chairman.
The financial analysts' apparent failure to understand
adequately Enron's business, financial statements, and results,
which led to their recommending the purchase of Enron stock
virtually up to the moment of the company's collapse.
The lenders' apparent failure to gain an accurate picture of
Enron's true financial position and operating results, while
extending large amounts of credit to the company.
The apparent failure of debt rating agencies to understand
Enron's precarious
position until it was too late.
In short, just about every element of our financial system's
safeguards failed for an extended period of time, often until the final
collapse of the company.
In light of this widespread breakdown of our systems of control and
regulation, there is a need to address each element of the system with
the goal of repairing what appears to be broken and strengthening
controls, accountability, and responsibility. I will leave the task of
repairing most of these elements to others and will restrict my
recommendations to issues affecting the accounting profession and its
governance and oversight.
Role of the Accounting Profession
Accurate financial reporting has long been viewed as the bedrock of
strong capital markets. Investor confidence in the reliability of
financial statements lowers the cost of capital and increases the
effectiveness of the capital markets in allocating resources. Enhancing
the effectiveness of audits is key to improving the reliability of
financial statements.
In this regard, the primary goal of the Panel on Audit
Effectiveness, which I chaired, was to thoroughly review, evaluate, and
recommend improvements to the way independent audits are performed and
to assess the effects of recent trends in auditing on the public
interest. The Panel was appointed in the fall of 1998 by the POB at the
request of the SEC. It included retired and active leaders in the audit
profession, two former SEC Commissioners, and a staff of experienced
auditors.\2\ Pursuant to the SEC's charge, the Panel undertook a
detailed study of the effectiveness of audits, the impact of nonaudit
services on auditor independence, and the adequacy of the auditing
profession's current governance system.
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\2\ See September 28, 1998 letter from Lynn Turner, Chief
Accountant of the SEC, to A.A. Sommer, Chairman of the Public Oversight
Board, Report, Exhibit 1.
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Over a period of 2 years, the Panel's investigation encompassed a
wide range of activities. Its principal effort was its Quasi Peer
Reviews, which were in-depth reviews of the quality of 126 audits of
SEC registrants in 28 offices of the eight largest accounting firms. In
addition to the engagement reviews, meetings with two focus groups were
held in most of the 28 offices--one with senior accountants/auditors
and the other with audit managers, most of whom work on audits of
public companies. This process also included in-depth interviews with
the partner-in-charge of the office's audit practice. Panel members
attended most of the Quasi Peer Reviews, and the Panel staff planned
and directed all of them. The Quasi Peer Reviews were a major source of
the Panel's findings and recommendations for improving the conduct of
audits.
The Panel's other activities included:
Focus group meetings with chief financial officers and
controllers, internal auditors, peer reviewers, and representatives
from the eight largest firms.
Regular meetings with the Office of Chief Accountant of the
SEC throughout the Panel's work to report progress.
A survey requesting opinions on issues of audit effectiveness,
distributed to over 500 selected individuals and organizations
representing a very wide range of constituencies.
Public hearings in the early stages of the Panel's work at
which 21 organizations testified, including the SEC, auditors,
financial statement preparers, analysts, plaintiffs' and
defendants' attorneys, standard setters and educators.
Reviews of the eight largest firms' audit methodologies,
policies and procedures, manuals and other guidance materials, risk
management information, professional development activities, and
policies and procedures for recruiting, evaluating, compensating,
and promoting audit personnel.
Meetings with representatives of various private sector bodies
involved in the governance of the profession.
Research, with the assistance of the SEC staff, into the
causes and circumstances that led to recent SEC Accounting and
Auditing Enforcement Releases.
Analysis of academic, professional, and regulatory literature
on the effects of nonaudit services on auditor independence.
Studies of the profession's current governance structure and
analysis of alternatives.
Collection of information on recent international initiatives
to strengthen audit effectiveness on a global basis.
Further public hearings on the May 31, 2000 Exposure Draft of
the Panel's Report and Recommendations at which 18 organizations
testified including the SEC, the auditors, the State boards of
accountancy, professional organizations, standard setters, and
educators.
Analysis of 42 comment letters received on the Exposure Draft.
On August 31, 2000, the Panel issued its findings and
recommendations, copies of which have been provided to each of you in
advance of today's testimony.
The Panel concluded that ``while many specific recommendations . .
. for improvements in the conduct of audits and the governance of the
profession'' are necessary, ``our report demonstrates that both the
profession and the quality of its audits are fundamentally sound.'' \3\
This remains my opinion today, although the aforementioned totality of
breakdowns in the Enron situation underscores the need to accelerate
implementation of many of the Panel's recommendations.
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\3\ Letter from Shaun O'Malley to the POB and Other Interested
Parties, preceding the Report.
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Of the more than 250 pages of its report, the Panel spent three
full chapters discussing a host of recommendations targeted to
furthering audit quality. Let me emphasize that, at the end of the day,
the goal of enhancing audit quality has to be the primary goal of both
private and public sector responses to the problems that Enron and
other recent failures highlight. It is a matter of concern to me that,
in the context of audit reform, so little is being said in the media
about how the various proposed solutions will improve audit quality.
Yet that is the issue upon which we must ultimately focus our attention
if something positive is to come out of these unhappy events.
The recommendations of the Panel, made prior to Enron's collapse,
bear some similarity to many of the proposals discussed in
Congressional hearings over the last 2 months, as well as the proposal
announced by the SEC. In my testimony, I will describe the thrust of
the Panel's recommendations in the context of three themes recurrent in
post-Enron proposals for reform: (1) the need for improved audit
quality; (2) the call for separation of audit and nonaudit functions;
and (3) the proposals for change in the governance of the auditing
profession.
The Need for Improved Audit Quality
Although the Panel found that an overwhelming majority of the 126
audits it studied were of a high caliber, the Panel also found
significant room for improvement in the audit process. Indeed, the
Panel made some 150 specific recommendations toward furthering the
quality and reliability of audits. I do not intend to discuss each of
these recommendations today, many of which pertain to the application
of detailed auditing standards. However, I will discuss a number of
areas in which I believe the Panel's recommendations were most
significant.
New Audit Approach to Detecting Fraud--``Forensic-Type'' Procedures
The Panel found that the risk assessment and response process
called for under existing Generally Accepted Auditing Standards (GAAS)
\4\ ``falls short in effectively deterring fraud or significantly
increasing the likelihood that the auditor will detect material fraud,
largely because it fails to direct the auditing procedures specifically
toward fraud detection.'' \5\ Rather, an auditor's duty is to report
fraud if it is discovered,\6\ but not to search actively for it. Such a
policy reflects the practical limitations on an auditor's ability to
investigate. The enormous cost inherent in uncovering the presence of
fraud is rivalled only by an auditor's lack of the means to do so (that
is, the power to subpoena).
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\4\ Beginning in 1948, the membership of the American Institute of
Certified Public Accountants (AICPA) adopted 10 statements referred to
as ``Generally Accepted Auditing Standards'' or GAAS. The Auditing
Standards Board (ASB), a senior technical committee of the AICPA, has
responsibility for interpreting GAAS through Statements on Auditing
Standards (SAS's). The SAS's and the 10 GAAS statements are referred to
collectively as Generally Accepted Auditing Standards. Report at 2.3.
\5\ Report at 3.46. See SAS 82.
\6\ An auditor also may have a legal obligation to report fraud to
the audit committee and, ultimately, to the Commission under certain
circumstances. See Section 10A, Securities Exchange Act of 1934, 15
U.S.C. 78j-1.
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The Panel concluded, with respect to the matter of fraud detection,
that a very dramatic shift in auditors' approach to their audits is not
only possible, but also necessary. Thus, the Panel recommended that
GAAS require auditors, in planning and performing certain phases of
their examinations, to suspend the neutrality of their professional
skepticism and presume the possibility of dishonesty at various levels
of management, including the possibility of collusion.\7\ The Panel
further recommended a number of specific forensic measures that should
be taken during any audit, with the principal objective of detecting
material financial statement fraud.\8\ The Panel believed that this new
approach to audits would not only help to discover material fraud
before its effects are felt by the market, but would also more likely
deter fraud from occurring in the first place.
---------------------------------------------------------------------------
\7\ Report at 3.51.
\8\ Id.
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It is important to note that, even in the event that the Panel's
recommendation is adopted, an auditor's ability to investigate fraud
will always be limited. Auditors do not possess the power to subpoena
documents or testimony, nor are auditors trained experts in the
identification of falsified documents. Moreover, clients will not pay
auditors for the enormous labor and resources inherent in even the
simplest SEC-style investigation. That said, it was the opinion of the
Panel that the recommended approach would have a significant impact on
the profession's ability to safeguard our markets from fraud.
In this connection, last week, the Auditing Standards Board issued
an Exposure Draft which would, if adopted, replace the current audit
standard relating to fraud. I am reviewing the proposal to determine
whether it will accomplish what the Panel sought to achieve in its
recommendations in this area.
Adopt Clearer and More Specific Audit Standards
All auditors are required to perform audits in accordance with GAAS
promulgated by the Auditing Standards Board (ASB) of the AICPA. The SEC
historically has accepted GAAS as necessary and sufficient to comply
with the requirements of the securities laws that call for independent
audits of financial statements.
The Panel noted that the guidance given to auditors in the
Statements of Auditing Standards (SAS's) issued by the ASB lacks
imperatives that compel auditors to take definitive steps in specified
circumstances. For example, in some cases an SAS may indicate what an
auditor ``should'' do, while in other cases a SAS might only indicate
what an auditor ``should consider,'' allowing significant latitude for
the exercise of judgment based on the circumstances of the engagement
and on the auditor's assessment of risk and materiality. The Panel
believed that auditing standards must provide both reasonable and
measurable benchmarks for performance by auditors.\9\ Therefore, the
Panel urged the ASB to modify, to amend, or to improve its standards by
making them more specific and definitive.
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\9\ Standards need to be reasonable in that they should not force
auditors to adhere to rules that do not take into account the myriad of
circumstances that may exist on audits. To serve as effective measures
of the quality of performance, however, auditing standards need to
provide clear, concise, and definitive imperatives for auditors to
follow.
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The Panel also noted that the ASB and its staff issue audit
standards and guidance in various, sometimes conflicting forms--that
is, standards, interpretations, audit guides, auditing practice
releases, statements of position--without establishing a hierarchy of
authority to guide in their application.\10\ Without such a hierarchy,
auditors find themselves searching for a rule among competing
guidelines issued by any number of committees and subcommittees. In
response to this problem, the Panel recommended that the ASB define a
hierarchy of GAAS and collect existing guidance in a readily accessible
source.\11\ The ASB has since issued an SAS covering the hierarchy of
GAAS.
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\10\ Report at 2.220-222.
\11\ Report at 2.232.
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Require Auditors to Obtain a Deeper Understanding of the Issuer's
Business
and Related Internal Controls
The Panel recommended that auditing standards ``require auditors to
possess a far deeper understanding of the entity's business processes,
risks, and controls'' than is currently called for under GAAS.\12\ This
is particularly important, given that today's businesses are far more
complex, often technology-based, and global in scope than ever before.
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\12\ Report at 2.26.
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In order to plan and conduct an effective audit, an auditor must
have a full understanding of an issuer's business and internal
controls,\13\ particularly its information systems. An understanding of
the internal controls of an issuer helps an auditor to determine how an
issuer's financial reporting might go awry. The Panel found that,
although auditors generally investigate issuers' internal controls,
auditors do so with neither the necessary depth nor the requisite
specificity of guidance from the ASB. The Panel therefore recommended
that the ASB provide more specific guidance on the required depth of
auditor knowledge and understanding about internal controls, as well as
the nature and extent of testing of controls.\14\ The Panel also
recommended that audit firms ``place a high priority on enhancing the
overall effectiveness of auditors' work on internal controls,
particularly with respect to the depth and substance of their knowledge
about companies' information systems.'' \15\ The Report noted a number
of areas to be addressed by audit firms, including professional
development and the increasing need for auditors to have a higher level
of technology skills and far more effective participation in audits by
information systems specialists.\16\
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\13\ Internal control is ``a process--effected by an entity's board
of directors, management, and other personnel--designed to provide
reasonable assurance regarding the achievement of objectives in the
following categories: (a) reliability of financial reporting, (b)
effectiveness and efficiency of operations, and (c) compliance with
applicable laws and regulations.'' SAS No. 78, cited at Report at 2.50.
Controls that are relevant to an audit are those that pertain to or
impact the entity's preparation of financial statements for external
purposes.
\14\ Report at 2.77.
\15\ Report at 2.78.
\16\ Id.
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Risk Assessments and Designing Substantive Audit Tests
GAAS includes an audit risk model that requires auditors to use
their judgment in assessing risks, selecting an audit approach, and
deciding what tests to perform.\17\ The model allows an auditor to take
a variety of circumstances into account in selecting the audit approach
for a particular engagement, including the auditor's understanding of
the entity's business and industry and the entity's system of internal
controls.\18\
---------------------------------------------------------------------------
\17\ In order to determine the depth of testing necessary for a
particular item on an issuer's financial report, an auditor must first
assess the risk that the item is misstated. For example, complex
transactions are more easily misstated than simple ones; an auditor
will, therefore,
assess a complex transaction to be high risk and test that transaction
more thoroughly than
others.
\18\ Report at 2.7.
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For example, if an issuer's internal control over sales and
accounts receivable is strong, the auditor might confirm only a limited
number of accounts receivable at an interim date and rely in part on
the company's internal controls and certain other tests for updating
the accounts to year-end. Conversely, if a company's internal controls
are not strong, the auditor might confirm a larger number of accounts
receivable and do so at year-end.
The Panel believed that professional standards, guidance, and
practices with respect to assessing inherent risk need to be
strengthened given GAAS's increased emphasis on inherent risk
assessments in determining the nature, timing, and extent of audit
tests. In addition, because the assessment of inherent risk is such a
crucial element of an audit, the Panel recommended that the engagement
partner be involved in making the inherent risk assessment.\19\
Finally, the Panel encouraged audit firms to review their policies and
procedures with respect to linking the risk assessment to the actual
nature, timing, and extent of tests performed during
the audit.
---------------------------------------------------------------------------
\19\ Report at 2.49.
---------------------------------------------------------------------------
Top Management of Accounting Firms Must Emphasize the Importance of
Quality
Audits, Including with Respect to Compensation and Advancement
Decisions
The Panel found that messages from accounting firm management to
audit personnel do not stress often enough the importance of quality
audit work, either in terms of the work's importance to the firm or its
role in protecting the interests of the investing public.\20\ Indeed,
the Panel's focus groups strongly indicated that the audit is commonly
regarded by the audit firm personnel foremost as a commodity, and one
of little value standing alone.\21\ As a result, the Panel recommended
that top management of accounting firms emphasize to all audit
personnel the importance, both to the firm and to the public, of
performing quality audits. According to the Panel, ``[t]he message
should be a positive, constructive message that is refreshed frequently
so it commands attention, rather than becoming a tired slogan that is
ignored.'' \22\
---------------------------------------------------------------------------
\20\ Report at 4.3.
\21\ Report at 4.4.
\22\ Report at 4.5.
---------------------------------------------------------------------------
In addition, audit firms should ingrain ``the importance of the
role and responsibility of audit professionals, as well as the concepts
of integrity and objectivity, independence, professional skepticism and
accountability to the public'' at the earliest stages of an employee's
training.\23\ Furthermore, throughout an employee's tenure, the
performance of quality audits should be applauded and publicized,
especially in situations where auditors take difficult stands on
earnings management issues, issues involving possible fraud, or
contentious accounting issues. In short, the Panel recommended a top-
to-bottom reaffirmation within audit firms of their public duties as
auditors.
---------------------------------------------------------------------------
\23\ Id.
---------------------------------------------------------------------------
Similarly, the Panel also recommended that audit firms ``ensure
that performing high quality audits is appropriately recognized as the
highest priority in performance evaluations and in compensation,
promotion, and retention decisions for all personnel.'' \24\ The Panel
recommended that performance and compensation measures should focus on
such matters as: (1) the depth of understanding of the client's
business, (2) responsiveness to unexpected conditions encountered in an
audit, (3) professional skepticism and persistence, and (4) knowledge
of accounting standards and principles.\25\ By emphasizing quality
audits in compensation and advancement decisions, the Panel reasoned,
the quality of audits will inevitably increase.
---------------------------------------------------------------------------
\24\ Report at 4.21.
\25\ Id.
---------------------------------------------------------------------------
Enhanced Communication with Audit Committees
There are several auditing standards that govern independent
auditors' communications with audit committees. In general, the
standards require that auditors inform audit committees about
significant accounting policies and their application, management
judgments and the process used in formulating particularly sensitive
accounting estimates, significant audit adjustments, disagreements with
management, consultation by management with other accountants, major
issues discussed with management prior to being retained, and
difficulties encountered in performing the audit.\26\ In addition, two
new standards regarding auditor's communications to audit committees
were recently issued. The first requires auditors to communicate
uncorrected misstatements, the effects of which management believes are
immaterial. The second requires auditors to discuss their judgments
about the quality, not just the acceptability, of the entity's
accounting principles and the estimates underlying the financial
statements.\27\
---------------------------------------------------------------------------
\26\ Report at 2.205.
\27\ Report at 2.205.
---------------------------------------------------------------------------
Notwithstanding these requirements, the Panel advocated that
stronger relationships be established between auditors and the boards
of directors and their audit committees that recognize that auditors
are ultimately accountable to the board of directors and the audit
committee as representatives of the shareholders.\28\ The Panel further
recommended the development of explicit mutual expectations of the
board and audit committee, management, and the auditors as an essential
first step in the process of developing a stronger relationship among
these parties.\29\ Finally, the Panel recommended that the auditor and
company management advise the audit committee of the company's plans to
hire any of the audit firm's personnel into high-level positions. On
this last point, I personally believe the audit committee should be
tasked with approving the hiring of any audit firm personnel above a
certain level who worked on the company's audit.
---------------------------------------------------------------------------
\28\ Report at 2.216.
\29\ Id.
---------------------------------------------------------------------------
Auditor Independence/Scope of Services
As the Panel's Report stated, ``Independence is fundamental to the
reliability of auditors' reports. Those reports would not be credible,
and investors and creditors would have little confidence in them, if
auditors were not independent in both fact and appearance.'' \30\ The
Panel noted that the effect of providing nonaudit services on auditor
objectivity has long been an area of concern. We, therefore, focused
specific attention on this issue. A full discussion of auditor
independence is contained in Chapter 5 of the Panel's Report.
---------------------------------------------------------------------------
\30\ Report at 5.1.
---------------------------------------------------------------------------
As an initial matter, let me state that the Panel fully supported
the role of the Independence Standards Board (ISB), a body constituted
by the joint effort of SEC and the accounting profession. The work of
the ISB resulted in a clear definition of auditor independence, a
comprehensive inventory of the potential threats to independence, and a
listing of the ways such threats could be eliminated or satisfactorily
mitigated. Most importantly, out of this work came a methodology for
addressing independence issues based on a conceptual framework, not
simply upon a set of wooden rules.
To the dismay of many in and out of the profession, the ISB was
effectively terminated by the SEC's rulemaking initiative in 2000--the
outcome of which was an essentially pragmatic, but incomplete
resolution, which lacked a conceptual framework for addressing
independence issues. I would very much like to see the restoration of
ISB's conceptual framework and methodology so that emerging
independence issues can be addressed and guidance developed promptly
and consistently.
The SEC's November 2000 rule prohibits the provision of many
nonaudit services to audit clients. However, two important services
were not adequately addressed in the rule. These services constitute a
significant part of the nonaudit services being performed by audit
firms: (1) financial information systems design and implementation, and
(2) internal audit outsourcing. Engagements to design and implement
financial information systems often involve large numbers of
professionals, last 2 to 3 years in duration, and generate substantial
fees. Internal audit outsourcing refers to a company hiring its auditor
for the purpose of conducting an internal audit.
All five major firms now have agreed to the proscription of such
services to audit clients, and the AICPA also has supported that
position with respect to public companies. The net result of the
combined action of the SEC and the elimination of the two services I
have described takes substantial amounts of the so-called
``consulting'' dollars off of the accounting firms' table and greatly
reduces the magnitude of the nonaudit services issue.
In light of concerns that had been raised in prior years regarding
the effects of these types of services on auditor independence, the
Panel on Audit Effectiveness included in its review a study of
engagements relating to issuers who received both audit and nonaudit
related services from the auditing firm. And of the 126 public related
audit engagements studied, the Panel identified 37 engagements in which
services other than audit and tax had been provided.
As stated in the Report, the Panel's reviewers did not identify any
instances in which providing nonaudit services had a negative effect on
audit effectiveness.\31\ To the contrary, the Panel found, ``[O]n
roughly a quarter of such engagements, the reviewers concluded that
such services had a positive impact on the effectiveness of the
audit.'' \32\ The additional knowledge of the company's business and
the skill sets enhanced by the performance of nonaudit services
actually assisted the work of the audit team.
---------------------------------------------------------------------------
\31\ Report at 5.18.
\32\ Id.
---------------------------------------------------------------------------
However, based on an independent survey and public hearings, we
found that many people continue to be concerned ``that the performance
of nonaudit services could impair independence or that there is at
least an appearance of the potential for impairment.'' \33\
---------------------------------------------------------------------------
\33\ Report at 5.20.
---------------------------------------------------------------------------
Thus, the Panel did not reach unanimity with regard to a
recommendation in this area. Rather, the Panel published a statement in
support of an exclusionary ban on nonaudit services to audit clients,
as well as a statement against such a ban.
The Panel did agree on the importance of the independence issue,
and, therefore, made a number of recommendations in furtherance of the
need for close monitoring of proposed nonaudit services. Among these
recommendations, the Panel provided ``guiding principles'' to be
considered by audit committees in contemplating whether to hire the
company's auditor to provide certain nonaudit services.\34\ According
to the SEC's November 2000 rule on independence, the Panel's guiding
principles
``represent a thoughtful and appropriate approach to these issues by
audit committees, and [the SEC] encourage[d] audit committees to
consider the Panel's recommendations.'' \35\
---------------------------------------------------------------------------
\34\ Report at 5.29. The Panel recommended that, in determining the
appropriateness of a particular service, one guiding principle should
be whether the service facilitates the performance of the audit,
improves the client's financial reporting process, or is otherwise in
the public interest. Id.
\35\ 17 CFR 210, at 24.
---------------------------------------------------------------------------
It is my own opinion that the profession's decision to forego
financial information systems design and implementation and internal
audit outsourcing services to audit clients is correct. Despite the
lack of evidence that these services, in fact, erode the independence
of auditors, the evidence is strong that such services are perceived as
a threat to independence. Furthermore, both services should typically
be performed by the management of an issuer, not by its auditors.
With respect to other nonaudit services, I believe the conceptual
framework that was under development by the ISB as the underlying
rationale for independence standards--that the ISB would develop as
necessary--would have provided a meaningful and proper way to
distinguish which services should be allowed and which not. Whether the
ISB's framework were to be applied by one of the audit profession's
self-regulatory organizations or by a regulatory organization yet to be
formed is less important than the need for some type of framework that
will identify independence threats and provide guidance on appropriate
safeguards in areas where acceptable practice is unclear or existing
practice should be improved. Furthermore, it is my opinion that audit
committees should take it upon themselves to review each nonaudit
engagement with the company's auditor pursuant to the ISB's standards
and the guiding principles set forth in the Panel's Report.
However, a rule banning all nonaudit services to audit clients
would throw out the baby with the bath water, while failing to increase
the level of auditor independence. Indeed, in light of the Panel's
findings of the importance of an auditor's knowledge of the company and
the importance of the auditor possessing related information technology
skills, I believe banning all nonaudit services for audit clients could
hinder audit effectiveness.
A Change in Governance of the Audit Profession
The accounting profession's combination of public oversight and
voluntary self-regulation is extensive and overlapping, and yet in
certain respects, insufficient to accomplish the goals of monitoring
the activities of the profession, providing disciplinary action where
appropriate, and establishing ethical standards and rules that will
lead to enhanced public confidence in the profession. A veritable
alphabet soup of organizations provides governance for the profession,
a summary of which appears in Appendix C of the Panel's Report. Yet
despite this extensive network of oversight (and, indeed, in part
because of it), the Panel concluded that the profession's self-
regulatory system suffers from certain limitations, some of which may
be inherent in a voluntary system.\36\
---------------------------------------------------------------------------
\36\ Report at 6.15.
---------------------------------------------------------------------------
Specifically, the Panel found that the current system of
governance: (1) lacks sufficient public representation; (2) suffers
from divergent views among its members on what should be the
profession's priorities; (3) implements a disciplinary system that is
slow and ineffective; (4) lacks efficient communication among its
various entities and with the SEC; and (5) lacks unified leadership and
oversight.\37\
---------------------------------------------------------------------------
\37\ Report at 6.15.
---------------------------------------------------------------------------
In light of these significant shortcomings, the Panel recommended
that there be a strengthened, unifying oversight body to help ensure
the effective working of the governance system. In the Panel's opinion,
the experience and the expertise of the independent POB would serve as
a sound foundation for such an organization. We believed that, pursuant
to a new charter, an expanded POB could aggressively oversee the
profession's standard setting, monitoring, disciplinary, and special
review functions. The POB would, therefore, serve as the oversight body
to whom the SEC, the State boards of accountancy, the auditing
profession, and the public would look for leadership.
Under the Panel's proposal, the POB would have the sole authority
to determine the profession's financial obligations to the POB and the
sole authority to determine its expenditures. The POB would also
approve of the appointment of the chairs of various self-regulatory
bodies (such as the ASB, which would continue to establish auditing
standards) and approve all other appointments to such bodies; evaluate
whether the funding of those bodies is sufficient for them to meet
their mandates; and oversee the evaluation, compensation, hiring, and
promotion of many of the entities' employees. The Panel also
recommended the creation of a coordinating task force, composed of the
chairs of each body within the POB's oversight, that would be
responsible for sharing information related to each body's
activities.\38\
---------------------------------------------------------------------------
\38\ Report at 6.23-25.
---------------------------------------------------------------------------
Although membership of the POB already consists primarily of
nonaccountants, the Panel recommended that members be term-limited and
nominated by a committee comprised of members of public and of private
institutions that are most
concerned with the quality of audits and financial reporting. Members
of these same constituencies would also comprise an advisory council to
advise the POB on issues related to audit quality and financial
reporting matters. And finally, the Panel recommended that the POB be
given the authority to commission special reviews related to
significant professional matters that affect the public's confidence in
the audit profession.
I believe that a strengthened POB would have served the interests
this Committee seeks to protect. Unfortunately, the POB has all but
disbanded. There are, however, many similarities between the Panel's
proposal and those being discussed by the SEC and the Congress. In
theory, I am in favor of the creation of an organization to oversee the
accounting profession, whether it is created by regulation or by
legislation. If carefully structured to ensure effective oversight,
disciplinary proceedings, and rulemaking in an unpoliticized
environment, such an organization could serve the same purpose we had
in mind for an expanded POB.
There are important considerations, however, in structuring a new
entity to carry out these responsibilities:
First, it must be decided whether the new organization will assume
an oversight role similar to that proposed by the Panel, or whether it
will assume some or all of the responsibilities of existing self-
regulatory bodies. With regard to the latter possibility, the Committee
may wish to consider the following:
One advantage in having Congress establish a new organization
to assume the peer review, investigatory, and disciplinary
functions of the profession is that Congress can provide statutory
confidentiality protection for the materials, interviews, and
findings developed as part of the organization's review and/or
disciplinary processes. These processes in the past have been
hampered by distrust and by concerns that the materials developed
were not protected. Providing confidentiality will expedite and
vastly improve the review, investigatory, and disciplinary
processes.
The ASB should remain the appropriate entity for establishing
auditing standards, but I believe that an expanded POB--or if
Congress determines, a new organization--should oversee the ASB's
activities to the extent of appointing its chair and approving
appointments of the remainder of the ASB and regularly evaluating
its performance. This type of oversight could help assure that the
ASB continually reexamines and timely addresses auditing issues
that arise in the review and disciplinary activities conducted by
the new oversight entity.
The proposed new organization should not have the power to
set, or even influence, the issuance of accounting standards. FASB
today is beset with political pressure that directly hampers
efficiency and, in some cases, the substance of the standard
setting process. However, FASB, in my view, remains the right
entity for determining accounting standards. The most important
step Congress can take in improving accounting standards is to
ensure that FASB is adequately funded and free from undue political
influence.
Second, a new organization must remain independent from the
profession, while remaining cognizant of current issues and trends
affecting the profession. Congress or the principal regulator should
determine an appropriate ratio of members from the profession versus
public members. Moreover, the organization's funding should not be, in
fact or appearance, reliant on the profession.
Third, the Congress should work hard to ensure that the oversight
organization is sufficiently staffed and funded to carry out its
sizable mandate. Already, the SEC struggles to keep up with its
oversight responsibilities. If a new organization assumes the review
responsibilities currently undertaken as part of the industry's peer
review system, it will have to do the job that now is done by many
hundreds of experienced employees, managers, and partners assigned by
their firms to conduct peer reviews. It will be extremely difficult, if
not impossible, as well as costly for a new organization to hire,
train, and supply the hundreds of experienced staff that will be
necessary to conduct reviews of the entire public audit profession.
Fourth and finally, I am aware of various efforts at the State
level in the wake of Enron's collapse to provide greater substantive
regulation of auditors. Congress should take steps to ensure that
national accounting firms are subject to a clear and consistent set of
regulations and do not find themselves guided by multiple, potentially
conflicting, sets of rules. Such a system not only would be costly for
accounting firms, but also it might actually create, rather than close,
holes in audit oversight and could harm the efficiency of the capital
markets.
Mandatory Rotation
Let me comment briefly on one recent proposal that I do not
support.
There have been recent suggestions that audit effectiveness would
improve by forcing issuers to change auditors every few years. I
believe such a requirement would undermine audit effectiveness. The
findings of the Panel reinforced the commonly-held understanding that
audit effectiveness increases proportionately with an auditor's
familiarity with an issuer's business, its inherent risk factors, and
its
internal controls. In light of the growing complexity of today's
business operations--in terms of technology, business processes,
financial control procedures, and globalization--such knowledge,
accumulated over time by members of the audit team, is critical to
effective auditing.
The empirical evidence supports this notion. A study conducted by
the AICPA into over 400 cases of alleged audit failure between 1979 and
1991 indicated that the alleged failures occurred almost three times as
often when the auditor was performing his first or his second audit of
the company. And similarly, the 1987 Treadway Commission's review of
fraud-related cases revealed that a ``significant number involved
companies that had recently changed their independent public
accountants. . . .''
I know there have been a number of failures, as well, where the
company's auditors had been on the scene for many years. But logic
simply tells you--and the recommendations of our Panel support this--
that knowledge of and experience with the audit client's business,
internal controls, and culture form the basis for an effective audit. I
firmly believe that mandatory rotation would introduce inefficiencies
and greater costs and, in the end, would diminish, rather than enhance,
audit quality.
Conclusion
Our capital markets are not broken. They may have been bent, but
they are wonderfully resilient and have stood the test of time. I
believe that much can and should be done by the accounting profession
itself to improve audit effectiveness. I also believe that much can and
should be done by other professionals and entities that comprise the
safety nets that combine to build confidence in our capital markets and
protect the investing public. And I believe that the Congress certainly
can play a constructive role in holding the type of hearings that have
been undertaken by this Committee and, if necessary when all of the
facts are gathered, by crafting legislation in the public interest. I
do want to urge caution in whatever legislative proposals are advanced,
because I fear that a hastily crafted package could potentially harm,
rather than help, the cause of audit reform.
I appreciate the opportunity to give you my views, and, going
forward, I will be pleased to assist this committee in whatever manner
would be most helpful.
----------
PREPARED STATEMENT OF LEE J. SEIDLER
Deputy Chairman of the 1978 AICPA
Commission on Auditors' Responsibilities
Managing Director Emeritus, Bear Stearns
March 6, 2002
Mr. Chairman, I thank you for your invitation to participate in
these hearings. I served as the Deputy Chairman of the Commission on
Auditors' Responsibilities, in charge of the day-to-day operations of
the Commission and its staff and, with Douglas Carmichael was the
principal writer and editor of the Commission's Report. And this group
was more commonly known as ``The Cohen Commission'' after its Chairman
Manuel F. Cohen. ``Manny'' unfortunately died in June 1977, shortly
after the Commission \1\ issued its Report of Tentative Conclusions.
Thus, the largely unchanged final Report, Conclusions, and
Recommendations of the Cohen Commission reflects the former SEC
Chairman's lifelong commitment to the public interest and to improving
the functioning of American securities markets.
---------------------------------------------------------------------------
\1\ To avoid confusion in this testimony, I will refer to the
Commission on Auditors' Responsibilities as the ``Commission'' or the
``Cohen Commission'' and to the Securities and Exchange Commission as
the ``SEC.''
---------------------------------------------------------------------------
The Commission was appointed by the American Institute of Certified
Public Accountants (AICPA) to:
Develop conclusions and recommendations regarding the
appropriate responsibilities of independent auditors. It should
consider whether a gap may exist between what the public
expects or needs and what auditors can and should reasonably
expect to accomplish. If such a gap does exist, it needs to be
explored to determine how the disparity can be resolved.\2\
---------------------------------------------------------------------------
\2\ Report, Conclusions, and Recommendations at xi. Hereinafter
``Report.''
The seven-member Commission was drawn from the accounting
profession, industry, financial services and academe. It met monthly
for 66 meeting days between 1974 and 1978. The Commission conducted 26
separate research projects and surveys and held a variety of
conferences and interviews with members of Government, the accounting
and the legal professions in the United States and Canada, stock
exchanges and others. After the Report of Tentative Conclusions was
issued, the members of the Commission and the staff participated in
seminars and made presentations of the Commission's positions to more
than 60 meetings of professional and business organizations. The AICPA
and the State societies of CPA's conducted 123 member forums.
The final Report, Conclusion, and Recommendations, 195 pages and
approximately 100,000 words, was fully and unanimously agreed to by all
the members of the Commission. That there were no dissents was due to
the cordial working relationship between the members, the excellent
work of the highly qualified, conscientious staff and to Manny Cohen's
belief that to be effective we had to be unanimous. We were unanimous,
but not necessarily effective. Most of our important recommendations
were never acted upon.
Although at times the administration of the AICPA disagreed with
many of the conclusions that the Commission was reaching, the
Commission received all the
resources and the full cooperation it required from the AICPA.
Conclusions: The Expectation Gap Exists
The fundamental conclusion of the Commission was summarized as:
The charge suggests the possibility that a gap exists between
the performance of auditors and the expectations of the users
of financial statements. . . . The Commission concludes that
such a gap does exist. However, principal responsibility does
not appear to lie with the users of financial statements.
In general, users appear to have reasonable expectations of
the abilities of auditors and of the assurances they can give.
The burden of narrowing the gap . . . falls primarily on
auditors and other parties.\3\
---------------------------------------------------------------------------
\3\ Report at xii.
If a ``gap'' existed in 1978, it is a chasm in 2001. In a comment
that sadly foreshadowed the current furor generated by disclosures
---------------------------------------------------------------------------
about Enron, the Commission noted:
The public accounting profession has failed to react and
evolve rapidly enough to keep pace with the speed of change in
the American business environment.\4\
---------------------------------------------------------------------------
\4\ Report at xii.
As might be expected, until preparing for this testimony I have not
reread the Commission's Report for many years. I am pleased to say that
in most respects the analyses, conclusions, and recommendations in the
Report remain valid. I believe that had some of our most critical
recommendations been adopted, many of today's issues would not have
arisen.
In the following testimony, I will emphasize those recommendations
of the Commission, still not adopted by authoritative bodies, that
would help close today's chasm and speed the evolution of the
accounting profession. In addition, I will present several of my own
recommendations in areas that were addressed by the Commission, but
which today appear to require stronger medicine than was prescribed by
the Commission in 1978. The passage of a quarter century (and the
difficulty of finding them) has prevented me from reviewing these
recommendations with other Commission members. While here I speak only
for myself, I believe that my fellow Commission members would agree
that changed conditions, the increased complexity of business
transactions and the deterioration of many aspects of the accounting
profession warrant these more stringent measures.
I hope the actions proposed here will receive early consideration
by the Committee. The impacts of Enron, in isolation, while costly to
Enron shareholders and devastating to employees' retirement plans,
would have had no significant effects on markets or the economy.
However, the realization that some other companies use the accounting
techniques employed by Enron has already had a short-term impact on
market volatility. The validity of the financial reporting of many
companies,
supposedly in accord with Generally Accepted Accounting Principles
(GAAP) and audited by independent accountants, is daily questioned by
investors and analysts.
In the 1970's, I was the first brokerage analyst to make a
specialty of dissecting and challenging the financial reporting of
public companies. The then lax accounting rules in franchising, leasing
and revenue recognition provided me with easy targets. Many others
later followed me into that specialty. I suspect that Enron heralds a
revival of ``accounting analysis.'' There is nothing inappropriate
about such scrutiny, indeed, it increases market efficiency. However,
unless investors perceive that effective action is being taken to
remedy these apparently widespread deficiencies and to reduce the
frequency of accounting surprises, confidence in the existence of a
``fair game'' in the market may suffer.
Outline of Proposed Actions
In the following testimony I will suggest a series of actions to be
taken which can be implemented through legislation or regulation. With
the exception of those directly related to the proposed statutory self-
regulatory organization (SRO) and the audit requirement for quarterly
reports, they could also be implemented by existing private
organizations: The Auditing Standards Board of the AICPA, the FASB, or
the Public Oversight Board.
Increase the Budget of the SEC
However, allow me to first present a call to this Committee. The
Securities and Exchange Commission, SEC, has been a critical and
effective force for improvement in financial reporting and in the
overall functioning of American capital markets. Notwithstanding
impression created by the Enron debacle, the United States has the best
and most comprehensive financial reporting in the world. Much, perhaps
most, of the credit for our system must go to the effective work of the
SEC. The proposals I am making will add even more to its
responsibilities. The SEC's budget is miniscule, compared to the rest
of the Federal budget and, more important, to the values in the capital
markets it oversees. I urge the Committee to take action to
significantly increase the SEC's budget to allow it to continue to
protect our capital markets.
My proposals are:
Enact legislation establishing a statutory self-regulatory
organization (SRO) with the NASD as a model and, under the
direction of the SEC, responsible for financial reporting standards
and regulation.
Move the AICPA's standard setting and regulatory operations
out of the Institute and into the new SRO.
Make the Financial Accounting Standards Board an integral
element of the Financial Reporting SRO.
Replace the present peer reviews of accounting firms by
accounting firms with examiners from the SRO staff.
To reduce the potential corrupting influence of consulting
fees, prohibit the performance of nontraditional consulting for
audit clients of public companies.\5\
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\5\ For brevity the term ``public companies'' is used to denote
those entities whose securities are publicly-traded.
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Require Forms 10-Q and published interim financial statements
to be audited as part of a continuing audit process.
Require audit committee approval to hire former auditors.
Require auditors to evaluate the financial statements as a
whole.
Require ``preferable'' rather than ``acceptable'' to be the
standard in the selection and application of accounting principles.
Require companies to record all clearly correct adjusting
entries proposed by auditors, regardless of materiality.
The Commission also addressed significant deficiencies in the
education and professional preparation of independent auditors. In
retrospect, these recommendations, still not implemented, were among
the most important made by the Commission for, as discussed below, in
the quarter century since they were made the accounting profession has
lost a great part of its professionalism. The recommendations are:
Establish graduate professional schools of accounting.
Reduce the schism between academic and practicing accountants.
A Model for Self-Regulation of Financial Reporting
The Cohen Commission studied then current efforts by individual
firms and by professional organizations to establish quality control
policies and procedures to encourage compliance with professional
standards. It concluded:
The Commission believes that the oversight of professional
practice should remain within the profession and that the
concept of individual firms' having responsibility for the
quality of their own practice should be retained.\6\
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\6\ Report at 145.
The Commission recommended a number of further steps, including
peer review. The recommendation for public presentation of peer review
results in a ``long form'' report has been mostly adopted.\7\ Reports
of peer reviews and the related letters of comment are now available on
the Internet but they provide little specific detail. For example, when
deficiencies are noted, the letters do not indicate which offices were
involved.
---------------------------------------------------------------------------
\7\ Report at 146.
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The Commission's recommendation that disciplinary action not be
postponed until all litigation was ended \8\ has been implemented to a
limited extent. The Quality Control Inquiry Committee (QCIC) of the
SEC's Practice Section of the AICPA (SECPS) now investigates
substandard audits quickly but the results are reported only to the
Public Oversight Board (POB) and the SEC; they are not made public. And
of the Commission's most important recommendations, only those asking
for greater auditor concern with detecting fraud have been adopted,
albeit gradually.
---------------------------------------------------------------------------
\8\ Report at 150.
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The Commission also studied the sanctions that could and were being
imposed on individuals and firms for performance or conduct that
violated professional standards. It is not unfair to say that the
Commission was disappointed by the then current situation (which does
not appear to have changed significantly). It noted:
Failure to Address Significant Problems. With a few
exceptions, individuals appear to be penalized only for
infractions which involve advertising (no longer forbidden) or
client solicitation and felony convictions related to the
preparation of false tax returns. While not unimportant, those
are not major problems facing the profession today. The major
problem is substandard performance.\9\
---------------------------------------------------------------------------
\9\ Report at 179.
However, after suggesting a number of areas for improvement it was
concluded, unfortunately incorrectly, that more progress would be made.
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With this optimistic outlook, the Commission noted:
An organization could be established within the profession
that would have the ability to penalize firms for substandard
performance. Such organizations do exist in other areas, for
example, the National Association of Securities Dealers. . . .
We do not see any promise that the creation of a regulatory
body as described above would be a significant improvement on
the present mixture of private and public regulation.\10\
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\10\ Report at 181.
I now believe that this conclusion, with which I agreed earlier,
was wrong. Substandard performance does not appear to have been reduced
or curtailed. Indeed, some recent cases are in many respects more
egregious than any reviewed by the Cohen Commission.\11\ I do not like
to rely excessively on evidence from one case, but the actions of a
major firm, as disclosed in the recent SEC release on Arthur Andersen
and Waste Management, strongly suggest that the problems are deeper
than any of those contemplated by the Cohen Commission.
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\11\ It is important to note that we do not know the actual extent
of substandard performance. Specific instances of substandard
performance are disclosed only when revealed by some other event such
as a restatement or bankruptcy. Most substandard audit performance, to
the extent that it exists, probably will never be disclosed. I would
like to believe that the vast majority of audits are completed
conscientiously in accordance with the standards. However, in an
ominous note, the Commission's research revealed that a majority of
auditors had, at one time or another, signed off for audit work that
they did not actually perform. (See Report at 179).
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The following excerpt from an SEC release on Arthur Andersen and
Waste Management summarizes the essence of that case.
As alleged in the Commission's complaint or found in its
related administrative order: In each of the years 1992 through
1996, the Andersen engagement team identified a variety of
improper accounting practices that caused Waste Management's
operating and income tax expenses to be understated and its net
income to be overstated. While Andersen quantified some of
these misstatements, other known and likely misstatements were
not quantified and estimated, as required by GAAS. In
connection with the audit of Waste Management's 1993 financial
statements, Andersen proposed a series of ``Action Steps'' to
change the company's improper accounting practices only in
future periods and to write off its prior misstatements over a
5 to 7 year period, rather than require immediate correction in
accordance with GAAP. Andersen also allowed Waste Management
to, in Andersen's own words, ``bury'' certain charges by
improperly netting them against unrelated, one-time gains.
Andersen told Waste Management that its use of netting was an
``area of SEC exposure'' but nonetheless allowed it to occur.
Ultimately, when the misstatements were revealed, Waste
Management announced the largest restatement in American
corporate history. In issuing an unqualified audit report on
the restated financial statements, Andersen acknowledged that
the financial statements it had originally audited were
materially misstated.\12\
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\12\ Securities Exchange Act of 1934, Release No. 44444 / June 19,
2001. This writer was engaged by the SEC to serve as an expert witness
in this matter. However, comments included here are based solely on the
published releases by the SEC.
The facts of this case are unique, not only in their magnitude, but
in the actual accounting proposed. The notion that misstatements could
be written off over some future period, rather than immediately
corrected, is unsupported, indeed unheard of, anywhere in accounting
practice or literature.
Worse yet was the consultation process and the concurrence of those
consulted:
For example, in its 1993 audit, Andersen quantified current
and prior-
period misstatements of $128 million, the correction of which
would have reduced net income before special items by 12
percent. The engagement team also identified, but did not
quantify or estimate, accounting practices that gave rise to
other known and likely misstatements. Allgyer (the engagement
partner) and Maier (then the risk management partner for
Andersen's Chicago office and the concurring partner on the
Waste Management engagement) consulted with the Practice
Director and the Audit Division Head and informed them of the
quantified misstatements and ``continuing audit issues,'' and
Allgyer consulted with the Firm's Managing Partner and they
provided him the same information. The partners determined that
the misstatements were not material and that Andersen could
issue an unqualified audit report on the Company's 1993
financial statements.\13\
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\13\ Securities Exchange Act of 1934, Release No. 44444 / June 19,
2001.
Thus, this is not the case of an ignorant or ``renegade'' partner.
Instead, this bizarre accounting was approved by a series of reviewers,
all the way to the highest level in the firm.
The Cohen Commission did not find any case exhibiting such
pervasive concurrence with such bad accounting. And as I said earlier,
most of the significant recommendations of the Cohen Commission, made
24 years ago, for reducing substandard performance have not been
adopted by the present private financial reporting establishment. I do
not know if my other Commission members would concur, but I now believe
that a stronger, statutorily directed oversight structure is called for
if necessary improvements are to be made.
The NASD Model
A number of proposals for more stringent oversight of the
accounting profession have been made in recent weeks, including that of
the Chairman of the SEC and in legislation introduced in the House of
Representatives.
Both call for new organizations. I have learned that it is usually
more efficient to look to and copy existing, successful models rather
than invent new devices. And
I believe:
The NASD provides a model for a statutory self-regulatory
organization (SRO) that could be applied to the accounting
profession.
Enacting legislation to transfer the AICPA's standard setting
operations and the oversight responsibilities to the new self-
regulatory organization for financial reporting would be the
quickest and most efficient way of commencing operations of the
SRO.
I make this call for increased regulation of my profession with no
small regret. I am a CPA, my father was a CPA. I started my career as
an auditor. Such success as I have achieved is heavily due to what I
learned as an accountant. I was privileged to work for or with some
truly proud professionals and truly independent accountants such as
Paul Grady, Philip Defliese, Joseph Cummings, Ray Groves, Robert
Hampton and on the Cohen Commission, LeRoy Layton and Kenneth Stringer.
I believe all of them would be truly outraged at many aspects of
their profession today. Their firms, once managed by the leading
technicians and theoreticians in the profession are now frequently led
by ``rainmakers'' selected for their ability to generate new business,
not for their accounting knowledge. Too many firms and practitioners in
a profession dedicated to the public interest have become too dedicated
to private gain.
I make these comments not because of the Enron case. The gradual
deterioration of the professional conscience of at least a sizable
minority of public accountants has been continuing for the past several
decades. Enron is merely a widely publicized symptom that may at least
have the benefit of bringing about long delayed changes in the
accounting profession. Ultimately, these changes must come not through
regulation but by restoring the sense of professionalism that too many
accountants seem to have lost. These are changes that Congress cannot
enact, the SEC cannot promulgate. The management of accounting firms
must be returned to accountants, not salesmen. Accountants must be
educated as professionals in the same manner as the lawyers, doctors,
and members of the other liberal professions.
The NASD
I assume there is no need to recount the history and functions of
the National Association of Securities Dealers (NASD) for the Members
of the Committee, but I will give a very brief summary for other
readers.
The precursor of the NASD was the Code Committee formed by the
investment banking business under the National Recovery Act (NRA) in
1933. When the NRA was declared unconstitutional, the members voted to
continue the organization on a voluntary basis. That private voluntary
organization grew and changed its name to the Investment Bankers
Conference. In 1937, the governing committee of the Conference, working
with the SEC, drafted legislation to create it as a self-regulatory
organization. The legislation that came to be know as the Maloney Act
was signed by President Roosevelt on June 25, 1938. In 1939, the
organization was renamed the National Association of Securities
Dealers.
The relationship of the NASD and its subsidiaries to securities
markets and to its participants is, in many ways, comparable to the
functions of the AICPA and the Financial Accounting Standards Board
(FASB), including development of qualifying examinations, registration
of sales and supervisory personnel, regulation of individual ethics and
business conduct, education and publications, and establishing rules of
fair practice. Of course, it also has other operations, not comparable
to the AICPA, such as the Nasdaq market and overseeing the American
Stock Exchange.
Create A National Financial Reporting Oversight Board
There have been several proposals to create a new oversight body,
some aimed at replacing or expanding the Public Oversight Board of the
AICPA. With the evolutionary NASD model in mind, I see no reason to
invest the enormous effort that would be involved in creating an
entirely new organization.
The AICPA's SEC Practice Section (SECPS), Auditing Standards Board
(ASB), Accounting Standards Executive Committee (AcSEC) and
Professional Ethics Division are already staffed and operational. The
time and money saved by starting with these existing units of the
AICPA, which appear to comprise about 30 percent of the Institute's
total expenses, would be significant. The SEC's familiarity with these
AICPA groups would conserve the SEC's scarce resources.
I propose that legislation be developed through joint efforts of
the AICPA, State CPA societies and boards, other accounting
professional organizations and the SEC and enacted in the same manner
as the Maloney Act to create a new National Financial Reporting Board
(NFRB) based on a core of the appropriate elements of the AICPA.\14\
Statutory direction would, hopefully, accelerate the past and the
current torturously slow rate of improvement in the accounting
profession.
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\14\ I have no pride of authorship related to the title National
Financial Reporting Board (NFRB). Another descriptive title, hopefully
with a more pronounceable acronym would be acceptable.
---------------------------------------------------------------------------
The NFRB would fit into and amplify the present structure of
professional regulation. CPA's are licensed by State boards of
accountancy which system would be undisturbed. Note that individual
securities brokers must be licensed by the States in which they deal.
The NFRB could license or otherwise qualify firms that audit public
corporations in much the same manner that broker-dealers are regulated
under SEC Regulation M and by NASD Regulation, Inc. (NASDR, a
subsidiary of NASD). The present Public Oversight Board (POB) and the
SEC Practice Section of the AICPA would be the basis for an arm
comparable to NASDR in the area of regulation of firms auditing public
companies. The Quality Control Inquiry Committee (QCIC) of the SECPS
already investigates substandard audits and likely would to do so, but
having subpoena power and making its findings public. Financing of the
NFRB would logically come from direct charges to public companies and
accounting firms qualifying to audit public companies.
Preserve State Societies and Regional Firms
State societies and State boards of accountancy play a major role
in licensing and maintenance of professional standards. For example,
the New York State Society of Certified Public Accountants (NYSSCPA) is
active at all levels of professional development. Its magazine, The CPA
Journal, is one of the few forums available for the publication of
debates and critical comment on issues in financial reporting by
practitioners and educators. It is far superior intellectually to The
Journal of Accountancy published by the AICPA. State societies are in
some ways competitive with the AICPA--they have significant
unduplicated memberships--and their continued contribution to
professional development must be preserved.
There are high quality local and regional accounting firms, some of
which specialize in specific industries and whose practice includes
auditing some public companies. Care must be taken to assure that the
NFRB makes appropriate allowance for services rendered by CPA's who are
not principally occupied with audits of public companies and for the
private companies they audit. This care should not include different
auditing standards, but would address, for example, different
requirements for advice and consulting that private companies require
from their accountants.
Hopefully the creation of an NFRB that I am proposing will have the
same effect as that suggested by Senator Francis T. Maloney, sponsor of
the 1938 Maloney Act Amendment to the Securities Exchange Act of 1934:
This Act is designed to effectuate a system of regulation . .
. in which the members of the industry will themselves exercise
as large a measure of authority as their natural genius will
permit.
Merge the FASB into the NFRB
When the Financial Accounting Standards Board (FASB) was created,
essentially by carving the accounting standards setting function out of
the AICPA, I wrote an article titled ``Goldfish in a Bowl of Sharks.''
\15\ I predicted that the new FASB (the goldfish), no longer enjoying
the built in support and shield of the accounting profession and the
large accounting firms and the membership of the AICPA, would be highly
vulnerable to influence and pressures exerted by all the other parties
(the sharks) affected by financial reporting. The AICPA, I suggested,
having lost its most important professional function--standard
setting--would be reduced greatly in professional status.
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\15\ The Accountants Magazine (Scotland) 1973.
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Unfortunately, these forecasts were mostly accurate. The FASB has
been beset by enormous outside pressures. Returning to being part of
the principal accounting professional organization will give it the
strong support of the NFRB and a shield against attempts to unduly
influence its decisions. In addition, the FASB, alone in bucolic
Connecticut, has been somewhat isolated from the mainstream.
Integration into the National Financial Reporting Board will provide
better direction and focus for the FASB's efforts. With the AICPA's
Auditing Standards Board and Accounting Standards Executive Committee
also under its umbrella, the NFRB would have the standards setting
responsibility for the accounting profession, as well as responsibility
for overseeing the appropriate application of those standards, under
the ultimate direction of the SEC.
I might add that I have heard proposals that the directorship or
board of an SRO created in this situation be ``independent'' of the
accounting profession. That is, the membership would not include
professional accountants. I disagree strongly with that notion. It is
the equivalent of suggesting that the board of directors of a
corporation exclude any member with extensive experience in the
corporation's industry. To the contrary, the board of the SRO should
include a reasonable number of members with strong public accounting
backgrounds. Despite the decline in certain aspects of the accounting
profession, there are still many highly qualified, independent
accountants who can bring leadership talents to a financial reporting
SRO.
The FASB is principally funded by contributions from public
accounting firms and public companies, as well as revenues generated by
its publications. As part of the NFRB, its financing would come through
the NFRB.
Professional Auditors of Auditing Firms
At present, the Public Oversight Board's (POB) peer reviews of
members of the SECPS are performed by their ``peers,'' that is, other
accounting firms. Major accounting firms are reviewed by other major
accounting firms. Despite a series of SEC cases and private litigation
which revealed clearly substandard auditing work, no major firm appears
to have been publicly sanctioned as a result of a peer review.
While the major accounting firms are willing to ``peer review''
each other where the results of specific audits are not disclosed, they
are not willing to testify against each other in open court. When the
SEC brings charges against a firm of public accountants, other
accounting firms will not serve as expert witnesses for the SEC,
despite the fact that several firms have sections devoted to litigation
support. Most financial accounting professors at universities,
apparently unwilling to risk the wrath of the accounting firms who
often support their work, also are unwilling to testify against
accounting firms.
This situation suggests that when the NFRB is established, it
should develop its own auditors to examine public accounting firms and
not depend on review by peers.
The Influence of the Fees on Auditor Independence
The relationship between independent auditor and client is unique
in our society. In theory, the auditor works for and protects the
shareholders. In practice, the management of the corporation pays the
independent auditor to assure that management's financial reporting is
accurate. A doctor cures his patients, a lawyer represents his clients
but an independent auditor polices the management that pays him.
For this unique relationship to work, the auditor must be truly
independent, willing to tell the client what is wrong, to insist that
what is wrong be corrected or to walk away from the client . . . and
from a stream of future fees. The drafters of the Securities Laws
understood the value to the capital markets of this independent control
over the accuracy of financial statements. By requiring that all
companies whose securities were publicly-traded have financial
statements audited by independent accountants they virtually guaranteed
a market for the services of American CPA's. The accounting profession,
particularly the larger firms, grew and prospered under this mandate.
Now, recent cases and the comments of many critics strongly suggest
that this critical independence is being subverted by fear of losing
the client and future fees. The following excerpt from the SEC's
release on Arthur Andersen and Waste Management \16\ provides
interesting insight into some of the ways in which an auditor's
independence was compromised:
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\16\ Securities Exchange Act of 1934, Release No. 44444 / June 19,
2001. This writer was engaged by the SEC to serve as an expert witness
in this matter. However, comments included here are based solely on the
published releases by the SEC.
As noted in the order as to Andersen, this conduct took place
---------------------------------------------------------------------------
against the following background:
Andersen has served as Waste Management's auditors since
before Waste Management became a public company in 1971.
Andersen regarded Waste Management as a ``crown jewel''
client.
Until 1997, every chief financial officer (``CFO'') and
chief accounting officer (``CAO'') in Waste Management's
history as a public company had previously worked as an auditor
at Andersen.
During the 1990's, approximately 14 former Andersen
employees worked for Waste Management, most often in key
financial and accounting positions.
Andersen regarded Allgyer as one of its top ``client
service'' partners. Andersen selected Allgyer to become the
Waste Management engagement partner because, among other
things, Allgyer had demonstrated a ``devotion to client
service'' and had a ``personal style that . . . fit well with
the Waste Management officers.'' During this time (and
continuing throughout his tenure as engagement partner for
Waste Management), Allgyer held the title of ``Partner in
Charge of Client Service'' for Andersen's Chicago office and
served as ``Marketing Director.'' In this position, Allgyer
coordinated the marketing efforts of Andersen's entire Chicago
office including, among other things, cross-selling nonattest
services to audit clients.
Shortly after Allgyer's appointment as engagement partner,
Waste Management capped Andersen's corporate audit fees at the
prior year's level but allowed the Firm to earn additional fees
for ``special work.''
As reported to the audit committee, between 1991 and 1997,
Andersen billed Waste Management corporate headquarters
approximately $7.5 million in audit fees. Over this 7 year
period, while Andersen's corporate audit fees remained capped,
Andersen also billed Waste Management corporate headquarters
$11.8 million in other fees.
A related entity, Andersen Consulting, also billed Waste
Management corporate headquarters approximately $6 million in
additional nonaudit fees. Of the $6 million in Andersen
Consulting fees, $3.7 million related to a Strategic Review
that analyzed the overall business structure of the Company and
ultimately made recommendations on implementing a new operating
model designed to ``increase shareholder value.'' Allgyer was a
member of the Steering Committee that oversaw the Strategic
Review, and Andersen Consulting billed his time for these
services to the Company.
In setting Allgyer's compensation, Andersen took into
account, among other things, the Firm's billings to the Company
for audit and nonaudit services.
This excerpt needs little elaboration. Allgyer is described as a
marketing man, cross-selling other Andersen services. The audit fee was
capped but other fees were not. Thus, if Allgyer were to take a strong
stand against the client he would have risked losing not only future
audit fees, but also the even larger consulting fees. In addition, one
might also ask how objective Allgyer would be in auditing the results
of actions taken in accord with his own strategic review.
Given the strong pressures that fees of any sort exert on
maintaining independence, it seems logical to eliminate, when possible,
fees that bear no relation to the audit function.
Prohibit the Performance of Certain Management Consulting for
Audit Clients of Public Companies
The Cohen Commission examined the question of whether performing
management consulting impaired the independence of auditors. The
Commission staff searched for cases where impairment of independence
resulted from management consulting engagements. The Commission also
solicited leading critics of the profession for specific cases. With
the possible exception of Westec, no cases were found. The Commission
analyzed the problems potentially associated with each of the nonaudit
services then performed by independent auditors. Its conclusion:
No prohibition of management services is warranted.\17\
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\17\ Report at 102.
However, this conclusion, reached in 1978, should be viewed in the
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light of another comment in the Commission's report:
Auditing dominates the practice of large public accounting
firms, but it has never been the sole function performed by
public accountants.\18\
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\18\ Report at 95.
However, the business volume relationship between auditing and
management consulting has changed since then. Twenty-two years later,
the Panel on Audit
Effectiveness (PAE) of the Public Oversight Board presented the
following figures for the ``Big 5'' accounting firms in 1999:
Percent of Revenues
------------------------------------------------------------------------
All Clients SEC Clients
------------------------------------------------------------------------
Auditing.......................... 34 percent 48 percent
Consulting........................ 44 percent 32 percent
------------------------------------------------------------------------
The growth in the last decade of the 20th Century was particularly
rapid. The PAE reported that the ratio of auditing revenues to
consulting revenues from SEC clients went from 6:1 in 1990 to 1.5:1 in
1999.\19\
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\19\ Panel on Audit Effectiveness at 5.13.
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The Cohen Commission did recommend a series of safeguards to reduce
the chance that independence would be impaired: Increased director and
audit committee involvement and public disclosure of other services.
These recommendations have been accepted in one form or another.
The PAE examined the same issue of whether the performance of
certain management services should be prohibited. The PAE members
divided, with some members for exclusion of certain management services
and others for no exclusion. The Panel therefore made no
recommendation.
It's the Fees, Stupid
In arriving at their conclusions, both the Commission and the PAE
took the same approach; search for examples where the performance of
management services impaired the appropriate performance of the audit.
That is, find instances where, because the auditor's consulting arm had
provided services the auditor was compromised in examining or auditing
the results of those services. Neither found any examples. In effect,
the theory was not supported by empirical evidence. The PAE pointed out
the difficulty of actually finding any such ``smoking gun.''
I would suggest a different framework for viewing the issue: The
impact of consulting fees, not consulting work, on the independence of
the auditor. As discussed above, an auditor taking a strong stand
against a client risks losing a future stream of audit fees from that
client. Consider the excerpt above from the Andersen and Waste
Management case. A truly independent audit partner would have faced
losing a stream of consulting and other fees even greater than the
audit fee.
In addition, the audit partner, Allgyer, essentially was the
salesman for the consulting services and was compensated for selling
them. Recall the comment above that Allgyer had a ``personal style that
. . . fit well with the Waste Management officers.'' Would the style of
a strong independent auditor have fit as well?
The Panel on Audit Effectiveness noted in its surveys that working
auditors received the message that quality audit work was not
important, that the audit has little value and that other services were
more important.\20\ Some audit firm partners to whom I have spoken
believe that audits are often offered as ``loss leaders,'' in other
words, as entry for sales of consulting services. In my capacity as an
Audit Committee Chairman soliciting proposals for new independent
auditors I witnessed substantial price competition and the submission
of bids that were clearly well below normal billing rates. Virtually
every audit partner tries, at one time or another, to sell consulting
services to audit clients.
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\20\ Panel on Audit Effectiveness at 4.3 and 4.4.
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I hold an economics degree and am not about to condemn price
competition. However, in the auditing context, absent a high level of
professional integrity and supervision, it can result in substandard
work. For example, the Cohen Commission's extensive survey of working
auditors found that fully 58 percent admitted to having signed off on a
required audit step, not covered by another audit step, without
completing the work or noting the omission of the procedures. ``Time
budget pressure,'' the result of low fees, was by far the most common
reason cited.\21\
---------------------------------------------------------------------------
\21\ Report at 179-180.
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A second impact of ``loss leader'' pricing is a potential loss of
independence. Professional ethics forbid an auditor to undertake an
examination if the client has an unpaid balance from a prior audit.
This is logical, since the debt may give the auditor a pecuniary
interest in assuring the continuing business of the client. If an
auditor has priced an audit so low that it will take 2 or 3 years for
the original loss to be recovered--a period cited to me by several
audit partners--is that not the same position as being unpaid for a
prior examination?
While one would not want to interfere with price competition, some
steps can be taken to alleviate the problems described just above.
First, the NFRB should extend the rule against commencing a subsequent
audit when a prior year's fees remain unpaid to also apply when the
prior year's costs are unrecovered.
Audit committees generally now have the responsibility for engaging
the independent auditor. Well before the current requirements for the
audit committees of public companies were instituted, the Cohen
Commission recommended that audit committees carefully consider the
tradeoffs between price and quality in audit proposals.\22\ In doing
so, audit committees should emphasize the quality and capability of
different firms before considering price. When negotiating fees, audit
committees, interested in assuring that they are receiving truly
independent audits, should eschew arrangements that will tend to
compromise independence, such as fixed fees for a period of years.
---------------------------------------------------------------------------
\22\ Report at 107. Most public companies are required to follow
the standards set in the Report and Recommendations of the Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit Committees.
---------------------------------------------------------------------------
Which Consulting Services to Permit? Which to Prohibit?
This testimony is not the place to provide a detailed answer to
these questions. However, some general concepts may be developed here
which could be amplified by NFRB, SEC, or legislative action.
First, we are considering only auditors of public companies with
shareholders or creditors removed from direct contact with or control
over management. The owners and creditors of private businesses are
capable of making their own decisions as to what consulting is
appropriate.
Second, audit partners frequently are highly knowledgeable about
the business and industries they audit. They should be encouraged to
give management and the board of directors the full benefit of that
knowledge as advice and counsel. For example, it may be decided to
forbid management consultants associated with accounting firms to take
M&A engagements similar to those undertaken by investment bankers, but
nothing should prevent an audit partner from giving a board of
directors advice about a proposed merger or acquisition.
In short, those services that an audit partner (or senior audit
staff ) can render themselves should not be prohibited. The Panel on
Audit Effectiveness, noting the increasing complexity of business
systems and the need for specialized knowledge to audit them, listed a
series of ``audit support'' consulting services.\23\ Such services
should be permitted.
---------------------------------------------------------------------------
\23\ Panel on Audit Effectiveness at 5.10.
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There are ``traditional'' nonauditing services offered by
accountants; the most significant of which is providing tax advice,
planning and return preparation. There is no logical reason to forbid
such services which have been offered without problems for decades.
However, the structuring, by accounting firms often employing lawyers,
of sophisticated, complex, sometimes marginally legal tax shelters (for
high fees) recently has become an issue. This would be the type of
``nontraditional'' consulting, along with strategic planning, business
reengineering, investment banking, executive placement, legal and
actuarial services, that will warrant consideration as being prohibited
for firms performing independent audits of public companies.
Require Forms 10-Q and Interim Financial Statements to be
Audited as Part of a Continuing Audit Process
The Commission recommended:
The audit should be considered a ``function'' to be performed
during a period of time, rather than an audit of a particular
set of financial statements. The annual financial statements
should be only one, although the most important, of the
elements audited. Eventually, the audit function should expand
to include all important elements of the financial reporting
process.\24\
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\24\ Report at 60.
This call for a change in the nature of the audit was considered
radical at the time. Although proposed again by Robert Elliott, a
recent Chairman of the AICPA, the concept has not been embraced by the
profession. However, in discussions following the Enron disclosures,
there have been repeated calls for release of more current financial
information.
It will take time to develop standards for auditor association with
``current'' financial information. However, a first and significant
step would be to require, by statute or regulation, that quarterly
reports of public companies be ``audited.'' Such reports are currently
``reviewed'' on a timely basis under procedures set forth in SAS No. 71
(1992). It should not be difficult to modify SAS No. 71 to integrate
the procedures called for therein with the annual audit, as envisioned
by the Commission.
It will take a greater, but by no means an insurmountable effort,
to develop a framework for the ``audit function'' envisioned by the
Commission. With such a structure in place, rapid progress could be
made to provide forms of assurance on more financial information that
may be more current than quarterly reports.
Former Auditors Working for Clients:
Notify the Audit Committee
The previously cited SEC release on Arthur Andersen and Waste
Management noted that a significant number of former Andersen auditors
occupied high level financial positions in Waste Management. The same
appears to have been true in Enron. This migration from auditor to
financial management is neither new nor unusual. The accounting
profession has traditionally been a source of talent for companies,
with individuals often moving to the same companies they audited.
There are positive aspects to this flow. The company hires people
already familiar with operations. If the auditor retains the
professional sense of being a CPA, as well as being a corporate manager
such employment is likely to be a positive force for integrity of the
company's financial reporting.
There are also negatives. In the worst case, the former auditor
knows exactly how his or her former firm conducts the audit, and how to
conceal information from them. In a less ominous sense, the former
auditor knows how far former compatriots can be pushed to accept
results preferred by management. In general, ``we are all friends,'' is
not exactly the appropriate relationship between independent auditor
and client. Recall that Allgyer, the Andersen audit partner had a
``personal style that . . . fit well with the Waste Management
officers.''
The Commission noted:
It would be impractical to for us to recommend that companies
be prevented from hiring individuals who were previously
employed by a public accounting firm regardless of whether a
client relationship existed.\25\
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\25\ Report at 101.
The Commission said no more about this issue. However, there should
be a safeguard against its getting out of control. Management should be
required to notify and receive advance approval from the audit
committee whenever a former auditor is engaged in a financial
management position.
Require Auditors to Evaluate the Financial Statements as a Whole
The Commission recommended:
Present standards require the auditor to use judgment to see
that the selection and application of particular accounting
principles do not produce a misleading result. He should
exercise a similar judgment in evaluating the cumulative effect
of the selection and application of accounting principles. This
is the only position consistent with the views expressed by
regulatory agencies and the courts that auditors have an
obligation to go beyond
determining technical compliance with specific accounting
principles and to evaluate the overall presentation of earnings
and financial position in the financial statements.\26\
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\26\ Report at 21.
This recommendation, which has never been accepted, was called the
``Smell Test'' by Commission member LeRoy Layton.
The profession's position is:
The independent auditor's judgment concerning the
``fairness'' of the overall presentation of financial
statements should be applied within the framework of Generally
Accepted Accounting Principles. Without that framework, the
auditor would have no uniform standard for judging the
presentation of financial position, results of operations, and
cash flows in financial statements.\27\
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\27\ AU 411.03.
Professional standards do require the auditor to evaluate the
aggregate effect of uncorrected misstatements on the financial
statements as a whole.\28\ Layton's ``Smell Test'' calls for a broader
look at the financial statements. It is possible for financial
statements to be ``unfair,'' even if there are no misstatements and
they are generally in conformity with GAAP. For example, it appears
that Enron's accounting for certain energy contracts in accord with
SFAS No. 133 (on derivatives) and other transactions greatly inflated
the Company's apparent total size.\29\
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\28\ AU 312.34.
\29\ In theory, an auditor might take an exception under Article
203-1 of the AICPA Ethics Code saying that it was inappropriate to
apply GAAP in a particular circumstance, but the ``Smell Test'' is a
broader concept. The Enron example cited here probably does not qualify
for Article 203 treatment since ``an unusual degree of materiality'' is
specifically cited as not being a reason to apply Article 203.
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This recommendation was in accord with a general theme that runs
through the Cohen Commission report; auditors must be made to exercise
more independent judgment. As Enron has demonstrated, specific
accounting rules cannot keep pace with the rapid evolution of business
practices and the ingenuity of determined managements. The last line of
defense of fair financial reporting is a well trained, informed auditor
exercising independent judgment.
Auditors Should Always be Required to Determine that Accounting
Principles Selected by Companies are ``Preferable''
When the Commission issued its report, and today, companies are
only required to apply Generally Accepted Accounting Principles that
are acceptable. If acceptable alternatives exist and a company is
applying one of them, there is no requirement to determine whether one
of the acceptable alternatives is better. It is only when a company
changes accounting principles that a preferability test is required.
The Commission noted:
When management decides to change an accounting principle,
use of an alternative must be justified on the basis that the
new principle is preferable.\30\ If the required justification
were not given, the auditor would be expected to qualify his
opinion. However, the auditor's evaluation of management's
choice among alternative principles should not be different
simply because there has been a change. The auditor should have
the same obligation to analyze the underlying facts and
circumstances for accounting principles for which alternatives
exist even in the absence of a change.\31\
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\30\ APB Opinion No. 20, para. 16. A similar requirement is found
in the SEC's Accounting
Series Release No. 177.
\31\ Report at 20.
This would appear to be a simple suggestion, not subject to a great
deal of debate. When alternatives exist, the company must always use
the preferable alternative. The Commission logically modified its
recommendation to exclude those situations where authoritative bodies
or extensive analysis had given full consideration to a particular set
of alternatives and could not determine that one was preferable.
Nevertheless, no action has been taken on this suggestion since the
Report was issued in 1978.
This issue relates also to the question of independent accountants
giving advice on the structuring of certain transactions. It is
legitimate and probably desirable for an auditor to give a client
advice on structuring new transactions so that the accounting for the
transaction will be acceptable. However, it is not desirable for that
advice to produce accounting that is ``barely acceptable.'' A
preferability standard should apply to advice as well.
Require Companies to Record All Audit Adjusting Entrees
Regardless of Materiality
Materiality is the most powerful of all elements in GAAP. Every
Statement issued by the FASB (and its predecessors) includes:
The provisions of this Statement need not be applied to
immaterial items.
In effect, a materiality decision--or more precisely, a decision
that a matter is not material--may outweigh the most authoritative
accounting standard or the most egregious accounting. Recall the
bizarre accounting in the quotes above from the SEC's Release on Arthur
Andersen. The Andersen partners accepted it on the grounds that it was
``immaterial.'' Yet, there is no practical, clearly applicable
definition of materiality. The standard definition is:
The magnitude of an omission or misstatement of accounting
information that, in the light of surrounding circumstances,
makes it probable that the judgment of a reasonable person
relying on the information would have been changed or
influenced by the omission or misstatement.
This definition was cited by the AICPA in SAS No. 47, by the FASB
in Concepts 2 and by the Canadian Institute of Chartered Accountants.
It does not provide an adequate basis for making practical accounting
decisions; it is essentially a legal construct. In March 1975, the FASB
issued a discussion memorandum ``An Analysis of Issues Related to
Criteria for Determining Materiality.'' In 1978, the Cohen Commission
said:
The FASB has recently put on its agenda the topics of
materiality and . . . We encourage prompt completion of the
projects because of their importance to the development of more
definitive statements of accounting principles and auditing
standards.\32\
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\32\ Report at 16.
The FASB has promulgated no additional work on materiality since
1975.
The better definition of materiality is critical to better auditing
standards and stronger regulatory control. Almost every significant
accounting action brought by the SEC hinges on whether the alleged
misstatements were ``material.''
I have little hope that my testimony here will result in any
progress on the general issue of materiality, after more than a quarter
century of inaction. However, there is one significant step in the area
that can be taken by regulatory action, by the SEC or, if established,
by the NFRB.
Consider the following exchange:
Auditor: We believe you should book this adjustment reducing
revenue.
Client: You are right theoretically, but I would rather not. The
consolidation is almost finished.
Auditor: We still think you should adjust.
Client: No. Besides, your adjustment is only 2 percent of net
income for the period. It is not material.
Hypothetical? Uncommon? No. Most experienced auditors have
encountered this situation. So has the SEC. On September 28, 1998 the
Chairman of SEC gave a speech at New York University, noting:
But some companies abuse the concept of materiality. They
intentionally record errors within a defined percentage
ceiling. Then they try to excuse the fib by arguing that the
effect on the bottom line is too small to matter. When either
management or the outside auditors are questioned about these
clear violations of GAAP, they answer sheepishly. . . . ``It
doesn't matter. It is immaterial.''
Whether many auditors are quite as pliable as the Chairman implied
is questionable. In practice, the outcome of such confrontations varies
depending on many factors, not the least of which is the personalities
and the character of the relationship between the auditor and the
client. One fact is certain, however: The auditor gets little help in
dealing with this problem from the profession's authoritative
literature. The recently issued SAS No. 89 requires the audit committee
be informed of uncorrected misstatements that are deemed immaterial,
but not that they be corrected.
I propose a simple, straightforward standard which I believe would
provide guidance in many of the situations described above. The
substance of the proposed rule is: Discovered misstatements must be
corrected.
The new standard could be promulgated as either an accounting or an
auditing standard (or both). Its rationale is simple: Today, there is
negligible incremental cost--in terms of time or money--associated with
making an audit adjustment anytime before the financial statements are
printed. In the digital age, worksheets and financial statements reside
in computers. The $149 accounting program in my laptop computer will,
when given an journal entry or other correction, instantly and
completely revise all the resulting financial statements. The software
used by corporations and auditors is certainly no less versatile.
Thus, arguments that it is too difficult or too late to record
audit adjustments have vanished in the computer age. It is time to
promulgate a materiality standard that reflects this reality.
Reinvigorate the Accounting Profession
As I have said several times earlier in this testimony, the
accounting profession has become less professional in the last several
decades. Through the 1960's, the best and the brightest of the
professional accountants led the accounting firms, filled the seats on
the standard setting bodies and taught accounting students.
Thereafter the accounting world began changing. Management of the
accounting firms gradually passed to those who could bring in business.
The technicians were eased out of management and essentially became
consultants to the staff accountants who were themselves less able to
deal with the increasingly complex accounting literature. Control of
the standard setting function at the FASB became independent of the
profession.
New accounting professors were increasingly drawn from the ranks of
Ph.D's who never practiced accounting and could, therefore, not become
CPA's. Academic accountants grew increasingly apart from the
profession, most occupied with research unrelated to problems and
issues of the profession and financial reporting. Increasingly,
accounting was taught in colleges and universities as support for
management, rather than as a profession.
Establish Graduate Professional Schools of Accounting
The most obvious of these problems (in 1978) was:
A student who graduates from a high-quality liberal arts
undergraduate college cannot generally obtain an equally high-
quality graduate professional degree in accounting.\33\
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\33\ Report at 89.
It was clear to the Commission in 1978 that the lack of a graduate
professional option was weakening the profession. In the past quarter
century, the problem has grown worse as an increasing portion of
students defer their career choice until they graduate college. They
can then attend graduate schools in law, medicine, business,
architecture, physical and social sciences, pharmacy and others, but
not accounting.
Without a graduate option, the accounting profession has cut itself
off from a growing portion of the best brain power. It is in
essentially the same position as single sex colleges, men or women
only, who gradually realized that they were closed to 50 percent of the
student pool. They opened their doors to the opposite sex.
The Cohen Commission called for the establishment of graduate
professional schools of accounting, following the law school model.
However, it offered no suggestions on how such schools might be started
or financed. This is not a problem that is susceptible to Federal
legislation or regulatory action. However, after considering the issue,
it might be useful to call for State boards of accountancy, which set
entry requirements, to increase educational requirements or offer
incentives to graduates of such accounting schools.
Close the Gap Between Accounting Academics and the Profession
As discussed above, most accounting professors have little interest
in or ties to the profession. This gap has had an adverse impact on the
profession. The Commission noted:
One of the roles of the academic arm of a profession is to
serve as the conscience of the profession. Academe provides
opportunity for reflection and study not permitted to the
practitioner; the professor need not fear the loss of a client
when he makes a statement critical of current practices. During
the hectic years of the 1960's . . . most members of the
academic community remained silent. Only a few professors were
openly critical of those accounting and reporting abuses that
gave rise to much of the present criticism of the
profession.\34\
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\34\ Report at 86. One of the few vocal critics during that period
was Professor Briloff who is scheduled to testify before the Committee.
The situation has not changed. The academic accounting community
still remains almost mute about the current problems of the profession.
Again, the establishment of graduate professional schools of
accounting, with professionally oriented faculties, would appear to be
the most likely solution.
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PREPARED STATEMENT OF ARTHUR R. WYATT, CPA
Former Chairman, American Institute of Certified Public Accountants'
Accounting Standards Executive Committee
Former Chairman, International Accounting Standards Committee
Former Partner, Arthur Andersen & Co.
Professor of Accountancy Emeritus, University of Illinois
March 6, 2002
Chairman Sarbanes, Ranking Member Gramm, and Members of the
Committee:
I appreciate your invitation to testify before the Senate Committee
on Banking, Housing, and Urban Affairs on Wednesday, March 6, 2002, and
to submit in advance of that date my comments on the issues raised by
recent failures in financial reporting by public companies,
deficiencies in accounting standards, and inadequate oversight of the
accounting profession.
While I am mostly retired at the present time, I have served about
25 years as a partner of Arthur Andersen & Co. and have been a member
of the Financial Accounting Standards Board, a member and Chairman of
the American Institute of Certified Public Accountants' Accounting
Standards Executive Committee, and a member and Chairman of the
International Accounting Standards Committee. My comments to follow are
based upon my experiences with those entities, as well as my
observations of the accounting profession as an academic and as a
consultant to attorneys in litigation concerning accounting issues.
I intend to address the following areas in my comments: The need
for attitudinal changes within the major accounting firms, the need for
a higher level of quality assurance, both within the accounting firms
and by outside overseers, the need for certain restrictions on the
range of services that public accounting firms should be permitted to
provide to audit clients, the need for continued improvement of the
Financial Accounting Standards Board, both in structure and in
processes, the need for audit committees of boards of directors to
become more proactive in the financial reporting process, and the need
for reconsideration of existing accounting profession disciplinary
structures.
Before dealing with these issues, however, it may be helpful to
provide some background on the evolution of the large public accounting
firms over the past 35 years. My observation is that over this period
the attitude of the leadership of the large accounting firms has
gradually shifted from emphasis on the quality of accounting and
auditing services provided to clients to emphasis on growing top-line
revenues. While this change in emphasis has been a considered one by
the firm leaders, the change has been an evolutionary one, more a
gradual process than tied to any identifiable events. Competitive
forces within the profession led firm managements to strive for growth,
largely by increasing the range of services provided. The focus on
growth in revenues altered attitudes within the firms as to the primacy
of the quality of the accounting and audit services provided.
I suspect that the various firm leaders would deny that such a
change has, in fact, taken place. But the issue is not whether firm
leaders intended to alter the emphasis on the quality of accounting and
audit services. Rather, the issue is whether a heightened focus on
expanding the range of services provided (in order to generate
increased revenues) acted to diminish the focus of partners and
managers on the quality of accounting and audit services provided. Firm
leaders would likely argue that they have never purposefully
deemphasized the primacy of quality of accounting and auditing
services. The facts would show, however, that attitudinally a gradual
change has occurred. Thirty-five years ago the leaders of most, if not
all, the major accounting firms at that time were well-recognized
technical experts, individuals for whom quality of service and
outstanding professionalism in its delivery were paramount. That
attitude was conveyed to younger partners and staff in a variety of
ways, including educational and training programs. Furthermore, younger
partners and staff could observe that advancement and salary increases
went to those deemed to deliver best high-quality technical and
professional services in the accounting and auditing arena.
Today, the large firms continue to have a high level of technical
expertise and continue to emphasize quality of services provided. Even
so, the most technically competent individuals are no longer recognized
as the principal leaders of the firms. Rather than being leaders of the
various firms, these experts now are less visible within the accounting
profession and, to some extent, even within their individual firms. The
firm leadership roles have been assumed by individuals whose expertise
lies in administration and/or marketing or promotional activities. By
this observation I make no value judgment as to which type of
background best prepares one to lead the complex accounting firms as
they exist today. Rather, my point simply is that on a relative basis
those with the greatest technical skills and a greater focus on high-
level professionalism have a lesser role and a lesser visibility within
the firms than was true 35 years ago. This relatively diminished role
affects attitudes within the firms about the relative importance of
quality of service provided and growth in firm revenues.
I do not intend to imply that the leaderships of any of the
accounting firms intended to trade off revenue growth for quality of
service. I have no evidence that any such intent has existed, and, in
fact, I would argue that such intent was not purposeful. Rather, firm
leaders made a series of decisions over the years to grow their
practices, a phenomenon clearly consistent with the direction taken by
most commercial enterprises in the country. The result of these
decisions, however, has been to create large commercially-oriented
accounting firms when the franchise granted to these firms (through the
State-monitored licensure of individuals permitted to attest to the
fairness of presentations in financial statements) was more a
professional service orientation than a commercial one.
The Attitudinal Issue
The impact of this attitudinal change within the firms has been
significant in my view. No longer is technical expertise and leadership
the obvious avenue to progress within the firms. Rather, expansion of
clients served and expansion of client services are viewed as primary
drivers. And, obviously, the loss of a client is a negative in one's
career path. Since many decisions required of audit firm managers and
partners are judgmental in nature, rather than clearly prescribed by
extraneous forces, such judgments are, at the margin, sometimes
influenced by perceptions of the attitudes of leaders of a given firm.
If those perceptions by firm audit personnel are that loss of a client
is damaging to one's career path, the judgments made may be more in the
direction of keeping the client than to achieving fair presentation of
financial statements.
This change in attitude also has had a significant impact on the
nature of new hires into the large accounting firms. Thirty-five years
ago nearly all new hires by accounting firms for their professional
staffs were college graduate accounting majors whose education not only
encompassed technical accounting and auditing issues, but also
emphasized professional and ethical responsibilities required of an
accounting professional. As the firms grew and the range of services
offered by auditing firms expanded, college accounting majors were no
longer plentiful enough to serve the needs of firms, and they no longer
possessed all of the skill sets needed to provide the expanded range of
services. The major auditing firms turned increasingly to nonaccounting
majors, bright students regardless of their field of study, for some of
their new hires.
While these new hires were talented in many respects, their
understanding of the professional responsibilities of reporting
auditors and the ethical constraints under which their work would be
undertaken was limited, if not nonexistent. Individuals with such
backgrounds might be more reactive to the attitudinal changes
previously mentioned.
Similarly, educational institutions struggled to modify their
accounting-major programs to better fit the perceived needs of the
major accounting firms. In fact, many of these academic modifications
were urged upon the academic community by the large auditing firms.
While exceptions could be cited, the emphasis on professionalism and
ethical responsibilities diminished in a relative sense. Accounting
programs employed as accounting professors some individuals with little
or no educational backgrounds in accounting and were not particularly
receptive to employing experienced professionals who might convey to
students in an effective way professional and ethical responsibilities
to be assumed by one entering the accounting profession.
The effect of this relatively increasing emphasis on
commercialization and relatively diminishing emphasis on
professionalism tends to diminish efforts to maintain a strong
professional focus that a professional firm may otherwise strive to
promote. Recognizing that accounting and auditing services are more an
art than a science, it should not be surprising at all that from time
to time individual accounting practitioners, no matter how complete
their training, would, for any number of reasons, fail to perform their
professional duties at the level of competency their clients, the
public, and the firm managements had a right to expect. For
professional accountants to reach sound judgments in a professionally
responsible way, their work environment, including the attitudes
projected from the top of their firms, needs to be as unequivocally
professional as possible.
While my comments on the scope of services provided by public
accounting firms will follow, I believe that the leadership in the
various firms needs to evaluate how well their existing organizational
structures and reward policies are serving what has to be their primary
focus, the delivery of high-quality professional accounting and
auditing services to clients. While these observations may not be very
helpful in considering legislative initiatives, I believe they are
crucial for the major accounting firms to address if the firms wish to
survive in the private sector as respected reporters on the financial
situation and results of operations of business enterprises.
Improvement in Quality Assurance
Large accounting firms have similar programs to try to assure audit
quality control. Even so, the increased number of financial statement
restatements in recent months suggests that existing quality control
programs need to be strengthened. The emphasis on quality control needs
to be heightened, and audit personnel need to gain a better
appreciation for all aspects of a firm's quality assurance program.
Renewed emphasis on the importance of audit quality control mechanisms
would be an important part of shifting the attitude within accounting
firms to a proper focus on the quality of financial reporting.
As individual firm quality control experts evaluate the work of
individual partners and managers in their numerous offices, special
efforts need to be made to review high-risk clients and/or clients
utilizing high-risk transaction forms. Likewise, quality control
experts need to assess specifically the extent to which individual
managers and partners address difficult client issues from the
perspective of fairness of financial reporting. Specific challenges
should be made of judgments by audit managers and partners that
adjusting entries proposed by them and not recorded by the client are
acceptable from the perspective of achieving fairness in the resulting
financial statements. Quality control experts within the firms should
seek out any evidence that suggests financial reporting by the client
entity is not reflective of
the transactions and events that occurred. Whenever such evidence is
found, the appropriate resolution must be pursued even when the end
result could be the loss of a client.
Changes implemented in this area are in the best interests of the
firms and, in the current environment, are likely to be instituted
quickly on a voluntary basis. Recent news articles suggest some of the
large firms have undertaken numerous initiatives on such matters. An
independent oversight board, as discussed later, should monitor such
changes to satisfy themselves that appropriate policies are in place to
assure high-quality audit efforts.
Expansion of Range of Services
The evolution of the drift toward increased emphasis on
commercialization and reduced emphasis on professionalism led the large
accounting firms to expand the range of services provided to their
audit clients. Importantly, however, we must acknowledge and emphasize
that accounting firms have always provided their audit clients services
that extend beyond the activities required in an audit to complete the
formation of an opinion on the fairness of presentation in the
financial statements. Many of these services are logically best
provided by the audit firms--tax return preparation and tax planning,
evaluation of accounting alternatives for planned transactions,
assistance with financial statement preparation for regulatory
purposes, audits or reviews of prospective acquirees in business
combinations are examples. Indeed, any additional services that are
directly related to assuring the fairness of presentation of client
financial statements are proper activities for audit firms to
undertake. Services of these types are often closely related to, and
helpful in, the successful completion of financial statement audits.
They supplement the knowledge base of audit personnel and do not
conflict with the central mission of auditors--forming an opinion on
the fairness of presentation of client financial statements.
Restrictions imposed on these types of services would create
inefficiencies for clients and would not be in the best interests of
investors or the financial or business community.
On the other hand, as the range of services provided broadened,
some were clearly creating potential for conflicts with the basic audit
services. While I am unaware of any evidence that consulting-type
services have ever adversely influenced an auditor's audit judgments on
decisions, the fact is that today existence of some services creates an
appearance that can no longer be tolerated. For example, rendering
internal audit services for audit clients was never a sound idea.
Likewise, services related to the design of financial reporting systems
place the auditor in an awkward position if the system does not
function as anticipated. Actuarial services, executive searches, advice
on specific investment decisions and many more services of this
nature that evolved over the years to generate increased revenues but
either have little relationship to the annual audit or may create
conflicts of interest should no longer be permitted by audit firms for
their audit clients.
The range of services provided by audit firms to their audit
clients grew for a variety of reasons. One was the leaning toward
commercialization previously mentioned. Another was recognition by
firms that their personnel possess skills that extend beyond those
needed to complete audits successfully. Another was a desire, and
ability, to fulfill requests by clients for additional assistance. As
investment bankers and other financial advisers created increasingly
complex business transactions (some designed to circumvent existing
accounting standards), clients logically asked their auditors for
assistance in evaluating the consequences of undertaking such
transactions.
Consistent with the reestablishment of professionalism as the
primary focus of auditing firm services, restrictions need to be
imposed on the range of related services that auditors should be
authorized to provide their audit clients. Drawing lines in this area
will not be an easy task, largely because words used are not always
interpreted in the same manner by all those who have to interpret them.
Given the current environment, it is certainly possible that some
regulations or legislation will suggest scope of service restrictions
that will damage the auditor's ability to develop the best possible
basis for expressing an opinion on the fairness of presentation of the
client's financial statements. Initiatives in this area need to be
undertaken, but they must be undertaken with care so that they do not
frustrate the auditor's ability to complete top quality audit services.
Self-policing mechanisms have not worked well, and the Securities
and Exchange Commission, audit committees or a newly created
independent oversight body may have to play a significant role in this
area. Regardless, attempts to regulate the range of acceptable services
that audit firms may provide their audit clients likely will be
frustrated without leadership in the several firms willingly agreeing
to move away from their commercialization instincts and reemphasizing
the primacy of meeting professional standards in all respects.
Accounting Standard Setting
The Financial Accounting Standards Board, FASB, is soundly
conceived and has operated reasonably well given the difficult
environment it faces. Two principal criticisms of the Board's standards
are that they are not always conceptually sound and that they take too
long to produce from inception of a project to release of a final
standard.
The Board has a conceptual framework that it utilizes in developing
positions on an accounting issue under consideration. That framework is
reasonably cohesive and has served the Board well. Even so, the Board
needs to recognize that its conceptual framework is a living document
that will require modifications from time to time as accounting and
economic concepts evolve. Improvements in its conceptual framework
should have a high priority for the Board.
Too often the Board has departed in its final standard from the
concepts that it has represented will guide its decisions, generally
because interested parties have not only raised objections to
conclusions tentatively expressed, but also have effectively lobbied
against adoption of those decisions the Board has signaled. Such
departures are not surprising given that the processes of the Board are
open, with public meetings, public hearings, and Exposure Draft issued
requesting comments from interested parties. While the comments
received through these open processes are often helpful in the crafting
of a final standard, too often the criticisms are not conceptually
based, but rather are emotional in nature, reflecting a dislike for the
direction the conclusions are taking. Thus, the Board often modifies,
or softens, its tentative conclusions to reflect some of the concerns
expressed in the due process procedures.
The due process procedures are soundly conceived and essential for
the Board to achieve a desirable level of credibility for its
standards. What is needed is a greater discipline by those
participating in the process to direct their comments to weaknesses in
the Board's reasoning processes and to eliminate the emotional
criticisms that have no logical basis. If the accounting standard
setting process is to achieve its objectives of providing guidance on
appropriate accounting for transactions and events of an entity, the
process must be recognized by all participants as being primarily an
intellectual process and not primarily a political process.
As long as the Board is willing to depart from its underlying
concepts in order to gain some measure of concurrence with the views of
its constituents, it will issue standards that will not survive for
long periods without being abused. The Board often receives negative
comments from industry constituents, from auditing firm
representatives, from Members of Congress, as well as others. When
these comments become part of an organized campaign to undermine the
direction a standard is taking and recommend alternative conclusions
that are not conceptually sound, the mission of the Board is
frustrated. This is particularly true when the intervenors are Senators
and Representatives who, as part of their commentaries, threaten some
type of legislation to frustrate the direction in which the Board is
moving. While Senators and Representatives have a legitimate interest
in the workings of the Board, they need to recognize that their
interventions may well lead to Board decisions that are not in the best
interests of investors and the broad business community. Being
supportive of the views of constituents and contributors, without
making conceptually sound alternative suggestions, too often creates
opportunities for interpretations of the resulting standards that are
not in the long-term best interests of any parties.
The time interval required for the Board to promulgate a standard
has long been a concern of the Board itself, as well as other
interested parties. A great contributor to the lengthy process is the
open due process procedures that the Board employs to assure that all
interested parties have an opportunity to provide commentary. Such due
process procedures are generally well conceived and serve the overall
standard setting process well. On the other hand, those who dislike the
direction a project is taking, whether Board members themselves or
Board constituents, probably have too great an opportunity to effect
delay by calling for additional research in order to buy time to lobby
against the direction they perceive the process is moving. The Board
may well need greater discipline in this area and the willingness to
simply move forward at earlier points in the process than has been the
case in the past.
Even with improvements in recent years, the Financial Accounting
Foundation trustee arrangement remains problematical. The trustee group
would benefit from heavier reliance on individuals independent of the
accounting firms and companies that provide a share of the Board's
finances. The challenge is to identify public-minded individuals who
are willing to devote the necessary time to meeting the trustees' two
main areas of activity--identifying and appointing competent Board
members and raising sufficient finances to permit the Board to operate
effectively. While the current financing mechanism could be tinkered
with, no individual entity currently contributes a significant portion
of the Board's budget. I am unaware of any instance in which any Board
member's vote on an issue was influenced by the position taken on the
issue by a contributor. I believe with the proper composition of the
trustee group the issue of independence of the trustees would be
resolved. Alternative means for financing required by the Board may be
considered, but I do not view the present mechanism to be troublesome
as long as major contributing groups are not represented as trustees of
the Financial Accounting Foundation.
For the Board to be able to continue to improve the quality of its
standards the Board needs to place increasing reliance on its
underlying concepts, avoiding to the extent possible standards that
compromise those concepts. Standards that are conceptually sound need
not run hundreds of paragraphs to thwart those who would attempt to
subvert the intent of the standards. Each standard issued by the Board
should contain, in the clearest English possible, the objective, or
intent, the Board intends to achieve by issuing the standard. Each
standard issued by the Board should also contain a clear statement that
anyone who is applying the standard should review carefully its
application to satisfy himself or herself that the objective specified
by the Board has, in fact, been best achieved through the application
that has been adopted.
I am convinced that the FASB process is soundly conceived, that the
Board members over the years have been dedicated professionals of great
integrity and independence, and that the quality of accounting
standards today is better than it has ever been, even with the
shortcomings that some standards contain.
In summary, the financial standard setting process is an
evolutionary one that has grown stronger over the years. Continued
improvement in the areas outlined would strengthen the process further.
Finally, if constituents would refrain from emotional criticisms during
the due process period and if Senators and Representatives would
refrain from interventions that are perceived by the Board as being
heavy handed and politically, rather than intellectually, based, the
accounting standard setting process will continue to improve and serve
investors and the investment community better than any alternative
structure.
The relationship between the FASB and SEC over the years has been a
positive one which benefits investors and creditors. While each
organization has a different mission, each has the same end objective
in mind. Continued cooperation between these two entities is in the
best interests of investors and creditors.
Audit Committees
The requirement for public companies to have audit committees of
the board of directors is a relatively recent phenomenon. Through
interventions of numerous parties, most importantly the Securities and
Exchange Commission, audit committee requirements and procedures have
been modified, and upgraded, over the last several years. Even so, my
experience (mostly as a consultant to attorneys in litigation matters
involving issues of accounting) is that audit committees remain far
less
effective than they could be or ought to be. Audit committee members
need to focus importantly on the various risks faced by their company,
including accounting risks related to the possibility of improper
accounting for new and/or complex business transactions.
While financial statements can be misleading in a variety of ways,
most deficient financial reporting matters fall into four areas: The
timing of revenue recognition, the propriety of cost deferral, the
omission from the balance sheet or related footnotes of any significant
obligations, and the adequacy of disclosures, particularly any that may
center or related party transactions. Audit committees need to question
corporate financial accounting personnel in depth about such matters
and the risk of possible financial misstatements. Likewise audit firm
representatives need to be similarly questioned. In addition to routine
agenda matters, each audit committee meeting should focus on a
particular business risk area (including potential accounting risks)
and any significant concerns emerging from such discussions need to be
aired further with the full board of directors.
At least the audit committee chairman, and preferably all audit
committee members, should have experience in evaluating business risks
and should be sufficiently conversant with accounting issues to raise
appropriate questions with an ability to evaluate the responses
received. Too often audit committee meetings are perfunctory in nature.
Real opportunities to gain an understanding of business risk areas are
missed. As a result the process in place is not as effective as it
could be, nor as effective as those who accomplished the establishment
of audit committees had a right to expect such committees would be.
Audit committees should be especially curious about the so-called
adjustments proposed by auditors but not made by company accounting
personnel. Oftentimes the basis for the company not making the entry is
that the amount involved is not material. Materiality is an elusive
concept that is even more elusive in practice. Audit committees should
pressure company accountants and the auditors to resolve any open
proposed adjusting entries either by the company accepting the entry
for recording or the auditor concluding that the proposed entry should
be eliminated from its schedule of open proposed adjusting entries. In
too many instances the materiality judgments made have masked what, in
fact, was inappropriate accounting, accounting that fell outside
Generally Accepted Accounting Principles.
The audit committee concept is a sound one. Through efforts of the
New York Stock Exchange and the SEC improvements in committee
composition and mission should continue to evolve. Honest managements
and responsible auditing firms should welcome audit committee
involvement when such committees are constituted properly, with
knowledgeable individuals willing to gain an understanding of the
underlying business risk issues and raise questions on appropriate
accounting and disclosure matters.
Disciplinary Mechanisms
My experience with this issue, as well as my knowledge base is
sparse. The current mechanism, under the auspices of the American
Institute of Certified Public Accountants, however, clearly is not
working. Over the years the AICPA has become more and more a trade
association and less and less a professional organization. The
diversity of interests of its members, from sole practitioner to large-
firm partner, to corporate executive makes it almost impossible for the
AICPA to exercise leadership and articulate policies that one would
expect of a professional organization. Its emphasis has been on
expanding its breadth of membership rather than on providing leadership
in professional practice areas or disciplinary policies that would be
effective.
Suggestions have been made recently for creation of a new
independent oversight board comprised of leading individuals
independent of the accounting profession. While the AICPA sponsored
Public Oversight Board has been comprised of highly regarded
individuals, its effectiveness has recently been questioned. Who should
be the ``parent'' or ``owner'' of such a board is a difficult issue
that I have no particular insights in resolving.
Over the years the Securities and Exchange Commission has been a
generally effective agency working toward improvements in financial
reporting. Even so, its resources have probably been far too limited to
achieve the optimum level of success in its diverse objectives. I would
be inclined to provide increased funding to the SEC and have it assume
the principal role in overseeing the effectiveness of the financial
reporting process. Creation of a new agency to undertake this
responsibility seems unnecessary in view of the record established by
the SEC over the past 65 years.
In summary, I feel that the leadership of the major accounting
firms should see today that it is clearly in their best interests to
refocus their objectives on quality professional performance and to
refrain from growth through expansion of services rendered. New
restrictions on scope of practice, possibly monitored by the SEC, are
desirable and in the public interest. The FASB should place increased
emphasis on conceptually sound standards and on more timely issuance of
such standards. The Board should experiment with how better to craft
its standards so that corporate accountants and auditors will be
encouraged to apply the standards so as to best meet articulated
objectives of the standards rather than to search out and expand
possible loopholes that lead to applications that fail to reflect the
economics of transactions undertaken. The Board should continue its
efforts to rebuff initiatives of its constituents, including elected
officials, when such initiatives are more emotionally than conceptually
based. Audit committees should be encouraged, possibly by the New York
Stock Exchange and the SEC, to be more diligent and effective in
overseeing corporate risk exposures and accounting policies that accord
fully with the intent of applicable accounting standards. Finally,
improved disciplinary and oversight mechanisms on professional practice
firms need to be instituted so that variant behavior is identified
early and punished if not corrected.
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PREPARED STATEMENT OF ABRAHAM J. BRILOFF
Emanuel Saxe Distinguished Professor Emeritus
Bernard M. Baruch College, CUNY
March 6, 2002
Accountancy and Society / A Covenant Desecrated
The Commission is fond of quoting Judge Friendly's statement: ``In
our complex society the accountant's certificate and the lawyer's
opinion can be instruments for inflicting pecuniary loss more potent
than the chisel or the crowbar.'' U.S. Circuit Judge Henry Friendly,
United States v. Benjamin 328 F2 85, 863 (1964).
Chairman Sarbanes, Members of the Committee on Banking, Housing,
and Urban Affairs of the U.S. Senate: I very much appreciate this
opportunity of appearing before you this morning to share with you my
views regarding the crisis in confidence which presently confronts my
profession of certified public accountancy and then to suggest what I
believe to be the essential critical path to resolve that crisis.
After much reflection I have opted for the title theme for today's
presentation, ``Accountancy and Society / A Covenant Desecrated.'' I
recognize that I have thus opted for an awesome theme; I mean it to be
just that, i.e., most certainly not a mere rhetorical conceit.
The Covenant
The covenant to which I am alluding involves on the one hand the
mandate which is imposed on certified public accountants by the
statutes which created that professional license; from the New York
Statutes going back to the close of the 19th Century. Definition:
The practice of the profession of public accountancy is
defined as holding one's self out to the public, in
consideration of compensation received or to be received,
offering to perform or performing for other persons, services
which involve signing, delivering or issuing or causing to be
signed, delivered or issued any financial, accounting or
related statement or any opinion on, report on, or certificate
to such statement if, by reason of the signature, or the
stationery or wording employed, or otherwise, it is indicated
or is
implied that the practitioner has acted or is acting, in
relation to said financial, accounting or related statement, or
reporting as an independent accountant or auditor or as an
individual having or purporting to have expert knowledge in
accounting or auditing.
On the other hand there is the very special franchise granted to
the accounting profession by a 3 to 2 vote of the Securities and
Exchange Commission at its inception, that requiring all registrants to
submit statements audited by accountants in the private sector rather
than by employees of governmental agencies. That special franchise is
generating revenues amounting to billions of dollars annually.
Why the Covenant
This covenant was undertaken between my profession and society for
most compelling reasons--reasons which have been increasingly
compelling with the passage of time and the corresponding expansion
exponentially, it might appear, of our economic society and complexity
of our corporate enterprises. It is to assure the effective functioning
of capitalism powered by the corporate complex which demands an
effective system of corporate governance and accountability--and it is
to help drive such a process that the covenant was entered into by
society with my profession.
Let me back up a bit: I believe it to be self-evident that in the
day-to-day existence of our citizenry the private sector of corporate
complexes plays a far more
direct role than the Government. Thus, the air we breathe, the
recreation we enjoy our mode of mobility, our habitats, health, and
economic well-being are all impacted by decisions by those who somehow,
somewhere control the conduct of corporate
enterprises.
Here then is where we meet up with the Power without Property
Syndrome, described early in the 20th Century by Gardner C. Means and
later expanded by Adolf A. Berle. Thus, enormous pools of power have
been delegated to managements by those who are the owners of the
resources, that is, shareholders, creditors, Government, employees, et
al.
To assure those who have thus delegated their resources to
managements we have conceptually, at least, built in a system of checks
and balances, a system of corporate governance and accountability. I
picture that system as a series of concentric rings, somewhat as
follows.
The Corporate Governance and Accountability System
At the vortex of the constellation is management, the very center
of power of the corporate complex. The first of the outer rings in this
configuration is the board of directors whose authority is derived from
the shareholders and presumed to be responsible for determining the
policies of the corporate enterprises and then reviewing their
operations to assure their constituencies that the policies are, in
fact, being fully and fairly implemented.
There then follows an especially critical sector, the independent
audit committee of the board of directors. Here, too, those who have
been elevated to this special role and responsibility should be
continuously aware of the reasons why such a committee has become such
a vital force in our corporate governance and accountability process.
They should be continuously mindful of the terms ``independent'' and
``audit'' and make certain that they possess the temperament and
healthy skepticism called for by the standards governing independent
audit committees. Thus, those committees were mandated first by stock
exchanges and then by the SEC in response to critical developments over
the years; it is only if the members fulfill their roles
conscientiously and professionally, determined to act as watchdogs
rather than managements' lapdogs, that they will be fulfilling the very
special mandate which has been bestowed on them and presumably accepted
by them.
This now brings me to what is for me the crucial ring in this
constellation, that of the independent auditor, the one who has entered
into the covenant with society; the one who is presumed to have
undertaken the role and responsibility of probing the conduct of all
aspects of the corporate enterprise as the surrogates on behalf of the
world of third parties.
In short, those are the qualities which our society had presumed of
the independent auditors as an incident to the entering into the
covenant. Absent those qualities, anything which compromises those
expectations represent a breach, a desecration of the covenant.
This brings us to the ring to representing the nexus of State and
Federal agencies involved in the regulation of the corporate complex.
At the outset, we have the States which bring the business enterprises
into existence by the granting of corporate charters or licenses as
appropriate.
It is also the States which bestow the licenses for the various
professional pursuits, accountancy, law, etc., which may be involved in
the corporate governance and accountability process. But of special
import for present purposes are the regulatory agencies, Trade,
Utilities, Transportation and, especially for us here today, the
Securities and Exchange Commission which is charged with the
administration of the Securities Acts of 1933 and 1934, and the source
of Regulation S-X providing the rules governing the registrant's
accounting responsibilities and practices. It is undoubtedly the SEC
which comes to mind regularly during these days of agonizing appraisal
and reappraisal as to what went awry at Enron--and wherever else
accounting irregularities are now surfacing with regrettably increasing
frequency.
The next succeeding ring is the Congress of the United States which
over the scores of years since the Great Depression has, through its
Investigative and Legislative actions critically, vitally, impacted the
standards for corporate governance and accountability.
We move outward then to the Judiciary, principally the Federal
courts which through their determinations in civil and criminal
proceedings further define the standards for conduct of all those
involved in the corporate enterprise.
This would complete the corporate governance and accountability
configuration as I envisage it. But then too at each of the stages of
the process we find the professions of the law, finance, journalism,
academe, in addition to accountancy beyond that of independent
auditing. All of these phases when functioning optimally consistent
with their professed objectives should assure the effective functioning
of our corporate enterprise system which, as I have emphasized, is the
engine which propels modern capitalism system. If this system of
interrelated responsibilities fails, we have the Enrons, et al.
Some Footnotes to History
In the hope that it might help to avoid repeating its mistakes,
herewith some
footnotes to history relating to past endeavors to overcome the
recurring crises in corporate accountability.
There was a flurry of activity during the second half of the
1970's, including:
Late 1976 a staff study dubbed The Accounting Establishment
was prepared for the U.S. Senate Committee on Government
Operations.
The following year extensive hearings were held under the
Chairmanship of Senator Lee Metcalf.
To placate the extensive criticism leveled at the accounting
profession its leadership, the AICPA, the Big 8, agreed to what they
assured us would be an
effective response to the crisis. This included the creation within the
AICPA of a Division for Firms especially its SEC Practice Section and
Public Oversight Boards; all that together with a system of peer review
was going to lead us to Nirvana.
Alas! As predicted, peer review became nought but mutual back
scratching; the POB was soon co-opted by the AICPA so that the
presumptive public protector became another layer of insulation to
protect the Accounting Establishment.
By way of a justification of the foregoing cynical observation, I
have regularly challenged the POB and its parent body the AICPA to
point me to any disciplinary sanctions meted out against those
identified with the Accounting Establishment who have been prominently
identified with serious audit failures after audit failures. That
challenge continues to the present.