[Senate Hearing 107-948]
[From the U.S. Government Publishing Office]
ACCOUNTING REFORM AND INVESTOR PROTECTION
VOLUME I
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 I
ON
THE LEGISLATIVE HISTORY OF THE SARBANES-OXLEY ACT OF 2002:
ACCOUNTING REFORM AND INVESTOR PROTECTION ISSUES RAISED BY ENRON AND
OTHER PUBLIC COMPANIES
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FEBRUARY 12, 14, 26, AND 27, 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
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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
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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
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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
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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
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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
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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
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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
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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
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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 I
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TUESDAY, FEBRUARY 12, 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 Committee on Banking, Housing, and
Urban Affairs conducts the first in a series of hearings that
have been scheduled and are being scheduled on accounting and
investor protection issues raised by the problems of Enron
Corporation and other public companies. These issues have taken
on increasing significance in recent years and Enron's
situation has, of course, placed them in the national
spotlight. They have a critical impact on the national
confidence in the financial markets.
In 2000, Enron Corporation was among the top 10 of the
Fortune 500 and had a stock market value of over $60 billion.
Its financial statements had been audited and certified by one
of the major public accounting firms, Arthur Andersen. Stock
analysts glowingly recommended its stock.
On October 16 of last year, Enron took a billion dollar
write-down of investments. On November 8, Enron reported that
it had overstated earnings since 1997 by $586 million. On
December 2, Enron filed for bankruptcy.
The stunning collapse of Enron has cast a long and dark
shadow over our capital markets, crowding other important
stories off the business pages and creating widespread anxiety.
Headlines like: ``Worries of More Enrons To Come Give Prices A
Pounding,'' The New York Times, January 30; and ``Nervous and
Scandal-Shy Investors Hold Prices Down,'' The New York Times,
February 6, have become routine. The Baltimore Sun just 2 days
ago has: ``Investors Squeamish Amid Turmoil.'' And you can pick
up virtually any paper in the country and see comparable
headlines.
A troubled and uncertain economy is further aggravated by
what is widely referred to as the ``Enron Effect.'' The
enormity of the losses that Enron employees have suffered in
their retirement
savings has sent shockwaves through working men and women
everywhere. As The Washington Post put it, if one company
``issued make-believe accounts, why should anyone believe that
dozens of other companies aren't practicing the same
deception?''
The failure of Enron raises numerous important issues that
have arisen on occasion in connection with other public
companies as well. These involve: The integrity of certified
financial audits; appropriate accounting principles and
auditing standards; the effectiveness of the accounting
regulatory oversight system; the impact of auditor independence
on the quality of audits; the completeness of corporate
disclosure in SEC filings and shareholder communications; the
adequacy of the SEC's ``selective review'' process for
disclosures filed by public companies with novel and complex
finances; conflicts of interest among affiliated securities
underwriters, stock analysts, and lenders, as well as
accountants; insider abuses; the clarity of recommendations by
stock analysts; corporate governance; the quality of agencies'
debt ratings; and the adequacy of resources available to the
Securities and Exchange Commission to meet its
responsibilities.
The Committee will hear from a broad array of witnesses
with long and distinguished experience in the relevant fields,
in both the public and private sectors. We will seek their
views on the developments that made the collapse of Enron and
other significant failures possible. Above all, we will seek
their recommendations as to appropriate steps this Committee
might take to minimize the prospect of any future event of this
type.
The Committee's inquiry in the weeks ahead will focus on
the protection of investors and the efficient functioning of
our capital markets. These markets are critical to a healthy
economy and, indeed, to our national economic strength at a
time when our Nation faces unprecedented challenges.
It is commonplace, but nonetheless worth repeating, that
our markets depend on investors' confidence. As The Washington
Post, among others, has pointed out in an editorial on January
24, it is the public trust that allows our Nation's vaunted
markets to function. As investors make the financial decisions
that significantly shape their lives and assure their families'
well-being, they must be able to rely on information available
to them as being complete, accurate, timely, and
comprehensible.
Today, for the first time in our Nation's history, a
majority of Americans are investors, either directly or
indirectly--a development in which our markets take great and
understandable pride.
As we proceed with our work, we must keep in mind that
although many of the issues we will be examining in the weeks
ahead are highly complex, they have implications that are
critical to the security of the American investing public. They
reach the fundamental principles of trust, which it is our duty
to protect and strengthen.
We are very pleased this morning to have this panel of very
distinguished witnesses to share their views on the current
situation and to offer recommendations for minimizing the
likelihood of similar problems in the future.
I will introduce each of them as we proceed through the
panel. But I simply want to say that we have the former
Chairmen of the Securities and Exchange Commission over the
last quarter of a century here with us this morning. We very
much appreciate the effort, time, and thought which has
obviously gone into the prepared statements that have been
submitted, and we are very much looking forward to this panel.
At this point, I will yield to my colleagues for any
opening statements they may have.
Senator Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman. I commend you for
holding this hearing. It will be the first of many, I hope, to
get to the bottom of a real problem.
I think that everyone recognizes that the Enron story is
what has focused our attention and led to today's hearings. I
am hopeful that the present investigations will uncover the
facts and lead to the appropriate sanctions and perhaps
prosecutions.
The Enron story is just one chapter in a larger book. Its
collapse is just one indication of the existence of much larger
problems. Enron highlights systemic issues which merit
consideration.
Over the last few years, a troubling pattern has developed.
Time and again we have heard of public corporations having to
restate the financial information they provided to the
investing public.
These recalculations have not been made because the
corporations were too conservative in their assessments. Indeed
not. What we have seen are corporations admitting that revenues
were not as large, that expenses and losses were not as small,
and that, in the end, things were really not as good as had
been initially indicated. This seems to be a corporate scheme
to trick the investors.
That public companies would try to make things sound as
positive as they can to the investing public does not surprise
me. Obviously, they have a strong interest in driving up their
share prices.
This self-interest, however, has long been recognized. To
counter it, our financial markets have traditionally relied on
the independent, objective analysis of audits performed by
certified public accountants.
The outside audit gave investors confidence that corporate
numbers did not come from the Land of Make Believe. Investors
could make decisions knowing that, for whatever risks they were
taking, at least the financial information had been reviewed
and certified as true by an unbiased party.
Regrettably, Mr. Chairman, growing doubt is replacing
investor confidence regarding the accuracy of financial
information. The trend of restatements and audit failures has
put the independence and objectivity of outside auditors in
question. In far too many cases, the numbers have just not
added up.
There are serious consequences associated with this
situation. First, real people have lost real money because they
relied on information that later proved to be inaccurate, if
not outright false. Look at the Enron situation. Billions of
dollars of market value have been wiped out and investors and
creditors will get back very little of what they put into the
company.
Unfortunately, Enron is only the tip of the iceberg. Some
experts have estimated that investors have lost almost $200
billion over the last 6 years due to earnings restatements and
to lost market capitalization following audit failures.
It must be noted, Mr. Chairman, that some amount of that
$200 billion represents retirement savings, investments for
children's educations--the financial hopes and dreams of
thousands of Americans--all gone after the follow-up stroke of
an accountant's pen.
Mr. Chairman, there are additional but perhaps less
tangible losses associated with the unchecked flow of bad
financial information in the marketplace. When some companies
put out inaccurate information about their financial condition,
investors cannot make informed investment decisions. They make
choices based on appearances instead of reality. What results
is that good companies that provide useful goods and services
fail to attract their fair share of capital because less
valuable companies look better on paper. Our society suffers
because the development of new and better products and services
are delayed or perhaps never occurs.
When auditing failures result in good investments on paper
being bad investments in reality, capital does not flow to its
best use, the market does not properly reward innovation, and
over time, the firms that lose out themselves see the value of
cooking the books.
Mr. Chairman, the unchecked flow of bad financial
information in the marketplace has a final and perhaps most
devastating effect: It destroys investor confidence.
If people believe that the markets are rigged, if they
believe that some have greater access to crucial information,
if they cannot trust the information that is available to them,
they will walk away. They will stop investing. They stop
participating.
Our economy has provided the best material standard of
living in the world because the goal of our laws and
regulations has been to favor clarity over complexity,
disclosure over dissembling, and fairness over favoritism.
Mr. Chairman, it would seem that the important goals we
once established are no longer being met. Audits no longer
consistently provide the type of accurate information that the
markets require.
At the end of the day, I believe it is our responsibility
to do something about this serious problem.
Chairman Sarbanes. Thank you very much, Senator Shelby.
Senator Miller.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. Thank you, Mr. Chairman, for conducting
this hearing and I thank these distinguished panelists.
I am going to pass on an opening statement, but I look
forward to asking some questions after we hear from them.
Chairman Sarbanes. Thank you very much.
Senator Enzi.
STATEMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. Mr. Chairman, I appreciate your holding
today's hearing and especially collecting the brain power of
every living Chairman of the SEC since 1975. It is very
impressive and should be extremely helpful to us.
In the Enron case, of course, we are still in the finger-
pointing stage. There are enough fingers being pointed in
enough directions to cover almost everybody. I am anxious for
us to get through the investigation-reporting stage and get to
some reasonable solutions.
And by reasonable solutions, I am hoping they are not
artificial actions that will give the investor over-confidence,
and I am also hoping that it won't be an over-reaction that
will cause problems for companies and force them into a
situation like we are seeing.
The rise and the fall of this company is complex and
confusing. From a visible standpoint, it happened over just a
couple of months and is pretty astonishing, even though the
troubles developed much earlier and probably should have been
caught much earlier.
As more and more details become apparent, we know that
complex accounting gimmicks with partnerships overstated
earnings by hundreds of millions of dollars and hid additional
debt of over a billion dollars, and this was all at the same
time that the executives at Enron were deriving tens of
millions of dollars of compensation from these same corporate
partnerships.
This was happening as the investors and employees were
being misled into investing their money in the company. What is
even more troubling is that the company's executives had to
know these problems would be realized at some point. They had
to know that the masquerade could not go on forever. However,
instead of being forthright, company officials were often
uncommunicative and arrogant during conference calls with
analysts. And if an analyst asked a question the company did
not feel they should answer, they would simply accuse the
analyst of being unknowledgeable and did not know what he was
talking about. This should have raised eyebrows through the
analyst community.
Enron is a situation where the system failed at every step.
The executives misled everyone, the board did not catch it, the
auditing firm neglected to do their duty adequately, the
credit-rating agencies did not fully understand the financial
position of the company when they gave Enron an investment-
grade rating and, as I already mentioned, the analyst community
did not lower their rating on the company when they refused to
answer questions.
Today, we need some insight from the SEC. In 1995, Enron
had revenues of $9.2 billion. In 1999, they were $40 billion
and then made an astounding jump in 2000 of over $100 billion.
Why, with this incredible increase in revenues didn't Enron
have audits reviewed more frequently?
I understand that companies in the economy overall were
showing incredible growth. But over a 10 year period, Enron had
returns a thousand percent higher than the S&P 500 as a whole.
Shouldn't this have sounded alarms to almost everyone?
Mr. Chairman, details are slowly emerging from this crisis.
I have every confidence that our enforcement agencies at the
SEC and the Department of Justice will prosecute any executives
who violated existing laws. However, I join all of my
colleagues in committing that we will take the necessary steps
to protect investors and ensure them that they can once again
be confident in placing their investments in markets.
We will take the necessary actions to strengthen laws where
needed and to make new laws if necessary.
Again, I thank the Chairman for beginning the process and
in bringing this distinguished panel to us.
Chairman Sarbanes. Thank you, Senator Enzi.
Senator Corzine.
STATEMENT OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman. I commend you for
holding this hearing and the process that we are about to begin
to work through the problems that we have been faced with that
are, I think, revealed by the Enron debacle.
Let me also begin by commending and thanking the witnesses
that are here. It is an extraordinary panel. Your work to
prepare for this hearing is exceptional and I want to
compliment you on the service you have given our Nation in
serving as Chairmen of the Securities and Exchange Commission.
It is time to move from the blame game into, in my view,
coming up with the right kind of responses that do not inhibit
our financial system and our ability to work well, but also
restore the kind of investor confidence that I think people
expect from America's public companies and is a necessary
element to the effective functioning of our financial markets.
I certainly believe we need to find the right balance in all of
the issues. I would just mention a few of them that certainly
concern me.
I think that we need to certainly restore the independence
of the outside auditors. Not only the auditors, but also other
outside analysts and commentators with regard to corporate
valuation, corporate reporting.
We certainly need to improve the oversight of the auditing
industry and there are different ways to review that and I
certainly look forward to hearing the comments of the witnesses
who have the experience along this line.
We need to upgrade the independence and I believe the
public's confidence in the corporate governance. We believe in
corporate democracy. We have to have a corporate governance
system that is reflective of that and in a sincere and serious
way.
We need to provide adequate resources so the SEC can
actually do its job. It has many authorities, but without the
resources, I think we have a hard time expecting people to do
the job the way that they are expected to, troubled by the
current flat allocation of budget resources to that.
I certainly look forward to questioning what kinds of
resources are necessary and where you think we ought to go with
that. And then there is the whole issue of speed and
facilitation and clarity with which accounting rules are
developed and provided.
I, being a student from time to time, know that these are
difficult to understand even by those most trained and I
certainly hope to hear your comments with regard to these
issues and a number of others.
We have kind of had a train wreck in this country, maybe a
number of them. We focus on one company, but there has been a
series of these and the restatement issues that several of my
colleagues have mentioned is a troubling aspect. I think we
ought to take this opportunity to be thoughtful and reflective
and come up with balanced reforms.
I certainly look forward to working with the Committee, the
Chairman, Senator Dodd, with all of you to try to get that
right balance and sense of direction that we should follow in
this.
Mr. Chairman, thank you very much.
Chairman Sarbanes. Thank you, Senator Corzine.
Senator Hagel.
COMMENTS OF SENATOR CHUCK HAGEL
Senator Hagel. Mr. Chairman, thank you.
I also want to welcome our distinguished panel of witnesses
and thank them for taking their time to be with us this
morning.
Mr. Chairman, I look forward to their testimony.
Chairman Sarbanes. Thank you very much.
Senator Stabenow.
STATEMENT OF SENATOR DEBBIE STABENOW
Senator Stabenow. Thank you, Mr. Chairman, and to all of
our guests today for your input. We very much need your
thoughtful suggestions and input to us.
I want to thank the Chairman for your thoughtful and
thorough approach that you are taking to this very difficult
challenge of reassessing the accounting and consulting
industry.
The issues that are going to be raised in the next 6 weeks
I think are critically important to the Nation. And in
particular, we must work to insure that the public can receive
useful and reliable information before they make investment
decisions, as my colleagues have said.
Unless we assure that companies provide accurate
information that is widely available to all potential
investors, we are allowing companies to jeopardize the American
people's retirement funds. And of course, we have seen that
most recently with Enron.
Whether the unraveling scandal reveals intentional fraud
and deception of a criminal nature or not, it is clear that the
information available was not enough for the public to make
informed investment decisions.
Now more than ever, with about half of the American public
invested in the stock market, we need accounting information to
be accurate, to say the least.
Investing in the market is becoming a necessity for
people's long-term economic security. And the Enron scandal was
not just an event unique to Houston or Texas, but of course we
know that there has been a ripple effect across the country.
In fact, in Michigan, the Genessee County Employees Pension
Fund lost $370,000 on Enron's fall, and I know that there were
hundreds of thousands of dollars that were lost in other
pension funds, not to mention the employees who lost their life
savings.
How can people have confidence in the market if they are
not given accurate information? Obviously, they cannot.
The fate of thousands of people's life savings is too
important for us not to act, and that is why I very much
appreciate this hearing.
Mr. Chairman, I hope that once we move beyond the
discussions to eventual legislation, that we will be able to
look at a number of different issues. I hope we will discuss
whistleblower protections. In the case of Enron, it appears
that many people in the company knew what was going on was
wrong, but were stuck in the corporate culture that prevented
them from coming forward. And I would like to know what
suggestions you would have for us to address that.
We must examine the issue of the correct regulatory system
for the industry, as we all know. It is clear that there are
serious problems that have been raised by the many stories
about insufficient oversight and regulatory authority,
problematic audits of consulting companies by other consulting
companies, and the degree to which it is appropriate for
companies to offer auditing and consulting services to the same
client.
I look forward to the input today. Mr. Chairman, I look
forward to the next 6 weeks and I am hopeful that we will be
able to arrive at some thoughtful and just responses that will
protect the investment security of the American public.
Chairman Sarbanes. That is certainly our objective. Thank
you very much, Senator Stabenow.
Senator Bayh.
COMMENTS OF SENATOR EVAN BAYH
Senator Bayh. Thank you, Mr. Chairman, for holding these
hearings. I want to compliment you and Senator Shelby on
particularly comprehensive opening statements. I think you
framed the issues before us today very well.
Because of that and the other comments by our colleagues, I
find myself in the position of a Member of the House of
Representatives who recently rose on the floor of that body to
say--I rise to restate that which has already been restated.
[Laughter.]
So, I do not want to follow in that pattern today. I will
limit my comments to three things.
First, I would also like to thank the panelists for being
with us today. Each of them are eminent public servants and we
are grateful for your time and your insights.
Second, obviously the integrity of the financial data
available to the public is the foundation upon which our
financial system is constructed. And when there are questions
about that foundation, the costs are great, not only for the
individuals immediately impacted, but also for the system as a
whole.
Finally, it seems to me that the balance, Mr. Chairman, we
are seeking to strike is between putting into place safeguards
that try to ensure that the tragedy of Enron can never happen
again with the losses to individuals in the system entailed by
that on the one hand, and on the other hand, not unduly raising
costs to the vast majority of honest business people and
participants in the marketplace, because those costs would be
felt by investors as well.
I am keenly interested in your insights, gentlemen, about
how to strike that appropriate balance to preserve the
integrity of the financial data and at the same time not unduly
increasing costs to the system as well. I look forward to your
comments.
Mr. Chairman, I thank you.
Chairman Sarbanes. Thank you, Senator Bayh.
Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. In about 26 minutes, I get to preside over
the Senate. And rather than me giving a speech and telling you
what I think we ought to do, I am anxious to hear what you
think we ought to do.
We are delighted that you are here and for each of you,
thank you for your stewardship and service to our country. I do
not know if there has ever been a time that the five of you
have been together like this. So this might be historic just in
and of itself.
The only other thing I would add is that when I am trying
to make a tough decision, I try to surround myself with people
that are smarter than me. My wife says it is not hard to find
them.
[Laughter.]
We have five smart people here, Mr. Chairman. My hope is
that we will come out of this hearing with a confluence of
opinion, where we can find those areas where there is
agreement, and that will enable us to go forward, whether we
act legislatively or regulatorily, or we simply let the
industry take the appropriate policing action.
But my hope is that from your mouths, from your words, will
come the foundation for a very good consensus of what we know
is an important and tough issue.
Thank you.
Chairman Sarbanes. Thank you, Senator Carper.
Senator Johnson.
STATEMENT OF SENATOR TIM JOHNSON
Senator Johnson. Thank you, Mr. Chairman, for holding this
timely hearing and welcome to our distinguished panel.
I will abbreviate my comments because we do need to
expedite things to get to the panelists themselves. But let me
note that aside from accounting issues, and we could go on at
some length about that this morning, another area of special
concern to me is the conduct of securities analysts and their
impact on the market.
In the case of Enron, we saw analysts turn a blind eye to
the emerging problems, possibly due to conflicts of interest
because of affiliations with investment banking operations.
Clearly, the firewall that should have provided an environment
of independence for analysts did not function in many
instances.
The SEC, I believe, must be aggressive in enforcing our
securities laws and in keeping our markets the most transparent
in the world. I am deeply concerned that the SEC has not been
given the resources to maintain a sufficient and stable human
resource base to fulfill its mission. Over one thousand SEC
employees, more than a third of the agency's staff, has quit
over the past 3 years, largely due to the low pay scale at the
SEC compared to other financial regulators in the private
sector. As any business person knows, that kind of turnover has
a clear impact on the institution's ability to operate
effectively.
Just before Christmas, the Senate passed H.R. 1088, the
Investor and Capital Markets Fee Relief Act, which President
Bush has now signed into law. In addition to reducing
securities transactions registration fees, the law authorized
the SEC to bring the pay of its employees in line with the
higher pay schedules of other Federal financial regulators.
Mr. Chairman, I was profoundly disappointed to find that
the President's budget failed to include additional amounts for
SEC salaries for fiscal year 2003, as was envisioned by the
Congress when we enacted that legislation.
It is no overstatement to say that a strong SEC is an
integral part of our homeland security. And money needs to be
made available to ensure that the guardians of our markets are
not paid less than those minding our banks. It is my hope that
we can engage in a dialogue with the Executive Branch to
address the pay parity issue and to create an environment at
the SEC that enables employees to contribute to the economic
security of our Nation.
In closing, I would like to note that Mr. Levitt was ahead
of his time by attempting to address many of these issues
during his SEC tenure. At the time I supported Mr. Levitt's
proposal to create strict guidelines governing the consulting
role of companies' auditors, and I am pleased that the private
sector and my colleagues are coming to understand the wisdom of
that proposal.
In addition, it is my understanding that a study was
initiated to determine whether the peer-review process employed
by auditors was appropriate and effective. Clearly, though,
much more needs to be done.
I want to thank the witnesses and thank the Chairman for
this timely hearing.
Chairman Sarbanes. Thank you.
Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Thank you, Mr. Chairman.
I want to add my thanks to you for holding this hearing and
to all of our witnesses today. The witnesses here have a great
legacy, which is the creation of capital markets that are the
envy of the world.
Since the Great Depression, when we decided that regulation
was necessary for growth of the markets, our country has really
reached a balance between regulation and free market
competition that has not just produced public confidence, but
also a great deal of trust. And it is not an accident that
billions and maybe even trillions of dollars from the rest of
the world flow to our capital markets. It is mainly because
people think they are on the level, that there is trust.
One of the great worries I guess that all of us have here
today is that that trust has been eroded. That is a cancer to
the markets and we have to do everything we can to restore it,
because if people do not think that they are on the level and
do not invest in them, that is probably the greatest problem
that these markets can face.
I am not going to get into a whole lot of detail, either,
Mr. Chairman. I know we have a vote. Just to make a couple of
points.
First of all, I think that disclosure, which has been the
hallmark of the SEC, has to be strengthened. There are a lot of
ways that we can do that. One of them that we should look at is
building on the Regulation FD that Chairman Levitt had
advocated.
People should know when senior executives are selling stock
and they should know it right away, and then they can make
their own judgment. But at least that makes sense.
Disclosure also of all of these special entities,
everything about them should be far more public than it is now.
I think that is an important thing to do as well.
Then we will have to go beyond disclosure, obviously. But I
think disclosure is sort of a sine qua non, and that is one of
the problems. If everyone knew about all of this sooner, all
the problems might not have happened.
Then, again, trying to, as we always have to every so often
in the free market system, sort of readjust the balance. And it
clearly needs some readjustment now. I hope that the kinds of
things that we have seen Enron do are not widespread.
The fact that we saw some of them at PNC, the banking
industry is one of the most highly regulated, and that gives me
cause for concern.
I very much look forward to hearing the testimony of all of
the witnesses today.
Chairman Sarbanes. Thank you very much.
Senator Dodd.
STATEMENT OF SENATOR CHRISTOPHER J. DODD
Senator Dodd. Thank you very much, Mr. Chairman. I
apologize for getting here a few minutes late. We have hearings
downstairs on early childhood education, which I know is an
important subject matter for all of you here as well.
Mr. Chairman, first of all, thank you for today's hearing.
I know there are a lot of other hearings going around on
Capitol Hill this morning, last week, next week, delving into
what happened. But this hearing and the hearings that you have
scheduled I think may be the most important in many ways, as
well as the hearings we had last week on financial literacy
which Senator Corzine, yourself, and others have spent a lot of
time talking about, because this is forward-looking.
Obviously, we have to know what happened in order to make
suggestions about what we should do. But bringing in people
such as the panel here today is going to be tremendously
helpful I think in helping us frame those ideas.
The collapse of Enron has wiped out the life savings of an
awful lot of good people. Thousands and thousands of dollars
have been lost. It has unsettled America's capital markets. It
has shaken investor confidence.
We saw the market reaction last week, although yesterday,
the markets seemed to rebound a little bit. But we won't know
for some time how shaken the markets have been as a result of
what has occurred.
Of particular importance to this Committee, the Enron
bankruptcy, has called into question the fundamental rules and
regulations that oversee America's financial system, and
therefore, the importance of this hearing and listening to our
panel.
If there is a silver lining in all of this, however, and we
always try to find silver linings, I suppose, in the dark cloud
here created by this huge bankruptcy, it may be that it will
pave the way for some reforms that will not only reduce the
chance of future Enrons, but also strengthen the American
economy.
A top priority for the Congress and this Committee must be
swift action on these reforms. I suspect we would not even be
talking about these issues, unfortunately, were it not for the
kind of situation that has occurred.
America's financial markets remain the most vibrant in the
world. And the reason for this has been very simple. The
Chairman has talked about this over the years, others have as
well. And in my view, it is the simple notion of investor
confidence.
The world comes to America, not because you have the
potential best return on your investment, but because they
believe that the rules are fair and the people are treated
fairly. That has been the cornerstone of our success over the
years. The integrity and accuracy of information made available
to the public has been critical to that conclusion.
The world comes to America because they know our numbers
are good and they will receive a fair deal. The independence of
the audit function has placed I think a very vital role in
attaining and ensuring this investor confidence. The seal of
approval provided by accounting firms has constituted a
franchise held in very high regard by the public, and
deservedly so. However, that franchise is in real danger of
losing the investing public's trust.
Once lost, that trust will be very, very difficult, if not
impossible in some cases, to recover. It would have grave
consequences, in my view, not only for the accounting
profession, but also far more importantly in many ways, for the
investor confidence that is the cornerstone of our financial
markets.
In recent years, there have been a series of high-profile
accounting failures, of which the Enron case is but the most
prominent and the most highly publicized.
A recent study by the Financial Executives International
Trade Group for Corporate Executives found that public
companies had revised their financial results 464 times between
1998 and the year 2000, nearly as many restatements as in the
past 20 years combined. These restatements have, in most
instances, dramatically downgraded the financial health of the
companies in question, costing shareholders billions of
dollars.
The ability of the accounting firms to audit a company's
books while at the same time selling it other services, has
created a significant risk in conflicts of interest and maybe
have chiefly contributed to this troubling pattern of major
restatements.
For example, Arthur Andersen served not only as Enron's
auditor, but also its primary financial consultant. Indeed, it
earned more from Enron in consulting fees than audit fees, $27
million versus $25 million. Such a dual relationship is akin to
someone building a house who is both the builder and the
building inspector. Even worse, the very possibility of
conflicts of interest creates the perception that aggressive or
creative accounting is commonplace even when it is not.
Congress can and should, in my view, Mr. Chairman, enact
several commonsense reforms to strengthen the independence and
objectivity of financial audits to shore up the public's
confidence in the integrity of the American financial
marketplace.
Two weeks ago, Senator Corzine, our colleague from New
Jersey, and I, announced our intention, Mr. Chairman, to try
and put a package together of some ideas for the consideration
of this Committee. I have also talked with Senator Enzi, my
Ranking Member on the Subcommittee dealing with the securities
industry. These ideas are designed, we hope, to improve
investor confidence, specifically by addressing the issue of
auditor independence.
This legislation will not solve all of the challenges which
we face in abating the current lack of investor confidence, but
we think the enactment of some, if not all, of them, would be a
critical component. In fact, we have sent to all of you, I
think, ahead of time some of these ideas, at least, not in
legislative form, but to invite your comments on them.
We think we ought to do this by restricting accounting
firms from providing nonaudited services to clients whom they
audit. It doesn't mean you cannot have consulting services. It
just means that you cannot do the two simultaneously for the
same client.
We must strengthen the independence of the FASB, the
Financial Accounting Standards Board. The best way we think to
do that is by providing a more independent source of financing
for the FASB, in order to minimize as much as possible any
potential unhealthy public or private pressure on the setting
of accounting standards.
The Securities and Exchange Commission must increase the
number of accounting cops it allows to handle increasingly
complex oversight responsibilities. The Government must have
the ability to assure the public that audits continue to meet
the high standards of independence and objectivity that have
been the hallmark of the American accounting profession.
Finally, we need to stop the conflicts of interest brought
about by the revolving door practice of executives from
accounting firms going to work for companies they audit. There
needs to be a significant time buffer separating such job
transfers.
Those are some ideas. Again, there are many more that
people have suggested. But I am hoping, Mr. Chairman, we can
move legislatively in this session of Congress before too long,
obviously, being careful, not over-reacting, creating
unintended consequences. But clearly, some of these steps I
think are warranted and would pass any kind of test as to their
necessity.
I thank you, Mr. Chairman.
Chairman Sarbanes. Thank you.
I thank all of my colleagues. We are now prepared to turn
to the panel. We will start with Arthur Levitt, the most recent
Chairman, and move across the panel.
Arthur Levitt was Chairman from 1993 to 2000. He is now a
Senior Advisor to the Carlyle Group and a Director to Bloomberg
and Neuberger Berman--an asset management firm. I think all of
us have worked with him in his public capacity.
I say to each of the panelists, we will include the full
statement obviously in the record. And as I noted at the
outset, a great deal of work has gone into these statements. If
you could take 5 to 10 minutes to summarize, that would be
helpful to the Committee.
Arthur, we very much appreciate your coming today. We would
be happy to hear from you.
STATEMENT OF ARTHUR LEVITT, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
1993 TO 2000
Mr. Levitt. Thank you, Mr. Chairman. Thank you for your
invitation to share my thoughts on the failure of Enron and its
implications for our financial markets.
Today, there is an emerging crisis of systemic confidence
in our markets. What I believe has failed is nothing less than
the system for overseeing our capital markets. We have an
opportunity to repair trust in those on whom investors depend,
and in the process, trust in the numbers that are the backbone
of our capital markets. But our response, I believe, must be
comprehensive. Healthy and resilient financial markets depend
on the accountability of every one of its key actors--managers,
auditors, directors, analysts, lawyers, rating agencies,
standard setters, and regulators.
Enron's collapse did not occur in a vacuum. Its backdrop is
an obsessive zeal by too many American companies to project
greater earnings from year-to-year. At one time I referred to
this as a ``culture of gamesmanship.''
What was once unthinkable in business has become ordinary.
In our highly competitive economy, more and more business
leaders are employing financial maneuvers that approach and
sometimes cross ethical boundaries. Accounting rules are dealt
with in terms of ``what can I get away with'' or ``if it is not
expressly forbidden, it is okay.'' Financial statements, often,
are not a very accurate reflection of corporate performance,
but rather a Potemkin village of deceit.
At Enron and throughout much of corporate America, optics,
unfortunately, has replaced ethics. When the motivation to prop
up stock prices overtakes the obligation to keep honest books,
capital flows to the wrong companies and the very market system
from which these executives profit is fundamentally weakened.
That is why undertaking reforms that both preserve and
enhance the independence of the gatekeepers who safeguard the
interests of investors is so absolutely essential. These steps
are not a panacea, but are the beginning of a much-needed
reinvigoration of our financial checks and balances.
First, we must better expose Wall Street analysts'
conflicts of interest. Two years ago, I asked the New York
Stock Exchange and NASD to require investment banks and their
analysts to disclose clearly all financial relationships with
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.
Second, company boards often fail to confront management
with tough questions. Stock exchanges, as a listing condition,
should require at least a majority of the directors on company
boards to meet a strict definition of independence. That means
no consulting fees, use of corporate aircraft without
reimbursement, support of director-connected philanthropies, or
other seductions. In Enron's case, at least three so-called
independent board members would have been disqualified under
such a test of independence.
Third, many accounting rules need to be updated to better
reflect changing business practices to give investors a better
understanding of the underlying health of companies. Because
the Financial Accounting Standards Board is funded and overseen
by accounting firms and their clients, its decisions are
agonizingly slow. This well-meaning group must defend itself as
well from Congressional pressure, which is often applied when
powerful constituents hope to undermine a rule that might hurt
their earnings. FASB's funding should be secured not just
through the accounting firms and corporations, but, rather,
than a number of market participants--from the stock exchanges,
the banks, the mutual funds. And the Financial Accounting
Foundation, which chooses FASB's members, should be composed
entirely of the best qualified members--not merely those
representing constituent interests. The FASB should then be
able to focus more on getting the standards right, and avoiding
delays and compromises that ill serve investors.
Let me turn briefly to probably the most urgent area of
reform. Like no other, the accounting profession has been
handed an invaluable, but fragile, franchise. From this Federal
mandate to certify financial statements, the profession has
prospered greatly. But as an edict for the public good, this
franchise is only as valuable as the public service it
provides, and as fragile as the public confidence that gives it
life.
It is well past time to recognize that the accounting
profession's independence has been compromised. Two years ago,
the SEC proposed significant limits on the types of consulting
work an accounting firm could perform for an audit client. An
extraordinary amount of political pressure was brought to bear
on the Commission. We ended up with the best possible
solution--given the realities of the time.
I would now urge--at a minimum--that we go back and
reconsider some of the limits originally proposed. While I
commend the firms for voluntarily agreeing not to engage in
certain services such as IT work and internal audit
outsourcing, I am disappointed that the firms have remained
silent about consulting on tax shelters or transactions, such
as the kinds of Special Purpose Entities that Enron engaged in.
This type of work only serves to help management get around the
rules.
I also believe that the audit committees--not company
management--should preapprove all other consulting contracts
with audit firms. Such approval should be granted rarely, and
only when the audit committee decides that a consulting
contract is in the shareholders' best interests. I also propose
that serious consideration be given to requiring companies to
change their audit firm--not just the partners--every 5 to 7
years to ensure that fresh and skeptical eyes are always
looking at the numbers.
More than three decades ago, Leonard Spacek, a visionary
accounting industry leader, stated that the profession could
not ``survive as a group, obtaining the confidence of the
public . . . unless as a profession we have a workable plan of
self-regulation.'' Yet, all along the profession has resisted
meaningful oversight. We need a truly independent oversight
body that has the power not only to set the standards by which
audits are performed, but also to conduct timely investigations
that cannot be deferred for any reason and to discipline
accountants. And all of this needs to be done with public
accountability--not behind closed doors. To preserve its
integrity, this organization cannot be funded, in any way, by
the accounting profession.
Finally, it has become clear that the reputation of our
markets is rooted--in part--in the quality of their regulation.
Earlier this year, the Congress passed legislation to fix the
disparity between compensation for employees at the SEC and
employees at other financial regulatory agencies.
Unfortunately, the Administration's budget does not include
funding for pay parity. We can ill afford--at a moment like
this--to allow inaction to implicate the quality of regulation
and, as a direct result, the quality of our markets. My message
to the Congress and the White House is very simple: ``Fund pay
parity.''
The rise of the baby boom generation, changing retirement
patterns and markets that sometimes defied the laws of gravity
brought more and more first-time investors into the markets.
These are our friends and our neighbors, whose hopes and
aspirations became inextricably linked to the health and
resiliency of our markets. We assault those dreams if company
executives sell out shareholder faith and if those purporting
to be independent are anything but. Enron, like every other
financial failure before it, proves that investors bear the
ultimate cost. It is time to repair what has been lost.
Thank you.
Chairman Sarbanes. Thank you very much, Arthur.
Next, we will hear from Richard Breeden, who was Chairman
from 1989 to 1993 of the SEC, and who is currently the CEO of
Equivest Finance, Inc. We are very pleased to have you here.
STATEMENT OF RICHARD C. BREEDEN, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
1989 TO 1993
Mr. Breeden. Thank you, Mr. Chairman, Senator Shelby, and
Members of the Committee. Thank you for inviting me to join you
this morning.
The events at Enron and Global Crossing, coming on top of
other painful surprises to investors from failed audits and
hundreds of earnings restatements can be viewed as isolated
events, each with its own set of circumstances. In some senses
they are. However, just in Global Crossing and Enron alone,
investors have lost over $100 billion, which is quite a bit of
retirement savings or college tuition down the drain. The
spectacle of corporate insiders plundering their own companies
or selling their stock quietly in advance of a looming collapse
has awakened a sense of revulsion among investors who were left
with worthless stock.
Aside from the need to investigate and punish violations of
the law in these specific cases, there may be a growing feeling
that these events are not isolated and that somehow, our very
fine disclosure and accounting system may have gotten off
balance.
At the center of these concerns is growing doubt about
whether audited financial statements are believable. Every time
a company collapses, and it turns out that the auditors knew
the company was overstating profits, but signed off on the
numbers anyway, without any warning to the audit committee or
to the public, a huge bite is taken out of public confidence.
After all, who would trust an auditor who saw their role
model as Mary Poppins, feeding us just a spoonful of sugar to
help the medicine go down. Most investors would like to think
that their auditor was Dr. No, or at least Officer Joe Friday,
determined to learn the facts, just the facts.
If people do not believe the audited numbers, the value of
a company's stock can fall dramatically, hurting existing
investors, and we have seen that in the market in the last
couple of weeks. Companies in that situation, particularly
those with high levels of debt or aggressive strategies, may
pay more for capital than they should and may lose access to
the capital markets as well.
If people do not trust the auditing profession to do an
accurate job and to present results fairly, then all companies
will eventually pay a price.
So this is important to us all.
Condemning the excesses is easy, but finding appropriate
solutions is not. In the main, we have an excellent system for
accounting and disclosure and we shouldn't overreact to changes
that aren't necessary. Sometimes we just need people to do the
job that they are there to do and to use the integrity that
their mother taught them.
However, this situation has exposed gaps and problems we
should address in accounting and auditing disclosure and
corporate governance. We can use better accounting principles
and stronger auditing practices to apply them consistently. We
need faster and more comprehensive disclosure. We need to make
sure that vital corporate mechanisms such as audit committees
are not left in the dark by management and auditors. Of course,
if these things were easy to do, we would have done them
already. I would like to mention just a few issues that are
discussed at greater length in my testimony.
One is auditor independence. Each of the Big 5 has now
announced that it is selling or spinning off some of its
consulting businesses. Now that that horse seems to be out of
the barn, it might not be too controversial to lock the barn
door. Congress will not solve every problem by prohibiting
consulting by auditing firms, but I think it is an important
step. Legislation here can prevent backsliding and competitive
pressures once the spotlight is off and the current plans are
out of the news.
There is a drawback to worry about here, though. If we
prohibit consulting practices, we make the audit firms far more
dependent on audit revenues. This means that the CFO and CEO of
a large audit client will have an even greater economic
leverage over the auditors by threatening to be able to pull
the audit than they did before. Some have suggested mandatory
rotation of auditors or even Government selection of the
auditor to avoid this pressure coming from the audit fee
itself.
Personally, I believe the costs would be too high from
either of these steps. It might be useful, however, to move
away from the perfunctory and largely meaningless annual
ratification of auditors in the proxy to a 3 or 4 year audit
engagement during which the auditors cannot be fired, except by
the audit committee. At the end of that engagement, the audit
committee should be mandated to conduct a more in-depth review
of the auditor's work and to conduct a reproposal to get bids
from competing firms.
Indeed, I think that audit committees should be the
exclusive parties to both hire and fire the accountants so that
a CFO of a company doesn't have the power to threaten to fire
the firm.
There has been much discussion here about a new oversight
board for accountants. This can be done in several ways,
clearly, what we have now is not satisfactory. Before we start
creating a new board, however, I would suggest that you start
by beefing up the SEC, by doing it now, and by doing it in a
meaningful way.
Every single day that I served as SEC Chairman, I sought to
obtain pay parity for the SEC staff. I would like to
congratulate you for getting it done. It took a while, and now
it should be funded.
Attrition among the staff at the SEC is the friend of
everyone who hopes to commit an undetected fraud. Crooks do not
hold up a sign inviting prosecution. Unraveling a sophisticated
fraud is usually a job of finding it first and then taking it
apart, and you have to know what to look for. Experienced staff
really are critical in being able to get the SEC's job done.
The SEC also does not have enough resources in the
accounting area in particular. For many years we did not have
enough staff to look at both IPO's and 34 Act filings. That is
not good enough. The SEC's entire budget could be doubled for
less than $500 million, which is a tiny fraction of what
investors lost in Enron and Global Crossing alone. And if we
did so, that money would be very well spent.
My vote for a new body to oversee the performance of the
auditing profession is therefore the SEC, which has the
integrity, the institutional strength, the experience, and the
determination to get the job done. If we set up other bodies
downstream from the SEC, then we have to look very carefully
and make sure that they have adequate teeth to get the job
done.
One recommendation for improving the system would be to
strengthen the internal governance within the Big 5. I believe
that it would be helpful to mandate the major auditing firms to
have a board of directors that would have at least a mix of 50-
50 between inside accountants and outside directors.
More than 20 years ago, the New York Stock Exchange
recognized the importance of balancing the interests, on the
one hand, of the seatholders and on the other hand, public
investors. Most of our exchanges today have a 50-50 mix of
insiders and outsiders on their boards. It is a healthy way of
preventing organizations from forgetting about their public
mandate and it would be healthy for the major accounting firms.
In the disclosure area, our program is clearly in need of
some improvements. Off balance sheet debt has been taken too
far and is too far out of sight. Disclosure should be made of
all the SPE's and their obligations and anything else that is
off balance sheet but capable of hurting a firm's cash flow or
business.
Chairman Pitt has noted that disclosure today in many cases
is far too slow and could become more real in time. That is a
very good idea. So too is his view that disclosure is too often
turgid and dense, made more to obfuscate than to illuminate.
And that too should be worked on.
Also, all securities trades by top insiders, even with the
company itself to repay debt, ought to be disclosed promptly.
Indeed, in a world of instantaneous wireless communication, we
should do better, even than monthly reporting.
Similarly, we should have heightened 8(k) disclosure
requirements for any conflict of interest involving the CFO or
his or her department, even if the amounts in question wouldn't
otherwise be deemed material. The auditors and the audit
committee depend on the integrity of the CFO. That is the heart
and soul of the financial department of any company, and that
position, above all others, has to be immune from conflict of
interest or investors should be disclosed.
Accounting principles is an area that Arthur has mentioned.
It is something that each Chairman who served at the SEC has
had frustrations with. The process today runs at about the
speed of a glacier running uphill. Standards are judged by
their length, apparently, or their pounds. Recent standards
have run to more than 800 pages, and that gives you an awful
lot of running room if you want to push your numbers
aggressively.
This is an area where there is a delicate balance and we
have to work carefully to make sure that the SEC has enough
clout with the FASB and that the FASB has enough independence
to do its job well. But the standard setting process has to
involve faster action, more relevant principles, and principles
designed to protect accuracy.
This is certainly an area where we do not want to throw the
baby out with the bathwater. But since millions of investors
have taken a bath in these cases, some of the water really does
need to be cleaned.
Chairman Sarbanes. Thank you very much.
We have a vote on. It is one of three votes in succession.
This one is almost over, so we are going to have to move very
quickly to get there.
I think what we will do is recess. We will stay through the
second vote, which is about 10 or 15 minutes, do the third vote
right at the beginning, and then resume the hearing. So, we
will have a short break here in order to accommodate these
votes and we will return and then proceed with you, Mr. Ruder,
and the panel.
The hearing stands in recess.
[Recess.]
Chairman Sarbanes. The hearing will resume.
Again, I apologize to our panel, but it is not really a
matter over which we have control. We had three votes in a row.
That is why we were away this length of time.
Having heard from Arthur Levitt and Richard Breeden, we
will now turn to David Ruder, who was Chairman of the SEC from
1987 to 1989. In effect, he preceded Richard Breeden. David
Ruder is now the Dean and William W. Gurley Memorial Professor
of Law at the Northwestern University School of Law.
David, we are very pleased to have you here. We would be
happy to hear from you.
STATEMENT OF DAVID S. RUDER, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
1987 TO 1989
Mr. Ruder. Thank you very much, although I regret that I am
no longer the Dean. Dean Van Zandt is now my boss, so I have a
chief to report to.
Chairman Sarbanes. Well, you were the Dean.
Mr. Ruder. I was the Dean. That is correct.
Chairman Sarbanes. All right.
Mr. Ruder. The Enron tragedy calls for investigation,
identification of wrong-doers, the imposition of penalties, and
reform. I strongly believe that allocation of blame should not
be made until the facts are known. Nevertheless, I believe that
some reforms are needed.
In the United States, the accounting profession plays a
crucial role in the disclosure process. The investing public
has learned to rely upon the accuracy of corporate financial
statements prepared and certified by accountants.
The regulation of financial statement preparation by
management and the audit process by independent accountants in
this country is the strongest in the world. I believe the
public should continue to have faith in the system.
Not only is the current system strong and reliable, but
also the theory that the faulty financial disclosure in the
Enron matter demonstrates an accounting system that is broken
and an accounting profession that cannot be trusted is simply
wrong.
If individual accountants have failed their duty, they
should be punished. But the wayward activities of a few is not
proof that the accounting profession as a whole is dishonest or
negligent. If the accounting regulatory system has faults, it
should be corrected. But fault-finding does not demonstrate
that the regulatory system is not working. Nevertheless, it is
very important to examine current regulation of auditor
independence, auditor standard setting, audit practices, and
accounting standard setting, and to make needed changes.
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, raising the question of auditor independence.
If an accountant is not recognized by the SEC as
independent, the accountant cannot certify a corporation's
financial statement. Without a certification, these statements
cannot be filed with the Commission and the corporation will
find it nearly impossible to raise capital.
The SEC has taken steps to increase auditor independence.
In November 2000, under Chairman Arthur Levitt's leadership,
the SEC published revised auditor independence standards
specifying circumstances under which the Commission will not
recognize an accountant as independent.
The new independence rules represent a strong improvement
in addressing the auditor independence program. I believe the
new rules should be given a chance to work.
There are categories of nonaudit work that create
efficiencies for corporations, such as tax advice and opinions
rendered in connection with registered offerings. These
categories should be monitored to see whether they impede
independence.
In two areas, however, steps should be taken now to
strengthen the rules. The area of financial information
services and design is an area likely to create conflicts.
The Commission's current rules recognize that there may be
benefits to the accounting control system if the auditor is
allowed to plan, design, and implement internal accounting
controls and risk-management controls. These areas are
fundamental to good accounting systems.
Strong arguments can be made that a corporation's auditor
should be able to design and install such systems. The
Commission has recognized this and should continue to monitor
this area.
But the rules contain significant restrictions on the
design and implementation of such systems and on systems that
aggregate source data underlying financial statements. This
area is not likely to justify exceptions and the Commission
should consider prohibiting this activity.
The Commission's rules regarding internal audit services
recognize that outsourcing the internal audit functions to the
company's external auditors creates conflicts or appearances of
conflicts because the external auditor eventually will be
auditing its own work. Here, too, the Commission should
consider prohibiting external auditors from engaging in
internal auditing, with exceptions for small business.
We need to build on the accounting and audit supervisory
system already in place. Prodded by the SEC, the accounting
profession last year reorganized its process for overseeing the
audit process. The AICPA expanded the power of its Public
Oversight Board, an independent body, to control the auditing
process in the United States. The Board is composed entirely of
five public members with no connection to the accounting
profession and is currently headed by Charles Bowsher, the
former Comptroller General of the United States. Although in
January the Board announced its intention to disband, it should
remain in existence until other audit supervisory measures are
in place.
I believe the oversight of the audit system should become
truly independent and should build on the POB's system.
A new, separate audit supervisory board should be modeled
on the private sector Financial Accounting Standards Board--
FASB--and perhaps on the self-regulatory system of the NASD.
The Board should be subject to oversight by the SEC, which in
turn should cooperate with the Board in the investigative area.
The Board should be composed entirely of public members, not
associated with the profession. It should have appointive
administrative, and budget powers and should oversee three
separate functions.
First, an auditing standards and ethics board composed of
persons independent of the accounting profession should
promulgate both auditing and ethical performance standards.
Second, an audit quality control committee composed of
professional staff members reporting to the supervisory board
should oversee internal audit firm practices. This unit should
also supervise a peer review system. The peer review system
which is already in place has been supported by the SEC in the
past and should be continued.
Third, an audit disciplinary committee should be
established which would give a professional staff the power to
report to the audit supervisory board regarding possible audit
failure and should have the power to impose disciplinary
sanctions. The information it gathers should be privileged from
outsiders. Information gathering activities, privilege
questions, and disciplinary questions would have to be
coordinated with the SEC.
Independent financing of a new board is crucial. An
independent body that depends upon sporadic voluntary
contributions from industry or accountants may risk loss of
financial support if it takes positions seen as contrary to the
best interests of those it regulates.
The promulgation of accounting standards by the Financial
Accounting Standards Board has come under some scrutiny,
particularly because of failure to produce rules with
sufficient clarity or lack of detail and because of failure to
do so in a timely manner.
The problem with delays in promulgation of rules and with
the details in rules comes in part because of pressure from the
business community.
The Board can increase the speed of its deliberation and it
is considering ways to do so, but it must continue to assess
the effect of its proposed standards on business operations.
Despite its attempts to seek the views of the business
community, FASB faces difficulty in obtaining financing from
business. It is financed partly through its sales of work
product and partly through contributions by businesses and
accounting firms.
When businesses do not like the FASB's standards or its
process for creating them, they sometimes withdraw financial
support or fail to provide it in the first place. 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 program.
I believe the solution to the financial pressures on the
FASB would be to provide a system of financing supported by
Congress which would not depend on voluntary contributions.
I have some remarks regarding corporate governance in my
written remarks. I urge that the Commission through its
disclosure process and the stock exchanges, through their power
to effect corporate governance, look into the corporate
governance as an area of possible reform.
Although not in my prepared testimony, I want to urge
Congress to provide additional financial resources for the SEC
and to make pay parity a reality. I was amazed to learn
recently that the SEC staff has increased from approximately
2,800 when I was Chairman in 1987, to only approximately 3,000
today.
During this same period, the number of filings made with
the SEC has expanded dramatically, securities market volume has
grown enormously, and investment company assets under
management have increased exponentially. The SEC will be much
more efficient with a larger budget and better paid staff.
Thank you.
Chairman Sarbanes. Thank you very much.
Our next witness is Harold Williams, Chairman of the SEC
from 1977 to 1981. That is when I first came to the Senate and
came on this Committee, and I can remember working very closely
with Harold.
Mr. Williams is now Of Counsel with the law firm of
Skadden, Arps, Slate, Meagher & Flom, and had served for almost
20 years as President and CEO of the J. Paul Getty Trust, the
Getty Museum that has risen on the top of a hill in Los
Angeles, which is a marvelous contribution to the cultural life
of the Nation, really was under his guidance.
Just as an aside, I want to express appreciation for that
contribution to the Nation's welfare.
We would be happy to hear from you.
STATEMENT OF HAROLD M. WILLIAMS, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
1977 TO 1981
Mr. Williams. Thank you, Mr. Chairman. That was a great
reward for being a Chairman of the SEC, the Getty.
[Laughter.]
I appreciate the focus of this Committee on systemic
reform. We have a crisis in confidence and one that really
cannot be ignored.
I am a great believer in self-regulation and self-
regulation coupled with rigorous oversight. But it is evident
that the existing structure is not adequate to the task and
needs to be redesigned and strengthened. At the center of the
crisis--but not alone--is the accounting profession. Events
have heightened concerns about whether the profession has, in
fact, the requisite degree of independence to discharge its
auditing responsibilities.
The profession's auditing responsibility is really a quasi-
public one and deeply infused with the public interest. And
this raises several critical issues. Can an auditor be
independent when his client is paying the bill? Does the
provision of consulting services impair independence or the
perception of independence?
Now, I am sympathetic with the difficulties involved in the
audit process. Auditing has become much more difficult as
corporate structures and financing techniques have become more
complex.
For example, the pricing of risk or the laying off of risk
has become an increasingly sophisticated high-technology
business. And as a result of this increasing complexity, the
requirement is for a greater exercise of judgment and it makes
auditor independence and insulation from pressures that could
compromise it all the more essential.
The case for insisting that an auditor not provide other
services to a client that it audits is a strong one. Accounting
firms have come increasingly to look beyond their traditional
audit role to consulting work for their revenues and
profitability. In part this is in response to corporate
pressures to hold down audit costs and in part to the growth in
consulting as a very profitable market. Whether providing
consulting services actually impairs independence calls for
access to the auditor's state of mind and is virtually
impossible to determine. However, the perception that it may is
of such concern that it cannot be ignored. And indeed,
perception is now at least as important as reality.
While I was Chair of the Commission, we introduced a
requirement that the proxy material calling for shareholder
approval of the selection of the audit firm include information
on the nonaudit services performed for the company in the prior
year. This provision was eliminated by my successor. It was
reintroduced recently under Chairman Levitt.
Now even if the auditor does not provide other services to
the companies it audits, given who pays the bill, the incentive
to keep a well-paying audit client happy will remain powerful.
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 as 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.
Even this proposal would not avoid the issue of providing
consulting services to audit clients and the perception that it
compromises auditor independence. There are solutions. One is
not to offer any nonaudit work to an audit client. Another is
to restrict those audit services to those totally consistent
with the audit itself.
The Public Oversight Board was being implemented 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 process 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 8 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 a requirement that a surcharge of a percentage of the
audit fees of public companies be assessed to pay for
independent oversight, whether it is the Public Oversight Board
or some successor body, so that its funding is assured.
The disclosure model itself today lacks the necessary
clarity and transparency and needs to be critically reviewed
and enhanced by the Commission. Our financial accounting and
disclosure requirements have not kept up with the rapid
evolution of our capital markets and corporate finance. The
existing model has worked well when auditing traditional assets
such as plants and equipment and accounts receivable. It works
less well when dealing with items such as intangibles and
sophisticated financial instruments.
Part of the responsibility for inadequate disclosure lies
with the accounting principles themselves and the functioning
of the Financial Accounting Standards Board.
The Generally Accepted Accounting Principles, GAAP, need to
be reviewed and standard setting improved and accelerated. I
believe the functioning of the FASB could be significantly
enhanced if its independence could be protected, to withstand
the pressures of the business community, the profession, and
even the Congress.
A source of funding that is dependable and not beholden to
the profession or the corporate community would increase the
ability of the Board to address more difficult and critical
issues and do so in a timely manner.
Rule making itself is very difficult, particularly as
financial activity and economic transactions become
increasingly complicated and sophisticated. For example, the
FASB has engaged for a number of years in an effort to create a
clear standard for disclosing off-the-books transactions and
special purpose entities. They have not been able to come up
with a rule acceptable to the business community and the
profession. Perhaps that acceptability should not ultimately be
the determining factor.
Some rulemaking amounts to ``closing the barn door.''
Obviously, that is not something that the corporate community
takes lightly because of its potentially negative impact on
earnings. An example is the pressure exerted by corporations
through Congress in the mid-1990's, that forced the FASB to
back down on a proposal to make companies take account of the
cost of awarding employee stock options.
I have some other comments in that area, but I will forego
those.
A separate issue is the lack of regulatory coherence,
particularly since the enactment of the Gramm-Leach-Bliley Act
allowing financial services companies to cross the boundaries
that had existed between firms that could undertake commercial
banking, securities underwriting, and insurance.
This is a situation that inevitably will create problems
unless the various regulatory agencies share and implement a
common understanding of the rules of behavior expected of the
various players who collectively oversee the financial markets.
But as we go about exploring regulatory or statutory
solutions, we need to be reminded that the more that problems
lead regulators or legislators to impose prescriptive rules,
the more people will settle for fulfilling the letter of those
rules rather than responding to the broader purposes that they
are designed to serve.
Rules inevitably leave loopholes that can be exploited if
the attitude persists that form is more important than
substance or that complying with the letter of the law rather
than the spirit is acceptable. At the other extreme, too
general a rule lacks guidance and invites overly generous
interpretations.
Ultimately, any system can be subverted if the parties
undertake to do so, or if the various players in the system let
down their guard and fail to act responsibly.
When everyone involved--management, board members,
investment bankers, and securities analysts--are caught up in
and benefit from a hot stock, no one is inclined to do the
thorough questioning that could raise troublesome issues and no
one is inclined to be willing to be the skunk at the picnic.
In the final analysis, the system works as it should only
when all the players honor the spirit, as well as the letters
of the law.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you. I think that your point on
the letter of the rules and the spirit of the law is very
important.
One of the tragedies, it strikes me, in all of this is that
Arthur Andersen himself, the individual who founded the
accounting firm, was a man of great rectitude and really worked
very hard to move the accounting profession to a new standard.
Of course, he passed away in 1947. But Andersen was a path-
breaker in terms of trying to do the spirit of the law, as you
put it.
Our concluding witness this morning is Rod Hills, who was
Chairman of the SEC from 1975 to 1977. He is a Founder and
Partner in the law firm of Hills & Stern. We are very pleased
to have you with us this morning, sir.
STATEMENT OF RODERICK M. HILLS, CHAIRMAN
U.S. SECURITIES AND EXCHANGE COMMISSION
1975 TO 1977
Mr. Hills. Thank you, Mr. Chairman.
I came before this Committee just about 26 years ago to
explain what the SEC was doing about 400 American companies
that had bribed foreign officials or given them questionable
payments for some kind of corporate favors.
Back then, we gave birth to the mandatory audit committee.
We substantially increased the auditor's responsibility and we
imposed internal controls on management for the first time, and
those were good steps of corporate governance. They are still
important today. But I think it is quite clear that it is time
for a change, a time for some upbringing. What is wrong? Three
basic things.
First, the regulatory system we have is almost 70 years
old. It is creaky. From my experience, almost anything 70 years
old gets creaky.
[Laughter.]
It needs a major overhaul.
Second, it has become increasingly clear that the
accounting profession is not able consistently to resist
management pressures to permit misleading or incomplete
financial statements.
Third, the audit committees of too many boards are not
exercising the authority given to them or the responsibility
expected of them. The audit today has become a commodity. The
CEO's see no added value in it. The accounting firms compete
for it on the basis of cost, not on the basis of quality.
The system has too many rules. It has become so precise in
what cannot be done, that the system has created the
implication that if it is not prohibited, it is permitted.
Paul Brown, head of NYU's Accounting Department said it
just perfectly. ``It is the old adage of a FASB rule: It takes
4 years to write it, and it takes 4 minutes for an astute
investment banker to get around it.''
[Laughter.]
Finally, the profession is ignoring the plain language of
its own opinions which traditionally state--in our opinion, the
financial statement prepared by management fairly present in
all material respects the financial position of the company. In
fact, today, the opinion only means we have found no material
violation of an applicable regulation.
In addition to its other troubles, the accounting
profession is not attracting the same talent that it did 20
years ago, a terribly serious problem for them. This difficulty
of finding top-notch personnel, the difficulty of finding a
precise rule to deal with a sophisticated corporate structure,
and especially the pressing financial need to keep a client,
allows too many audit partners to let a questionable accounting
policy to slip by.
Audit committees should be protecting their auditors. But
board members are too often chosen by the CEO, who also decides
who will sit on the audit committee and who will chair it.
The members seldom ask the auditor if there is a fair or
better way to present the financial position of the company.
They seldom play any significant role in choosing the audit
firm or in choosing the new partner from the audit firm. And
they seldom establish themselves, in short, as the party in
charge of the audit and they do not establish themselves as the
party in charge of retaining the auditor.
Professor Roman Weil of Chicago's Graduate School of
Business has written: ``I want accountants to use fundamental
concepts in choosing accounting methods and estimates. I want
accountants not to hide behind the absence of a specific
rule.''
If this were the practice, companies could be made to be
far more candid in attempting to examine and express the real
value of their companies. Those are changes that are not going
to come easy and they are not going to come early. But there
are a number of things that can be done quite efficiently,
quite early.
If the SEC would state unequivocally that the failure to
have a competent, independent audit committee constitutes a
material failure in the internal controls of the company, then
auditors would have the responsibility of looking to the
quality of the audit committee. They would have to ask
questions in writing of board members: How did you get on the
board? How did you get on the audit committee? Who selects the
chairman of the audit committee? What percentage of your income
comes from this board and from other boards? What experience or
education do you have that is relevant to the service that you
are giving on the audit committee?
It should be apparent to everyone, as it has been to many
for a long time, you cannot have an independent audit committee
unless you have an independent nominating committee who brings
people on the board in the first place.
The SEC should also widely broadcast the significance of a
rule it passed a couple of months ago, on December 12. That
release requires auditors to carefully explain how the
selection of different policies or estimates could cause the
reporting of materially different financial results. Had that
rule been in effect a few years ago, there is a substantial
chance that the Enron debacle would never have happened.
The SEC should also make it quite clear that the audit
committee's most important task is to make the auditor believe
that the audit committee is solely responsible, its discretion
and its decision is solely responsible for keeping the auditor
or losing the auditor.
If such steps were taken, easy steps to take, the
accounting firm should not take any engagement unless it is
certain of the support of the audit committee. And with that
kind of support, the firm should have the resolve to qualify
their opinion whenever the financial presentation, though it
may satisfy all the rules, does not seem the best way to
present the financial position of the company.
In short, the profession could be cured with a concerted
effort by the SEC, the FASB, and the IACPA. However, the pace
of change has been so slow over these 26 years, that Congress
may very well need to mandate the change, preferably through
the formation of an informed and effective committee that can
come back this year with a plan of reform.
These aren't complicated things.
Congress may also wish by legislation to do what the SEC
and audit committees can do without a legislative prod.
The consulting service thing is a significant issue. I find
myself basically agreeing with Chairman Levitt. I would hate to
see a blanket prohibition, but I would like to see some
discipline. And I think the discipline can be exercised by the
audit committee.
Surely, the consulting fees should not regularly exceed the
audit fees. And surely, the audit committee should understand
that they are better served by having other people. I would
hate to see a blanket prohibition, but I would like to see more
discipline, and I do believe it can be put on the audit
committee.
The point I wish to make to this Committee is that Enron is
emblematic of the problems of the accounting profession. Enron
has the headlines--sorry--Andersen has the headlines. But all
accounting firms have had the same kinds of trouble. I have
seen all five of them have problems.
As I think I said in my written testimony, I have six times
in my life personally had to write off more than $100 million
of income that should not have been reported in the first
place. And on one occasion, we had to write off literally
billions of dollars of wrongful income from a publicly-traded
company.
I would like to echo the comment that Arthur Levitt made a
few days ago. And that is that Andersen overall is a splendid
institution and it is an institution critical to our economy.
It is necessary that it survive this ordeal.
Finally, I would like to say that the accounting profession
is of enormous importance to our country and to the global
economy. And as we identify its deficiencies, we should also
acknowledge the responsibility we all have to help it to reform
itself.
Thank you.
Chairman Sarbanes. Thank you very much.
Again, I thank all of the panelists for very, very
thoughtful presentations. We will try to move quickly so
everyone gets a round of questions here. We will hold it to 5
minutes.
I wanted to pick up on this restatement of earnings issue.
Fortune magazine, I think in its latest issue, has an article
entitled, ``Dirty Rotten Numbers.'' And in the course of it, it
says: ``No one can calculate how many companies are playing
loosey-goosey with their books right now. We can only count
them when they get caught or when they restate earnings, or
when a journalist or an analyst--God forbid--raises a red
flag.''
What is clear, however, is that there is more bad
accounting out there than ever before. And, of course, we have
seen the restatement of financial statements, the number of
them has escalated at a rather staggering pace over the last
few years. In fact, we have asked the GAO to investigate the
pattern of publicly-traded companies issuing so many financial
restatements. And the GAO has launched that inquiry.
Now, obviously, frequent restatement of earnings go
directly to the heart of the financial markets because they
raise questions about the reliability of published financial
statements and therefore undermine investor confidence. I am
interested in why you think we have seen such a proliferation
of accounting restatements? And how specifically might we
address this problem? Who would like to take a crack at that?
Mr. Hills.
Mr. Hills. I think it has happened gradually over the
years. Obviously, the more important stock prices become to the
company, the more important it is to meet analysts' estimates.
Chairman Sarbanes. Now does that relate to the fact that
stock options have become such an important aspect of executive
compensation?
Mr. Hills. I think so, and to a lot of people, the
pressure. I mean, what you have is human nature. When stock
goes up as fast as it has during a period of time, it is human
nature to want some of it, and you get caught up in the frenzy
of trying to boost the stock price.
In October of every year, in comes the field with the
estimates for next year's earnings. And you are 15 cents short
per share of what Wall Street expects.
The chief financial officer becomes an operating line
manager. He goes out to find the 15 cents. He looks at the
estimates, the appreciation schedules and he finds a way to get
the 15 cents. He may find a very difficult accounting policy
and maybe he will wend his way through the maze of it, and he
comes up with the 15 cents. He goes to the accounting partner,
the audit partner. The audit partner looks at it and he says,
that is not exactly the way I would like to do it. He says,
well, it is okay. Maybe in that first year, it is not 15 cents.
Maybe it is only a couple of pennies. In the second year, the
same concept gets to be four pennies. And then six pennies.
Then, all of a sudden, something that he let slip by the first
year becomes really quite serious. The audit partner says, how
the bloody heck do I get out of this? Too often, he goes to
management and says, can't you sell something for profits to
offset what you should have taken as losses before?
They cannot sell it, and they take the loss.
But it comes from a careless implementation of an
accounting policy that doesn't seem so important the first
year. And of course, when one penny can make a difference in 10
dollars in the stock price, people say, you cannot find a
penny?
People always wonder why, when a company does not make its
price by, say, a penny, the stock plummets. That is because
Wall Street knows that the corporate community has smoothed
earnings. It is one of the intolerable things we have all
tolerated for far too long. Everybody knows that there is a
cookie jar with a few pennies in it, that you can reach in and
pull it out. So if somebody cannot find that penny, Wall Street
says, boy, that company is in real trouble because that cookie
jar is empty.
That is the serious problem in our economy. We have
developed really bad habits in terms of the analyst community.
Just simply the notion that the world works that way is crazy.
It is not the way it works and we have allowed it to happen
that way far too long.
Mr. Levitt. The number one source of restatements has been
revenue recognition. Why? Because companies feel the pressure
to meet Wall Street expectations.
Chairman Sarbanes. At the Banking Committee hearing last
week on the failure of Superior Bank, a large thrift in
Illinois, actually, the FDIC's Inspector General testified that
the bank's auditor, who had certified the bank's valuation of
its residual assets, also provided consulting services for the
bank about the methodology for valuing those same assets. And
that overvaluation led to the demise of the thrift. That, of
course, leads to the question of auditor and consulting
services. Do you think auditors should be able to do any
consulting services or should there be a complete severance? If
you do not think there should be a complete severance, what
consulting services should the auditor be precluded from?
The accounting firms now have done sort of a self-
regulation thing. But they have backed off of only certain
forms of consulting services. Obviously, the whole system needs
to be examined now. I am interested in your view on that
question.
Mr. Ruder. Can I speak to that?
Chairman Sarbanes. Sure.
Mr. Ruder. I had the dubious pleasure in preparation for
writing an article and preparing before this Committee of
reading the Commission's release relating to auditor
independence. And it became clear to me that the SEC had spent
an enormous time under Chairman Levitt's leadership in dealing
with this independence problem. Although, I do not think any of
us were satisfied that the Commission had gone far enough in
its rules, its release, and its rules clearly indicate that
there are some areas of consulting services that are not in
conflict with the auditors' independence and which will benefit
the companies that they are auditing.
Those areas are fairly narrow in scope and need to be
looked at and monitored by the Commission in order to see
whether they have reached the right conclusion in their last
rulemaking.
I think, by and large, that the Commission is right and
Arthur Levitt was right--you can speak for yourself, Arthur, I
know--that there should be no management consulting. There
should be no audit services which would amount to self-
auditing, no internal audit services, and no information
services which would put the auditor in the position of having
created areas that it must then audit. But I think one has to
be quite careful in trying to say, no nonaudit services
whatsoever.
Chairman Sarbanes. Arthur.
Mr. Levitt. I believe, obviously, in self-regulation. I
think that is terribly important. But I believe even more in
the importance of public confidence as the backbone of our
markets.
And while I think the accounting profession has come to the
table with some constructive notions, largely out of concern
that a legislative reaction might be more Draconian, I do not
think that is enough. I fear backsliding. I think it is all too
easy to do that.
Now, I am not saying that there should be a bright line
which separates all consulting from all auditing. A limited
amount of tax work might be appropriate to the audit, a limited
amount. That is a very dangerous area because you slip over
into--look, you hire us, we are going to save you millions of
dollars in taxes by investing in heaven knows what else. I
think that is dangerous.
But I think the importance of a legislative action here to
hammer home the separation is terribly essential to see to it
that we do not face the same problem 5 or 7 or 10 years down
the road.
Chairman Sarbanes. Richard.
Mr. Breeden. I would certainly agree with Arthur's
comments. Congress for many years, and actually in my White
House days, we struggled with it and worked with the Committee
a great deal under the Bank Holding Company Act. We have long
had a provision in the law saying that bank holding companies,
because of the unique role they play, could engage in banking
or activities closely related thereto, and we gave the job to
the Federal Reserve to define what is closely related enough to
be allowed.
There is some consulting that is very closely related to
the audit. Sometimes we used to do consulting projects for
companies when I was at Coopers to evaluate their internal
controls if they wanted to go beyond the internal control work
that is part of the audit.
Well, that is very closely related to the audit service
itself. Building a $100 million computer system is not at all
related to the audit itself.
I think we should have some legislation here. The
backsliding problem is a real one, and the competitive
pressures--if one firm starts to backslide, then the others are
going to have a tremendous pressure that their partners are
going to say, hey, these guys over here are doing it. Why can't
we do it?
And so, to reaffirm public confidence, which is really what
it is all about. There is nothing evil about consulting. There
is nothing wrong with it as a business. But maybe we are at a
situation where it is a little bit like breaking up AT&T, maybe
saying, look, spin off these consulting arms and keep them
separate and let them be healthy businesses on their own, is a
good thing.
Chairman Sarbanes. Harold.
Mr. Williams. I would agree. I think we are dealing with a
perception issue here that is insurmountable. My view would be
either no consulting services, or at least no services that are
not totally consistent with the audit responsibility.
In my written testimony, I suggested an additional
possibility, which is, to whatever extent consulting services
are performed by the firm, that the revenues and profitability
from those services be segregated so the people on the audit
side cannot profit from it.
Chairman Sarbanes. Rod.
Mr. Hills. It seems to me that the SEC does have a bully
pulpit. Arthur had done a marvelous job, quite apart from the
regulations, to alerting everyone to this problem.
Every board in which I sit--still three--every board has a
limit--no consulting service above say $50,000, without
specific approval by the audit committee. And the presumption
is you go outside.
There may be some legislation here that would require that
kind of discipline. But the idea that we know exactly the
distinct difference between the audit and consulting is very
difficult.
We have talked about the internal audit, and yet, the SEC
has never required that there be an internal audit. We do not
know really the difference between the internal audit and the
external audit. It is there. You can see it in broad terms. But
there is a very nebulous line.
So a bully pulpit, maybe some legislation supporting it.
The SEC can require that there be very precise disclosure of
what the reason was for the consulting. We have some new rules
in effect and, to my sense, it would be wise to see how these
new disclosure requirements work.
I think if the SEC said there should be a demonstrable
reason for using a consulting service, that would be good.
But my great concern is that talking about consulting
services diverts attention from what really will work because
you are not going to reduce the pressure on the audit partner
by taking away the consulting services.
If he loses his audit position, he loses his job. The
pressure of keeping the client is there. The only way you are
going to get that pressure off is by protecting that auditor
with an audit committee or by some regulatory body.
I must say, finally, that the depression in the audit
accounting industry is dramatic. The quality of people going
into it has changed over 20 years terrificly.
What we do to make it less appealing as a job is going to
harm the profession. Clearly, the auditing firms can do
consulting work for nonaudit clients. They need to keep their
skills up to some degree. So, in short, please, no bright line
and let's see what the SEC can do.
Chairman Sarbanes. My time has expired.
Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
I would like everyone to look at the chart I had prepared.
I believe that there is a clear trend in the number of
restatements. You can just start over here in 1997 to 2000.
When a firm or a few firms get away with some accounting
gimmickry, other firms, their competition, start going down the
same path in order to compete. A lot of companies start playing
Follow The Leader.
Look. The accounting firms start selling their magical
methods to everyone else, perhaps. The restatement trend in the
chart here provides evidence of this, I believe.
It is not just that there are more restatements, although
they are bad in themselves. The cause of the restatements, as
Chairman Levitt referred to it--the cause of the restatements
is very telling. This second chart demonstrates the large
number of restatements due to the fact that there were errors
in the methods of revenue recognition that were used.
Would anyone here care to comment about the significance of
revenue recognition issues? And does revenue recognition have
any heightened or particular effect on things like share price?
I think this is telling--revenue recognition.
Chairman Levitt.
Mr. Levitt. You state it as it is. This is part of the
numbers game. It is so easy to use revenue recognition to prove
a point, to meet a standard that analysts working for
investment bankers have set up. And those restatements are
costly.
Senator Shelby. They are also costly to the investment
public, too, aren't they?
Mr. Levitt. Enormously costly to the investing public. And
in terms of the standard setters, in some instances, the
standards are sufficiently imprecise, that companies are
obliged to restate their earnings.
Recently, a standard on business combinations has caused a
rash of restatements, and that is just beginning.
Senator Shelby. Chairman Breeden.
Mr. Breeden. Well, I think you have put your finger,
Senator, on a very serious problem. What you call revenue
recognition there, I mean, there are several areas in which
accounting principles today allow future profits to be rolled
forward into the present day.
Senator Shelby. Future profits.
Mr. Breeden. Yes.
Senator Shelby. Good term.
Mr. Breeden. Future profits, and some of those standards
attempted originally--the classic one is gain-on-sale
accounting.
Senator Shelby. How do you in reality have future profits?
We were always taught profits were realized, that it was not a
gain. You either had a profit or a loss.
Mr. Breeden. I guess beauty is in the eye of the beholder.
[Laughter.]
Senator Shelby. That is what is dangerous here, is it not?
Mr. Breeden. And in the eyes of the FASB, future profits
can sometimes be beautiful.
So, we have a series of rules that have allowed companies
to take projections--in Enron's case, they formed a joint
venture that was going to broadcast certain TV programs over
the Internet, I think, and entered into a joint venture with
Blockbuster.
They signed a 10 year contract and they sat down and said,
all right, we are going to project that over the next 10 years,
everybody who has ever heard of a movie will subscribe to our
service. We are going to have this huge amount of revenues and
we are calculating that our profits will be a fairly
substantial amount, hundreds of millions of dollars. And they
booked it right there and then, before any cash had come in the
door, before there had been any actual cash flows that would
support those optimistic projects.
Senator Shelby. Who came up with that rule? Was that FASB
who came up with that?
Mr. Breeden. Ultimately, all the standards are FASB
standards.
Senator Shelby. FASB. That defies reality, though. I mean,
you are counting profits before you ever earn them.
Mr. Breeden. There are a number of areas where----
Senator Shelby. And most of the time, they never earn them,
do they?
Mr. Breeden. Well, the problem is, I think people would
accept that if you have something that is quite certain, you
have done something, it is finished, you have a completed
contract and it is highly likely to produce a certain result,
that may be one thing. But there are all too many cases now
where profits are rolled forward based on models that people
say, we have this wonderful model and we even have some
derivatives that support it, and try and lock in pieces of it,
and therefore, we should be allowed to count it today.
Senator Shelby. But models are based on assumptions for the
future.
Mr. Breeden. Exactly right.
Senator Shelby. They are not based on the real earnings as
the average investor would think, would they?
Mr. Breeden. Well, the old adage of garbage in /garbage out
is a pretty serious one.
Senator Shelby. Garbage in /garbage out. And we have had a
lot of garbage as we see here, haven't we?
Mr. Breeden. Right. Absolutely.
Mr. Levitt. Senator Shelby, the Commission issued late in
my final year the Staff Accounting Bulletin 101 about revenue
recognition. That created an absolute firestorm of opposition,
mostly from the high-tech community, that pressured the
Commission against doing that.
There was vast Congressional inquiry into Staff Accounting
Bulletin 101. We had to delay the issuance of that and finally,
over very strenuous objections, we did issue Staff Accounting
Bulletin 101. But that went to this question and this is highly
contentious. This question of revenue recognition is a very,
very divisive issue.
Senator Shelby. It might be divisive, but the investor
public needs to know what the truth is, don't they?
Mr. Levitt. And they were hurt by the delay of 101.
Senator Shelby. Absolutely.
Chairman Ruder.
Mr. Ruder. The problem that accountants face and some
businesses face is lack of certainty. And the problem with
accounting as it becomes more complex and reaches more
difficult areas such as derivatives, is that the accountant and
the businesses are required to exercise judgment.
There are estimates that go forward all through the
accounting system. And as we argue that the accounting rules
should be less precise and more general, we are then offering
the businesses and the accounting profession more problems
about making judgments.
I think we have to be very cautious about looking for
certainty in the accounting area. The problem is to get an
accounting system which will allow people to make reasonable
judgments.
Now the problem, you are exactly right, is when people use
that judgment system to attempt to defraud others.
Senator Shelby. Absolutely.
Mr. Ruder. And it is the revenue recognition system and
other areas in which people take advantage of this judgment
area.
Senator Shelby. Maybe we won't have certainty, but we can
have honesty.
Mr. Ruder. Absolutely.
Senator Shelby. Mr. Williams has a comment?
Mr. Williams. Well, I think it goes back to the earlier
question, too. We are an environment that encourages aggressive
accounting. When you are on a track of ever-increasing earnings
and you are rewarded for it, that pressure is going to be
there. But part of it goes back to the question of the
independence of the auditor. If the auditor is in the position
not merely to say, that is a conceivable way to do it, but has
the independence to say, that is really not right, I think we
would see some changes.
That is why I go back again to the independence of the
auditor, because you cannot legislate integrity and we cannot
pass rules that are going to solve this problem. We have to
create an environment that enables the players themselves not
only to be able to address the issue honestly, but also to do
our best to require them to do so.
Senator Shelby. Chairman Hills.
Mr. Hills. I have argued with economists and lawyers about
revenue recognition so often, I have lost so many times about
what the rules really are, that I am humbled by even trying to
address it. Suffice it to say, trying to value assets is like
trying to value a company. Nobody knows how to do it precisely.
I do believe the right way here is to force the
independence of the auditors. I think the December 12 release
of the SEC is the beginning of that path.
The auditors have to come in and say, there is another way
to do this. If they put it squarely to the audit committee,
well, you have done it this way, but, by the way, there is $600
million of debt and $600 million of losses in that subsidiary
firm that you are not disclosing, and we the auditors want you
to know that that was the other way to do it, and if they have
enough courage, and they should have, they would say, if it was
left to us, we would do it that way. And if you write that in
the MD&A, or the 10(k), you have gone a long way to solve the
problem.
Senator Shelby. Mr. Chairman.
Mr. Breeden. One little footnote on that. In the law, we
have statutes and then we have the Constitution. We have
sometimes higher principles that are more general principles
that override lots of other details.
I think over the years, FASB has issued more and more
standards that are literally 700 or 800 pages long. And we are
in need here of a little more of a concept of the Ten
Commandments, some constitutional principles from the FASB that
says, look, no matter what the 800 pages, when you are finished
with the cookbook, thou shalt not do certain things. Thou shalt
not overstate income. Thou shalt not conceal or fail to
disclose certain magnitudes of relevant information.
There is a value to the cookbooks in working through
specific problems. But we need a better sense of some
overarching principles that say, when you are all done, the
result had better fairly reflect what you see in reality.
Senator Dodd. The international standards in accounting
follow more that approach.
Chairman Sarbanes. Senator Corzine.
Senator Corzine. Thank you, Mr. Chairman. I wish we had
hours to go over these issues.
Chairman Sarbanes. This is a wonderful panel.
Senator Corzine. You have talked about revenue recognition.
One of the other areas is expense recognition. One of the most
controversial topics is option accounting and payment.
First, I would love to hear comments with regard to the
debate that goes on with whether this also undermines the
quality of earnings of reported and how you all feel about it
because I think it is equally important to revenue recognition
and potentially distorting the presentation of earnings.
Second, I would love a little discussion with regard to
what is the proper oversight body with regard to the accounting
industry?
I was very pleased from a personal perspective that
Chairman Breeden talked about creating an SEC division of
accounting, and went on to talk about the need to do that.
If we cannot pay people, I do not know that we should move
down that road. But that really is another issue.
I wonder whether we believe that we can create a self-
regulatory organization that has the independence and the
discipline to generate the public confidence.
I would love to hear any of your specific commentary with
regard to Chairman Breeden's particular response of a SEC
division which I guess is a suggestion as an alternative to the
POB. So both of those areas, I would love to hear comments on,
and a lot of others, but those I think are maybe important to
get out on the table.
Mr. Breeden. Senator, maybe I can start and just summarize
briefly where I am.
Self-regulation is a wonderful thing and I think all of us
have great regard for it, and when it works, it works
beautifully. But I can tell you that there are enormous
differences between self-regulation as it exists in the
securities field and self-regulation as it has historically
existed in the accounting field.
We had cases when I was at the Commission where a major
problem occurred at some of the major securities houses and
sometimes the person would be out on the street before we would
even find out about it.
The firms had, in general, not universally, but in general,
a good attitude that if they had bad apples in the barrel, they
were going to get them out of there. And the SEC would come
after them if they did not.
So self-regulation, as William O. Douglas said, the SEC was
the shotgun behind the door, and that Government presence backs
up self-regulation.
The accounting industry, I think historically, has not come
at it the same way. Their attitude is more like Marines. We do
not leave anybody behind. We do not leave our wounded. We want
to protect everybody. And it is a noble instinct, but the fact
of the matter is that you are going to have in any group people
who deserve to have their ticket pulled, who need to be given
another line of work because they are just not competent or
they do not have the affects that are required.
I think we have had consistent failure of self-regulation
in the accounting field to do the disciplinary job.
If an accountant is caught selling drugs on the street
corner, I think the AICPA will throw them out. But we have had
case after case in which the SEC has had to try and throw
people out, where they have knowingly allowed companies to
overstate income and not forced changes to occur.
Sometimes we have too many restatements, but sometimes we
do not have enough, when accountants know that the accounts are
being overstated.
My own view is that at least the starting point ought to be
that the body with ultimate power of overseeing the
professional behavior of the accounting profession needs to be
a Government body. They need to have subpoena power. They need
to have handcuffs. They need to have teeth.
This is an area where there has to be clear requirements of
law that become applicable.
Now downstream from that body, and I believe that body is
the SEC. We have 70 years of experience. We do not need to go
and invent another one. We need to invigorate the SEC and make
sure it has the tools to do the job. Let's not reinvent the
wheel. Downstream from the SEC, private sector groups can be
helpful. And I do not mean to exclude that. But let's do not
lose sight. The primary enforcer of the law needs to be the
Commission.
Mr. Williams. I would support that.
Mr. Ruder. My testimony really follows what I think the SEC
is proposing generally. And that is the creation of, not a
self-regulatory organization, but a regulatory body in which
all of the members are not connected with the accounting
profession. That body would have the power to create auditing
rules and then would have a disciplinary function and would
have a function which would allow it to review the way in which
the auditing profession is self-regulating itself.
That whole apparatus would be financed by a legislatively
imposed finance system, but would then be supervised by the
SEC.
I think that Richard and I agree that we are talking about
a way
in which the SEC can leverage its resources by having a public-
private body which it can use to accomplish its functions.
Senator Corzine. That is really different, though, than
what I thought I heard Chairman Breeden say. I think he was
suggesting expanding, creating an SEC division of accounting.
Mr. Breeden. I think we agree in part and diverge in part.
I think that if the problem is we need to leverage the
SEC's resources, then impose the user fees and give the
resource to the SEC and let them go out and do the job.
We shouldn't be creating private-sector groups because we
think that we do not have the resources to enforce the law. And
we are talking about law enforcement here, not just a trade
association.
Mr. Levitt. I am not sure that there are any absolutes
here. I tend to be closer to David Ruder's formulation in that
we are not talking about self-regulation any longer. We are
talking about oversight. We are talking about reassuring a
public whose confidence has been severely shaken.
I tend to believe that the SEC is pretty stretched right
now in terms of resources. And while they retain the ultimate
responsibility for overseeing this effort, if you were able to
assemble a small group of publicly credible individuals that
would undertake this assignment, perhaps even on a short-term
basis, overseen and perhaps appointed by the SEC, that would be
a useful first step.
As to your question about options, I clearly believe that
options have value. The fuss and furor would never be as great
as it has been if options did not have value.
I believe the greatest mistake that I made in my years at
the Commission was not encouraging the FASB to move forward
with an accounting for that value on the income statement.
So, I think that issue, which the international accounting
standards board is much further along than the FASB is today, I
think that this should be very much on the front burner.
Recognize it as a contentious issue, but move ahead with it. It
has implications that are enormously important to America's
investors. And in this environment, for us to stand back and
allow that chasm to not be closed I think is a dereliction of
our responsibility.
Mr. Hills. Senator, I quite agree with that. The notion
that we do not have an expense item in our balance sheets for
profit and loss options is perfectly silly.
On the accounting profession, let's say again, the SEC is
way, way short-handed in dealing with accounting problems. I
had a case 3 years ago where we reported a $2\1/2\ billion
write-off. I know the Commission is working very hard on it. It
is a very difficult case. They do not have the manpower. They
will bring it sooner or later, but they do not have the
manpower to bring justice swiftly.
Senator Corzine. I would say, though, and this is a
recurring theme of the comments, that subject of self-help by
the Congress, making sure that we have both the resources, pay
parity, to have the SEC do the job that it is being asked to
do.
Mr. Hills. Absolutely.
Senator Corzine. It is one thing to say that we ought to do
something else because we do not have the resources. We can
correct that problem if we think it is important enough.
Mr. Hills. In addition, the idea of having a separate body
that is supported by guaranteed funds rather than voluntary
funds is important.
But Arthur Andersen, in response to its problems, did an
interesting thing in turning over considerable authority to a
different board.
There is nothing wrong with auditing firms having their own
audit committees.
Chairman Sarbanes. Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman.
I really appreciate this learned panel and I really
appreciate the fuller statements that you did not have the
opportunity to share with us. I would encourage all of my
colleagues to read those. There are a tremendous number of
ideas in there that are worth looking at. I have to say that I
started with Mr. Hills' paper, because he was the furthest
removed from any of this.
[Laughter.]
Mr. Hills. I wish it were true.
[Laughter.]
Senator Enzi. And I have to say that, after reviewing that,
I looked at your credentials and found out that you have done
some teaching as well. I decided that I would really like to
take a course from you.
[Laughter.]
I learned a lot from all of the papers, but I like the
clarity with which you presented things. There was a focus on
accounting because there has to be a focus on accounting, but
it did not dominate quite the way that the testimony did.
I know that in this one, the accountants are the easy
target. But I think it is kind of like when there is an
airliner that crashes, all planes become a little safer the
next day.
There is a depression in the accounting market. I tried to
talk all three of my kids into going into accounting, but none
of them would. I think there is kind of a shortage of people
going into that.
I have a concern for what happens if some of the drastic
things that we are talking about on a Federal level get adopted
into small business. If the bankers themselves, when they are
talking to a small group of investors, want to have some of the
same separation, thinking that it would make it a far safer
investment. And it might. But it might not also be available.
One of the things I had hoped was that there would be a
little bit more concentration on some things that the SEC could
do.
Now, I appreciate the comments about the need for pay
parity, and this Committee on a number of occasions has tried
to get that, and we will be working for it in the budget and in
the appropriation as well, I am sure.
Chairman Sarbanes. My own view, the package that was put
together on the fee reduction and the pay parity was linked and
that, really, the good faith was broken by taking the one and
not coming through with the other. But that is an issue we will
have to try to address and resolve.
Senator Enzi. I do have a couple of questions.
In 1997, the SEC granted an exemption for the Investment
Company Act to Enron and the exemption allowed Enron to shift
debt off of the books of its foreign operations. It also
allowed executives to invest in partnerships affiliated with
Enron.
I wondered if Chairman Levitt could give me some more
information about this type of an exemption, why it would be
granted and if that exemption is granted widely to other
companies.
Mr. Levitt. I am told that that exemption followed a
pattern of events that occurred and exemptions that occurred in
the past and was part of delegated authority given to the
Division of Investment Management and other divisions in those
instances where a particular Commission action followed along a
pattern of action that had occurred in the past.
In talking to the then-director of that division, I am told
that the exemption followed a much more limited application of
a request that was made at that time and was entirely
consistent with practices that the division had followed for
some years before that.
Senator Enzi. Thank you.
It also appears that Enron's board suspended their
corporate ethics codes. Specifically in mid-1999, they granted
a waiver to Mr. Fastow, who set up LJM-1. What are the
restrictions on companies waiving ethics codes? Do they have to
report these waivers to the SEC?
Mr. Levitt. I do not know the answer to that question.
Mr. Breeden. I do not think, Senator, that there is any
direct reporting requirement. Of course, the question of
fiduciary standards is principally an issue of State law under
a Federal system. The corporation laws of Delaware or other
States would principally apply.
One of the things I said in my testimony was, certainly,
that we should require, and this is something that the
Commission can do, to go out and require the filing of an 8(k)
in events like that where an ethics code is being suspended or
certain types of conflicts are created.
There is a concept that 8(k)'s, which is the immediate
report--you do not wait for your quarterly report. That is
something you file right away. There is a concept in the law,
rightly, that you only disclose things that will have a
material impact.
And for a huge company, the number of what is material is a
huge number. So that companies can take the view that, well, we
allowed Mr. Fastow to go out and do an investment and that is a
small dollar amount and therefore, it doesn't meet the
materiality threshold.
In my view, we should define conflict situations involving
the key corporate officers, and certainly key financial
officers, as inherently material, because they say something
about the level of board oversight. They say something about
the risks the corporation is willing to tolerate, and that they
will be dependent on other defense mechanisms to protect
against those conflicts, and therefore, we ought to just define
that as always material.
Senator Enzi. I see that my time is expired. I would
appreciate the opportunity to submit some questions to you. I
have some very specific ones based on what you wrote that I
would like some clarification on, and would hope that I could
do that with each of you.
Chairman Sarbanes. I am sure they would be happy to respond
to your questions.
Senator Enzi. Thank you for your testimony.
Chairman Sarbanes. Senator Stabenow.
Senator Stabenow. Thank you, Mr. Chairman.
Again, thanks to all of you. This has been a very important
opportunity for us to hear your input. It has been extremely
helpful and I hope we will be able to call upon you as we move
forward.
In the interest of time, I will be brief. But I do have a
question for Mr. Levitt that relates to the report that was put
together or in the process of being put together by your Chief
Accountant when you were at the SEC, Lynn Turner.
I am sure you are aware of the Wall Street articles that
have been done regarding this report in the amount of dollars
and outside consultants that were put together, and the
description of the report, even though it was not released,
which is a concern of mine. I have some questions for Mr. Pitt
as to why the report was not finished and released.
I am wondering if you might give a sense of your goals in
requesting that the report be put together, and any
recommendations that you are aware of that were in that report,
even though it was not released at this point.
Mr. Levitt. Our concern during this period was that the
very real danger to the public interest represented by a fierce
and contentious fight between three of the Nation's largest
accounting firms and the Commission that was aired publicly in
a series of public hearings throughout the country left
unresolved a number of issues dealing with the independence
question.
In that connection, knowing that we were unable to get
everything that we wanted in terms of rulemaking, I asked the
division to take the results of that public hearing, together
with letters that we had received from a variety of sources in
the months prior to our rulemaking, and turn that into a
document which would be widely distributed throughout the
country, to both reassure and warn the public about the dangers
inherent in an unresolved independence issue.
I had urged our Chief Accountant to do this, even after I
had left the Commission. But I believe that she too was seeking
separation and I think in the change-over, the transition
period where a new Chairman had not yet been chosen, the
Commission was short-handed, it fell between the cracks.
I became so frustrated that I told him to send me all his
work papers and I would write it myself.
But what has happened, interestingly enough, is the Enron
issue has so ventilated and exposed this issue, that the need
for such a report has been totally obviated.
I would like to make another point clear. And that is that
my successor Chairman Pitt, was in no way involved in the
decision not to move ahead with this report. That just resulted
from administrative confusion and all of that occurred before
he set foot in the agency.
Senator Stabenow. I appreciate that. I would still welcome,
if you would like to sit down and put that together, I would
certainly welcome having the opportunity to review that.
One other quick question.
Mr. Ruder, in your testimony, you argued that steps should
be taken to prevent employees with 401(k) plans from over-
investing in employer's stock.
I am surprised that my colleague, Senator Corzine, did not
ask you this question because I know of his leadership and work
on this issue. But I wonder if you have a percentage in mind
when you speak about capping such investments in 401(k)'s. What
would be your recommendation?
Mr. Ruder. Well, my testimony takes the position that an
employee determining his retirement benefits, should not be
engaged in having all of his or her investments in a single
company, and that the portfolio theory of diversification ought
to be applied.
I am not a portfolio theorist, but my number would be
between 10 and 20 percent of an employee's portfolio, and no
more to be allowed in a company's stock.
If that employee has other resources and wants to buy stock
on the outside separate from his or her employment account,
that is fine. But to put that employee at risk regarding the
success or the failure of his or her company based upon his
retirement amounts, I think is wrong.
Senator Stabenow. Thank you.
Thank you, Mr. Chairman.
Chairman Sarbanes. Senator Dodd.
Senator Dodd. Thank you, Mr. Chairman.
Let me echo the comments of others that have been made.
This has been very, very worthwhile, tremendously helpful. The
only problem you are probably going to create as a result of
this is we are going to be calling on you a lot, I think, in
the next number of weeks to talk about some of this.
Mr. Breeden, you had a rather lengthy summary and analysis
of very specific suggestions, and I commend you for it.
I mentioned earlier that Senator Corzine and I had
submitted a series of suggestions, not in legislative form.
Some of them we have all gone over already--the auditor
independence issue, the SEC's resources, the independency of
FASB.
In your testimony, a lot of you included this, and very
quickly, the revolving-door issue. I think, Mr. Breeden, that
you called it the cooling-off period. There has been a
suggestion here that we ought to, in terms of people being
hired, this not uncommon practice of people who are part of the
auditing team or the accounting team being then hired by the
very firm.
We have seen these rules adopted here at the Federal level
in terms of periods of time, limitations of a couple of years
or more. Just very quickly, do you feel as if a rule in that
area is necessary?
Mr. Levitt. Yes, I do.
Senator Dodd. You do.
Mr. Breeden. Yes.
Mr. Ruder. I think it would be very positive.
Mr. Williams. I agree.
Senator Dodd. Would you do a couple of years, more or less?
Mr. Hills. I think it is definitely needed. Keep in mind
that there are a lot of jobs in a corporation. This is a
terrific example of something that needs some real thought.
Senator Dodd. Yes. And by the way, we would appreciate it,
you commented on this pretty much, but we think the FASB issue,
for instance, there that you might have the exchanges become
the source of the funding for FASB, done through the exchanges.
It is one idea that is not unique. I think others have raised
this.
I think, Mr. Ruder, you talked about having obviously a
separate, maybe Federal, agency hired by the SEC, but paid for
out of Federal taxes, rather than being paid out of any other
entity. Is there a possibility of the issue being paid by the
exchanges? Does that have any appeal?
Mr. Levitt. I think the exchanges are one vehicle. But I
think maybe a better vehicle would be perhaps a user fee based
upon public companies that are audited and could pay a small
percentage of that toward funding these.
Chairman Sarbanes. All these fees we gave away, we could
have kept a little bit of it to fund this operation on the
basis of investor protection, providing a direct assurance to
the investor that the judgments that were going to be made were
going to be done by independent people whose paycheck wasn't
dependent.
Mr. Levitt. You just cannot imagine the problem of seeing
the members of the board of the FASB have to go hat in hand to
corporate America asking for funding each year. It is crazy.
Senator Dodd. I looked and tried to get a breakdown of how
they do it. I think 20 percent comes directly from the
accounting industry and the rest comes from selling of
publications and reports. Is that correct?
Mr. Levitt. A lot comes from selling publications and
reports, but a lot comes from going to corporations.
Chairman Sarbanes. They sell them by weight. That is why
they have 800-page rules.
[Laughter.]
Mr. Breeden. We could perhaps kill two birds with one stone
by putting a user fee on that would apply, require the payment
of a small percent of all assets that are held off balance
sheet.
[Laughter.]
Senator Dodd. I was going to get to that in a minute here.
[Laughter.]
Go ahead, Mr. Williams. I am sorry.
Mr. Williams. My proposal was that we add it as a surcharge
to the audit fees.
Senator Dodd. Yes, that is another way of doing it.
Mr. Ruder. There are many ways that it can be done. I
happen to be on the board of the Financial Accounting
Foundation at the present time. It is really a hard matter to
be a board member there and find that the body just does not
have enough money to fulfill its obligations, and then to feel
that you have to go out and raise the money for it.
I would like to see a fee which was sufficient to fund the
FASB and this new body that we are talking about and relieve it
even from attempting to have to make money from its
publications. These publications should be free, in my view.
Senator Dodd. Yes.
Mr. Ruder. We ought to make them widely available to
everybody and not require people to pay for them.
Mr. Williams. And intelligible.
Senator Dodd. Also, and he's not here, but the Chairman
knows him and we have had him here before. That is Ed Jenkins.
I think he has done a terrific job at FASB. I have a very high
regard for Ed Jenkins. He is leaving I think in a couple of
months.
But as people start to whack the FASB, and some of the
shortcomings, and we are all aware of why they occur--I also,
and I ask you to comment on this, the idea that we are going to
sort of politically through a legislative process determine
accounting principles and standards, makes me uneasy.
I have been a Member of this Committee when, frankly, I
have seen the Committee try to dictate what an accounting
standard or practice ought to be, and it scares me, where you
get votes of 12 to 13 on something because of obvious reasons
rather than what may be the wisest decision.
Also, how the board makes decisions. What are there, seven
members of this board? It takes five votes to get anything
done. You have had the SPE rule for, what, 15 years.
By the way, I am glad you included this very specifically
in your recommendations of what ought to be done. And I agree
with you totally. But there is obviously a reason. What has
happened over 15 years?
Arthur, why has this taken 15 years?
Mr. Levitt. The pressure on this, as in other issues, has
been enormous, and in their efforts to respond to that. There
are an endless series of hearings and resubmissions and delays
in the interest of meeting the demands of the community and the
demands of legislative pressure. It is a very cumbersome,
unresponsive process. And you are quite right that the efforts
to legislate a change injects a measure of politics into this
that we were supposed to insulate it from.
Senator Dodd. Yes.
Mr. Williams. It is another example of lack of
independence. It is not just the auditors that lack
independence. It is the rulemaking agency that does as well.
Senator Dodd. Exactly. Let me just add something. What
Enron did on the SPE's, is that legal? That is legal today what
they did. I mean, they may have, how they handled the money----
Mr. Levitt. They would argue that it was legal. I am not
convinced that it is. But they would make the argument that the
rules are sufficiently vague.
Senator Dodd. That you could set up 4,000--that is the
number I read in the press--separate entities to hide losses?
Mr. Levitt. That was the number.
Mr. Breeden. Certainly one of the things the investigations
and others will look at is whether they were using these
entities in compliance with the law or whether they, in fact,
violated the standards applicable to them.
Senator Dodd. Yes.
Mr. Breeden. Clearly, we do not have enough disclosure with
these entities. But we do have to be careful that asset-backed
financing is a hugely important technique for particularly
smaller companies, letting credit be extended against the
credit of certain income-generating assets rather than against
the credit of the company itself, is perfectly responsible.
There is nothing wrong with it.
The company in which I was CEO, we had not one, but two
SPE's. Maybe that is a little bit of a public confession here,
but we did run every penny of our SPE's through the income
statement and they were on the balance sheet. They could have
been off balance sheet. We put them on. But whether on or off
balance sheet, they at least should be disclosed.
Mr. Levitt. Senator, in 1990, the SPE issue came before the
FASB and the firms strenuously argued against reconciling this
issue at that time.
Senator Dodd. Which firms?
Mr. Levitt. The accounting firms.
Mr. Ruder. Sir, there is one other thing that needs to be
borne in mind here. And that is, if management of companies are
not honest in their approach toward their accounting, they can
use the accounting system to their advantage. That is a
fundamental question that is very hard to deal with.
Senator Dodd. Last, I just want to make the point, and Mr.
Chairman, I wish we had time just to discuss this one issue if
we could. It is a point that you have all made to one degree or
another.
That is what I consider the sort of international approach,
which is the Ten Commandment approach that, Dick, you talked
about--thou shalt not--as opposed to writing, because every
time you write that subparagraph third, there is someone out
there figuring how to get around that paragraph.
Mr. Breeden. Exactly.
Senator Dodd. I will make it as an observation rather than
a question so we get to the next person. But I think it is a
very important point that we may want to look at as we try to
detail this in such a way, so fly speck it that you obviously
create massive loopholes by someone just trying to then get
around your wording, as opposed to the more generic commandment
that then puts people on notice that if you cross the line, the
rules are going to be a little bit more vague. And I realize
that there is danger in that. But there also may be a real
advantage to it.
When you start looking at corporate boards of directors,
audit committees, regulators, the accounting standards, the
security analysts, the stock exchanges, the rating agencies,
this is a very complex area.
Your testimony today has been terrific. I appreciate it.
Chairman Sarbanes. Senator Reed.
Senator Reed. Thank you very much, Mr. Chairman. Thank you,
gentlemen, for your testimony today.
Let me begin with perhaps an overly simplistic question. It
may be naive. But the sophistication of financial instruments
today, it seems that directors certainly are very much
dependent upon the advice of accountants and the management of
companies. Indeed--I will phrase the question--perhaps with the
sophistication of some of these instruments, that the
profession of accounting is not up to giving that kind of
advice. What is your views on that?
Mr. Levitt. I think you have put your finger on something,
in terms of why are we where we are today? I think the
development of these instruments and the changes in the economy
and the rise of technological innovation has far outpaced the
ability of gatekeepers of all kinds to stay on top of this. And
that is why we are where we are now.
Senator Reed. If anyone else would like to comment.
Mr. Williams.
Mr. Williams. I even wonder whether in many cases the
accountants themselves are capable of understanding what they
are looking at.
Senator Reed. Is that a concern that all of you have? I
have and it is very intuitive because I am certainly not an
expert here. But it seems to me we have created this situation
where directors, intelligent, capable people who want to do
right, just simply do not understand the complexity of these
instruments. Then you have accountants who they turn to,
assuming that they are the experts, et cetera, and they too
might not have that expertise, which leaves it up to the very
clever architect of these instruments sometimes within the
company or without the company, to sell them a bill of goods.
And that might be why we are here.
Mr. Ruder. Good corporate practice today involving
complicated derivative instruments calls upon the valuation of
those instruments, not only by internal financial people, but
also by a third party. And there are third parties out there
that can advise boards of directors. It is my understanding
that the better governed companies will turn to those third
parties.
Senator Reed. But that is not a requirement.
Mr. Ruder. No.
Mr. Breeden. Senator, just to insert----
Senator Reed. Mr. Breeden and then Mr. Hills.
Mr. Breeden. On your point, it is, I think, important to
recognize that--and this goes back to what we were talking
about with Senator Dodd--the SPE standard, the whole concept of
off balance sheet debt creates an enormous, it is like an
enormous gravitational force.
Chairman Sarbanes. Yes.
Mr. Breeden. Because if you can borrow money and use it in
your business to increase earnings, and you can not report the
debt so that people taking a quick look at your company say, ah
ha--I mean, wouldn't we all like to live in our house but not
have our mortgage?
So it is kind of the best of both worlds. You can have the
proceeds of the debt, but you just do not have to show people
it.
And, yes, the rating agencies should look through that and
should go do the homework and find all 4,000 SPE's and add them
up. But it is more likely to most corporate executives that you
might get away with it if it is hidden out of sight.
Now when you talk about pressure, and we have beaten up the
accountants a little bit and talked about the independence
pressure, but Wall Street should not come out unscathed here in
this panel. We have sold trillions upon trillions of dollars of
instruments whose primary purpose is to do a financing and keep
it out of sight.
Mr. Levitt. Absolutely.
Mr. Breeden. That is done because the rules allow it. No
one is trying to break the law. No one is trying to defraud
anyone. But the rules allow it, and so Wall Street says, fine,
we will help you do that. Executives want to keep the data out
of sight. Wall Street wants the accounting rules there and
figures out a way to do it, with the net result that Enron
shows tragically, that you can have half of the balance sheet
hidden away under the camouflage netting somewhere. And that
whole system, it is not any one person's fault.
Senator Reed. Right.
Mr. Breeden. But we have to try and tackle all parts of it
to get back to where investors can really understand, along
with directors and rating agencies, what the heck are they
dealing with.
Senator Reed. Mr. Hills, you had a point.
Mr. Hills. Let me say again that the audit process has
become a commodity. The CEO's are not looking for added value.
The auditing firms are not getting the people. Twenty-five
years ago, roughly 23 percent of all the graduates of Wharton,
30 percent of all the graduates of Chicago Business School went
into the accounting profession. Nobody goes any more from those
sources.
The auditors are going to have to pay more money for people
and the companies are going to have to pay much more for the
audit.
Senator Reed. Let me follow up a point that was raised I
think indirectly by Mr. Breeden's comment. That is, it seems to
me that in any transaction there are several things. One is the
impact on the company, the consequence financially. But also,
there is a purpose to it of why are they doing that?
Again, this is a question that I do not know the answer.
Does the accounting profession have to take into consideration
in their reporting the purpose of the transaction or simply an
evaluation of what effect it will have on the bottom line?
And is it important to understand the purpose of some of
these transactions and disclose those purposes, as well as
potential financial impacts.
Mr. Breeden. Senator, I think the starting point is to
understand, is there an economic purpose at all?
Senator Reed. Yes.
Mr. Breeden. The Powers Committee Report indicated that
many of the transactions that Enron engaged in did not, in
fact, shift risk, did not, in fact, have any true economic
purpose. Therefore, their only purpose was to massage the
financials.
Senator Reed. But under present accounting rules, SEC
rules, an accountant would have no obligation to disclose to
the audit committee, to the public, to anyone else, that this
transaction has no economic purpose.
Mr. Breeden. No, sir. I think if the accountant concluded
that--and I am a lawyer, not an accountant here, although I
worked in an accounting firm, so take this with a grain of
salt.
Senator Reed. I am just a country lawyer.
[Laughter.]
Senator Dodd. You played one on television.
[Laughter.]
Mr. Breeden. I think if the accountant concluded that you
have a transaction that has no economic purpose, and yet is
being reflected in the financial statements, particularly in
very large magnitudes, that comes close to the accounting
definition of a fraud.
If you are putting things in the financial statements that
have no economic purpose whatsoever, then the only purpose that
you by definition have is you are trying to manipulate the
financial statements to appear different than they should.
I think then you get into the mandatory reporting that was
put in place by Congress several years ago in which an
accountant, when they see something that they believe is an act
of fraud, they are required to go to the board, give the board
their opinions on that, and if the board does not act, they are
required to go to the SEC. That is certainly a statute that
appears to not have been invoked here.
Mr. Levitt. It is a statute that does not apply to the
legal profession. The legal profession, a lawyer, according to
the ABA, if he encounters fraud on the part of one of his
clients, financial fraud, is not allowed to report it to any
regulatory body. That is wrong.
Senator Reed. Thank you very much. Does anyone else have
any other comments?
Mr. Hills.
Mr. Hills. I was just going to say, do not underestimate
the fear that the auditor has in telling somebody.
In the case I mentioned a while ago where we wrote off more
than $3 billion, for 4 years, the auditors were telling
management that there was 12 serious things they had to do.
They never mentioned it to the audit committee.
Senator Reed. Thank you very much.
Chairman Sarbanes. Senator Schumer.
Senator Schumer. Thank you, Mr. Chairman.
I thank the witnesses for their testimony. I have been here
for some of it, watched some of it on our little closed-circuit
television. And I guess the general thing that concerns me, and
I think Chairman Hills touched on this a little bit, is the
free-rider problem.
Overall, we have goodwill for our accounting profession.
So, everyone says, okay, that goodwill, which is essential to
every firm's functioning, stays. Even if I cut the corner a
little bit, it won't hurt. And that adds up and adds up and
adds up and sooner or later, something happens.
So one of my questions is, what can we do to stop that from
happening? I have a number of ideas here. Some of them are
pretty calm, some of them are pretty radical. But I would like
to know your opinions of all of them as we try to figure out
what to do.
Maybe I will mention all four and then have you comment
because I know we have to get going. So that may speed things
up a little bit. Here are the four.
Obviously, with special purpose entities, this is one of
the most opaque accounting techniques that have been brought to
the public's attention. One of the most disturbing elements of
these offshore partnerships, I was shocked to learn that only 3
percent of the capital must come from outside investors for a
partnership to be considered off balance sheet. Has there been
consideration to raising that number to, say, 15 or 20 percent?
I have never understood the rationale of the 3 percent.
Should we consider the use of SPE's material de facto? I
think somebody brought that up and I would be interested in the
other four people's opinion. What is the result if we do
nothing on SPE's? We do a lot of other things, but we do
nothing on SPE's. That is the first area.
The second, also people have talked about this, is
disclosure of stock sales. I think the thing that bothered
Americans the most was that the top people at Enron sold stock
and other people did not know. Some were prohibited from
selling and others were not. But nobody knew. I mentioned this
in my opening statement. Chairman Levitt has done some work in
regard to this. I wonder if an instantaneous disclosure
requirement of stock sales by senior executives, the Internet
makes it all very easy to do, might help solve this problem.
Obviously, there might be too much information. But at
least it would be out there and it is better than no
information--too much meaning some of these sales--a guy wanted
to build a new house in Aspen and he sold a lot of stock and it
had nothing to do with the performance of the company, but so
be it.
These two others are a little stronger.
One which I think Chairman Levitt has mentioned is
mandatory rotation. I do not know if that has come up here, the
idea of--it has been raised. Okay. Well, if everyone's talked
about that, I will go look at the record and see what people
have said. If anyone wants to say anything more about it, it
has its pros and cons.
Someone against it who I trust told me that they thought
the worst thing--this could be bad because the biggest--the
time when the companies would most get away with stuff if they
wanted to, like in Enron, would be the first 2 years of the new
auditor before the auditors learned about the company.
Finally, what about an uber-auditor, so to speak? When you
hear of an IRS audit, everyone says, uh oh, IRS audit. Well,
what about the SEC occasionally going in on its own, giving it
the authority and resources, which of course we tried to do in
the 31(e) bill and we hope--Senator Johnson has talked about
this--but what about occasionally the SEC just doing its own
audit, like the IRS does, probably not on that frequent a basis
as the IRS does, not for one out of every 50 or 100 companies.
Particularly if they had the power to go in and they began
to smell a little something, they could go in and do it. And
the fact that they could do it would be prophylactic and that
they would do it on occasion might help reveal some of these
problems before they grew and grew and grew.
I am particularly interested in your answers to the last
two, that one, but all the others as well. We can go down the
line, Chairman Levitt first.
Mr. Levitt. As far as the mandatory disclosure, I think
that would be a useful exercise. I think the notion of the SEC
doing spot audits occasionally, if they had the resources, that
might be a useful exercise. As far as the SPE's are concerned,
I really would have to think more about that issue. I know that
the Big 5 and all the investment banks like the imprecision of
the SPE's, which gives them an opportunity to be creative and
charge fairly hefty fees. But this is a complex issue and I
would rather not give you a knee-jerk answer to it.
Senator Schumer. Thank you.
Chairman Breeden.
Mr. Breeden. Well, I too think your idea of an uber-
auditor, I guess that is part of what I was trying to say in an
earlier exchange about my doubts about all these private-sector
bodies that we are going to form and it will take 2 or 3 years
to get up and running. Meanwhile, what are investors supposed
to think about our markets.
I think the SEC has always had this role built into its
function, not to do a whole audit. I do not know that this is
as important. But to go in and test accounting interpretations
that are really being used in the field and if they find that
they are not allowable, then to prosecute people for it,
because that can be fraud.
It may not be with fraudulent intent and it may just be
something that people have to be forced to go back and restate
and make disclosures. But the SEC has long had that role. It
has been underfunded. They have not had enough people. But we
should give them more people and use the SEC, not reinvent the
wheel.
I absolutely believe that, ultimately, at the top, it has
an important role.
Remember, we have five auditing firms. There are five CEO's
who, in a way, control the audits of every major company on the
planet. That is a concentration of power that has never existed
before and it creates huge responsibilities on the firms and
somebody has to be overseeing how they carry out their
responsibilities.
The stock sales, I think instantaneous disclosure is the
way to go, for at least things that are above trigger levels.
The SPE's, the 3 percent rule, I believe comes from an SEC
interpretation that says, well, you may not be entitled to SPE
if you are above that, but you certainly are not entitled to it
below it.
But people then take that as saying, okay, if you get 3
percent, you are home free. And that should not be the end of
the analysis and we should certainly make people disclose them.
Senator Schumer. Chairman Ruder.
Mr. Ruder. The Financial Accounting Standards Board has the
SPE matter on its agenda. I hope it will be faster than usual
in dealing with it. It is also going to be dealing with a
special problem called lease financing, which creates similar
problems.
The disclosure of stock sales through the Internet or
whatever, immediately or a day after is absolutely a wonderful
idea and I hope the SEC will go forward with it.
I think the SEC does currently perform an auditing function
in its investigative role. Under Chairman Levitt's regime, the
lawyers in this field began to talk about the year of the
accountant, and the SEC was very active in investigating
companies.
One of the reasons you saw so many restatements in the last
3 years was because the SEC was putting great pressure on
companies through their accountants and their lawyers. I think
that, with more resources, which I agree with, the Commission
can expand that role.
I understand you are going to have a discussion of foreign
matters here. One of the things you should be quite aware of is
that the auditing function in the United States is one thing.
But the auditing function abroad is still another.
We have conglomerate companies with auditing going on by
foreign auditors who do not even come close to the standards
that we insist upon in the United States.
So there is a whole area out there of concern both for the
United States and for foreign countries which needs to be
investigated.
Senator Schumer. Chairman Williams.
Mr. Williams. I do not understand the standard either,
where it originates from and certainly I think it needs a
relook.
A lot of these issues could be dealt with by disclosure.
And if we forced greater disclosure of the rules of recognition
or even the SPE's, the ventilation itself, the public
disclosure, would give the security analysts and others a
chance to revalidate the decisions that were made.
On stock sales, I agree. I think simultaneous reporting
would be valuable.
On mandatory rotation, I have been one of the supporters of
it. I would add another dimension to it, and that is I think
the audit firms ought to have a firm commitment for 7 years. So
there is not only the matter of rotating after the 7 years, but
they ought to be assured of that account so they are
independent and they are not threatened with losing the
account.
Finally, on uber-auditor, I do not like the concept. If the
SEC had more resources and a sophisticated enough staff to
really do the job that they are now trying to do, which means
greater review of filings when they are made, greater review of
annual reports and 10(k)'s than they are able to do now, and
the kind of sophistication to smell a lot of this stuff, which
is not that easy, then with that stronger oversight function
and oversight of the profession and a different kind of self-
regulatory body reporting to the SEC who would in turn have the
responsibility to conduct these audits, with disciplinary
authority to go along with it, I think we would have a very
viable structure.
Senator Schumer. Thank you.
Chairman Hills.
Mr. Hills. The short-term answer to SPE's is lots of
disclosure and understanding and the auditors should be
responsible for that.
Stock sales, absolutely. The companies, however, should
have a policy with respect to key employees selling stock, and
that policy should be disclosed.
As to mandatory rotation, I would like to submit a more
thoughtful piece on that. I think it is a serious issue.
Chairman Levitt and I conspired to bring somebody of real
caliber into the enforcement division as an accountant. The
trouble he had finding somebody of that caliber gives you an
example of how hard it is going to be.
Absolutely, they should have that talent. We do not have
that talent in sufficient numbers.
Mr. Levitt. Senator Schumer, I would like to make a point
that, in some of the cases that we have seen most recently, the
really outrageous cases of Waste Management, Enron, and
Sunbeam, these were failures that occurred with accountants
having been there for long periods of time.
I do not accept the notion that the failure is likely to
occur during the first years of introduction of a new auditor.
And there are so few firms today, that I just reject that as a
problem.
Senator Schumer. Just to review, so the majority here do
support rotation.
Mr. Hills. Well, let me say this. Accountants are not
perfect and I would not like the idea of being saddled with the
same accounting firm and no discretion if I am on an audit
committee to deal with them. So it is not an easy answer.
Mr. Breeden. Senator, I think I was maybe the odd man out
there on rotation.
The resources to audit a multinational company that is
doing business all over the world are stupendous. There is a
lot of lead time and a lot of planning. The idea of rotation is
appealing to deal with independence. But in practical
application, it will create very substantial risks, not just
your 2 year risk, but also finding the right groups. Firms over
time bring in specialists who can help handle particular
companies, who have certain kinds of accounting risks, and you
break all that up when you force a change.
It may be something that the overriding importance of
independence will take us to. But I do think that there are
some intermediate steps.
The one thing I had suggested, not a 7 year engagement
because I think that is too long, but a 3 or 4 year fixed
engagement with a requirement that at the end of that, the
audit committee itself make a determination that the auditor
should be retained.
If so, tell the market, put it in the proxy, explain why
they believe that it is in the interest of shareholders not to
rotate and to keep that auditor. And if they do, there may be
good reasons for it, let them.
Mr. Ruder. On rotation, sir, I have advocated that there be
a public body to oversee the auditing function and that is the
kind of issue that a knowledgeable public body could determine.
As to my own view, I think the suggestion that has been
made is that you should rotate the engagement partner as a
means of dealing with this conflict problem, is a much more
meaningful way of answering the problems that Richard has given
us rather than trying to rotate the entire accounting firm.
Mr. Breeden. But we do rotate engagement partners today.
They cannot stay more than 7 years and it has not solved the
problem. We clearly have to go beyond just rotating the senior
partner.
Senator Schumer. Thank you, Mr. Chairman.
Thank you, everybody.
Chairman Sarbanes. I think we need to draw this hearing to
a close, and the witnesses have been enormously generous with
their time, both here today and in the preparation of their
statements.
I very much regret that we lost that chunk of time earlier
in the morning because of the votes. We would have had quite an
extended period there to get the benefit of your wisdom. But
you have been enormously helpful.
First of all, we have not talked about derivatives. Do we
need to look at that and the unregulated nature of the
derivatives? Is there general agreement that that needs to be
examined.
Mr. Hills. Can we break for dinner?
[Laughter.]
Chairman Sarbanes. I do not want to get into the substance.
Mr. Ruder. I believe there is both systemic risk in the
derivative area and individual risk in the derivative area, so
that there needs to be a new look at the way derivatives are
regulated.
Mr. Williams. I agree with that.
Chairman Sarbanes. Now, I would like to ask this of the
panel. I hate to impose on you further.
We are very interested in the systemic and structural
changes that might be made that would change the balances of
these decisions that are made. So, you get a higher standard of
care and scrutiny working. Obviously, we need to think
carefully about what that would be.
And so, I think, if you could take the written testimony of
the other members of the panel and look through it as well,
because those statements are quite good, and if you could then
give us the benefit of your thinking in that regard. In
particular, any legislative language, since you are all former
Chairmen, that would deal with some of the proposals you
suggested that you could forward to us, that would be very
helpful.
I would hope we could come back to consult with you as we
proceed ahead.
The Committee work program, just partly to outline it, on
Thursday, we are hearing about international accounting
standards.
We are going to have Sir David Tweedie, who is the Chairman
of the International Accounting Standards Board and former
Chairman of the U.K.'s Accounting Standards Board. And Paul
Volcker, who is Chairman of the Trustees of the International
Accounting Standards Committee.
Right after the recess, we will hear from the former Chief
Accountants of the SEC, former Chairmen of FASB, and then we
are also going to do a corporate governance panel. Then we will
move on to March with a series of hearings, probably two a
week.
But we really want to examine very carefully and lay the
groundwork here for reaching some judgments about what should
be done, much of which, of course, each of you has outlined
here today in your testimony before the Committee.
So, we very much hope you will be willing to continue to be
of assistance to us. I hope we have a chance here to get
systemic and structural changes that will really move us to a
different plateau.
I have watched much of this over the years and FASB has
been criticized for being slow. But every time they try to do
something of significance, they run into a storm of counter-
opinion.
We talk about the Congress not setting accounting
standards, and I agree with that. But then the Congress does
not want the FASB to set accounting standards, if the
accounting standards are, ``moving in the wrong direction, as
they perceive it.'' Of course, they perceive it because of the
people who come in on them and say, ``well, this is moving in
the wrong direction.''
We have to somehow be able to break out of that mold and
put in place a structure and a system that gives us greater
assurances we are not going to be confronting what we are
looking at now.
We very much appreciate your coming today. Unless my
colleagues have something they want to add, I am going to draw
this to a close.
Senator Dodd. I think it has been very worthwhile, Mr.
Chairman, tremendously helpful. And I hope that you will stay
engaged with us on these issues. They are tremendously
important and tremendously complex.
I think the Chairman has a great schedule here for us to
look at all of these carefully because when you start pulling
all of this together, and the unintended consequences.
Everybody has 20/20 hindsight. When you are in the middle
of this trying to craft rules of the road here that are not
just going to respond to an Enron, which is the obvious matter
that has brought us all to this level of temperature and
interest.
We want to make sure in solving that problem, that we are
not creating some other ones and lose sight of the fact that
the world still comes here because of the confidence in the
markets and also the fairness and the openness of them.
And I want to make sure as we go through this that we are
not creating problems that we wouldn't want to look back on in
some future Congress and have to undo again.
So, we look forward to working with you.
Chairman Sarbanes. We have an intense period ahead of us.
There is no question about it. We need to address this
situation with some expedition. At the same time, we need to be
very thorough and careful so we reach the right judgments. I do
not regard those two as being inconsistent with one another.
You just have to redouble your efforts in order to move ahead.
Obviously, we have to have some sense of urgency about it.
Otherwise--I quoted those headlines in the paper and if we do
not put something into place, I do not know how you are going
to restore investor confidence.
Plus, I do not intend to let it languish and then we lose
the momentum to do something of consequence here.
Did someone have something that they wanted to add?
[No response.]
Thank you all very much. We appreciate it tremendously.
Mr. Williams. Thank you.
Mr. Ruder. Thank you.
Mr. Hills. Thank you.
Chairman Sarbanes. The hearing is adjourned.
[Whereupon, at 1:56 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Chairman Sarbanes, thank you for holding today's hearing concerning
the accounting and investor protection issues raised by Enron and other
public companies. I would also like to thank the distinguished panel of
former SEC Chairmen for agreeing to discuss this matter with us today.
The Enron bankruptcy is a national scandal, one with terrible human
and financial cost. We in Congress are faced with the task of figuring
out what went wrong, whether current laws are adequate, and the role
that greater enforcement of existing laws might play. The collapse of
such a large, publicly-traded corporation raises a host of issues
related to auditing, financial reporting, pension fund management,
corporate governance, and Federal regulation. We must explore every
avenue to ensure that all Americans, big and small investors alike,
have the information and the confidence they need to invest in our
economy.
The panel before us today is particularly well qualified to speak
about what role the SEC could or should play to ensure that more
situations like Enron do not occur. In an ideal world, I would hope
that Enron was an isolated incident. However, a number of other similar
situations appear to be cropping up daily. And I have a real concern
that these problems may indicate system-wide problems related to the
accounting industry.
Just last week, this Committee heard testimony from Federal banking
investigators on the failure of Superior Bank of Hinsdale, Illinois, a
failure that may cost the FDIC in the neighborhood of $500 million. At
the heart of the institution's failure was inaccurate valuation of
residual interests in securitizations. Superior's auditor, a nationally
recognized accounting firm, failed to unearth obvious problems that
ultimately led to the failure of the institution.
Another recent high profile bankruptcy involved the
telecommunications firm Global Crossing. Last Friday, it was reported
that the FBI would investigate the firm's accounting practices.
Clearly, accounting irregularities can have far reaching effects.
Consider last week's massive sell-off in the stock market. The sole
reason cited by analysts for this sell-off was investor concern over
accounting practices. And no wonder--our markets function only when
investors have the information they need to evaluate the health of a
business. If the disclosures are incomplete or incorrect, investors,
even the most sophisticated, cannot make good decisions.
Aside from accounting issues, another area of special concern to me
is the conduct of securities analysts and their impact on the market.
In the case of Enron, we saw analysts turn a blind eye to emerging
problems, possibly due to conflicts of interest because of affiliations
with investment banking operations. Clearly, the Chinese wall that
should have provided an environment of independence for analysts did
not function in many instances. Incredibly, some analysts continue to
rate Enron a ``strong buy.''
[The issues we are talking about can often have far reaching and
sometimes unanticipated consequences. Take, for example, Enron's effect
on the surety bond market, which pushed Kmart into bankruptcy. Enron
utilized surety bonds to insure the proper execution of energy and
other types of forward contracts. When Enron failed, many of the
companies involved in issuing these types of bonds got out of the
market, causing remaining issuers to raise their fees significantly.
This, in turn, put pressure on companies like Kmart, which use surety
bonds to insure large inventory orders. The unraveling of the surety
bond market was the last straw for Kmart, forcing them into
bankruptcy.]
The SEC must be aggressive in enforcing our securities laws and in
keeping our markets the most transparent in the world. I am deeply
concerned that the SEC has not been given the resources to maintain a
sufficient and stable human resource base to fulfill its mission. Over
1,000 SEC employees more than one-third of the agency's staff--has quit
over the past 3 years, largely due to the low pay scale at the SEC
compared to other financial regulators and the private sector. As any
businessperson knows, that kind of turnover has a clear impact on any
institution's ability to operate effectively.
Just before Christmas, the Senate passed H.R. 1088, the Investor
and Capital Markets Fee Relief Act, which President Bush signed into
law on January 16. In addition to reducing securities transaction and
registration fees, which essentially amounted to an unfair tax on
American investors and businesses, the law authorized the SEC to bring
the pay of its employees in line with the higher pay schedules of other
Federal financial regulators.
I was profoundly disappointed to find out that the President's
budget failed to include additional amounts for SEC salaries for fiscal
2003. It is no overstatement to say that a strong SEC is an integral
part of our Homeland Security. And money should be made available to
ensure that the guardians of our markets are not paid less than those
minding our banks. It is my hope that we can engage in a dialogue with
the Executive Branch to address the pay parity issue and create an
environment at the SEC that enables employees to contribute to the
economic security of our Nation.
In closing, I would like to note that Mr. Levitt was ahead of his
time by attempting to address many of these issues during his SEC
tenure. At the time, I supported Mr. Levitt's proposal to create strict
guidelines governing the consulting role of a company's auditors, and I
am pleased that the private sector and my colleagues are coming to
understand the wisdom of that proposal. I also understand that a study
was initiated to determine whether the peer review process employed by
auditors was appropriate and effective. Clearly, though, more needs to
be done.
I thank the witnesses for their extensive and thoughtful written
testimony, and I once again thank you, Mr. Chairman, for scheduling
this hearing.
----------
PREPARED STATEMENT OF SENATOR DANIEL K. AKAKA
Thank you, Mr. Chairman.
Last week, we examined the issue of financial literacy. The
testimony of the witnesses confirmed my belief that all citizens need
to be better prepared to make informed decisions regarding fundamental
undertakings such as saving and investing for a comfortable retirement.
However, as Enron, Sunbeam, and Waste Management have shown, even
individuals with the greatest financial knowledge can be misled because
of inaccurate and potentially fraudulent information provided by
companies and approved by auditors.
Institutional investors owned 70 percent of Enron's shares
according to the Chicago Tribune. Mutual fund managers, public employee
pension plan administrators, and bankers were deceived by the
accounting techniques used by Enron and approved by Andersen.
Those who suffered most from the collapse of Enron were 401(k) plan
participants and individual investors. We all are all too aware of the
Enron employees and the retirees who staked their retirements on the
future success of their company.
Institutional and individual investors were taken by surprise last
fall when Enron announced a third quarter loss of $638 million,
reduction in stockholder's equity, overstated earnings, and significant
debt to various partnerships.
Expanded participation in the financial markets has provided
increased opportunities for individuals to build wealth. In my home
State of Hawaii, over half of all households own stock. Investing
decisions are already extremely complex. When information provided by
companies is false, investors are not given the opportunity to make
informed decisions. False information can lead to losses which destroy
the wealth of investors.
I look forward to this Committee's thorough examination of
accounting practices and investor protections. We must ensure that
investors are provided reliable information to use in making their
investment decisions.
I thank the witnesses for joining us and look forward to their
recommendations on what can be done to restore the confidence in our
financial markets after the implosion of Enron.
Again, Mr. Chairman, thank you for convening this hearing.
----------
PREPARED STATEMENT OF ARTHUR LEVITT
Chairman, U.S. Securities and Exchange Commission
1993 to 2000
February 12, 2002
Thank you for the invitation to share my thoughts on the failure of
Enron and its implications for our financial markets.
Today, there is an emerging crisis of systemic confidence in our
markets. What has failed is nothing less than the system for overseeing
our capital markets. We have an opportunity to repair trust in those on
whom investors depend, and in the process, trust in the numbers that
are the backbone of our capital markets. But our response must be
comprehensive. Healthy and resilient financial markets depend on the
accountability of every one of its key actors--managers, auditors,
directors, analysts, lawyers, rating agencies, standard setters, and
regulators.
Enron's collapse did not occur in a vacuum. Its backdrop is an
obsessive zeal by too many American companies to project greater
earnings from year-to-year. When I was at the SEC, I referred to this
as a ``culture of gamesmanship'':
. . . A gamesmanship that says it is okay to bend the rules, tweak
the numbers, and let obvious and important discrepancies slide . . .
. . . A gamesmanship where companies bend to the desires and
pressures of Wall Street analysts rather than to the reality of numbers
. . .
. . . Where analysts more often overlook dubious accounting
practices and too often are selling potential investment banking deals
. . .
. . . Where auditors are more occupied with selling other services
and making clients happy than detecting potential problems . . .
. . . And where directors are more concerned about not offending
management than with protecting shareholders.
What was once unthinkable in business has become ordinary. In our
highly competitive economy, more and more business leaders are
employing financial maneuvers that approach and sometimes cross ethical
boundaries. Accounting rules are dealt with in terms of ``what can I
get away with'' or ``if it is not expressly forbidden, it is okay.''
Financial statements, often, are not an accurate reflection of
corporate performance, but rather a Potemkin village of deceit.
At Enron and throughout much of corporate America, optics has
replaced ethics. Too often, those who manage public companies, audit
them, and serve on their boards of directors have forgotten that the
opportunity to realize wealth in our capitalist system comes with a
responsibility to the public from whose capital they are able to
prosper. When the motivation to prop up stock prices overtakes the
obligation to keep honest books, capital flows to the wrong companies
and the very market system from which these executives profit is
fundamentally weakened.
That is why undertaking reforms that preserve and enhance the
independence of the gatekeepers who safeguard the interests of
investors is so important. These steps are certainly not a panacea, but
are the beginning of a much-needed reinvigoration of our financial
checks and balances.
First, we must better expose Wall Street analysts' conflicts of
interest. 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 that 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.
Second, company boards often fail to confront management with tough
questions. Stock exchanges, as a listing condition, should require at
least a majority of the directors on company boards to meet a strict
definition of independence. That means no consulting fees, use of
corporate aircraft without reimbursement, support of director-connected
philanthropies, or other seductions. In Enron's case, at least three
so-called independent board members would have been disqualified under
this test of independence.
Third, many accounting rules need to be updated to better reflect
changing business practices to give investors a better understanding of
the underlying health of companies. Because the Financial Accounting
Standards Board is funded and overseen by accounting firms and their
clients, its decisions are agonizingly slow. This well-meaning group
must defend itself as well from Congressional pressure, which is often
applied when powerful constituents hope to undermine a rule that might
hurt their earnings. FASB's funding should be secured not just through
the accounting firms and corporations, but also a number of market
participants--from the stock exchanges to banks to mutual funds. And
the Financial Accounting Foundation, which chooses the FASB's members,
should be composed entirely of the best qualified members--not merely
those representing constituent interests. The FASB should then be able
to focus more on getting the standards right, and avoiding delays and
compromises that ill serve investors.
Let me turn briefly to probably the most urgent area of reform.
Like no other, the accounting profession has been handed an invaluable,
but fragile, franchise. From this Federal mandate to certify financial
statements, the profession has prospered greatly. But as an edict for
the public good, this franchise is only as valuable as the public
service it provides, and as fragile as the public confidence that gives
it life.
It is well past time to recognize that the accounting profession's
independence has been compromised. Two years ago, the SEC proposed
significant limits on the types of consulting work an accounting firm
could perform for an audit client. An extraordinary amount of political
pressure was brought to bear on the Commission. We ended up with the
best possible solution--given the realities of the time.
I would now urge--at a minimum--that we go back and reconsider some
of the limits originally proposed. While I commend the firms for
voluntarily agreeing not to engage in certain services such as IT work
and internal audit outsourcing, I am disappointed the firms have
remained silent about consulting on tax shelters or transactions, such
as the kinds of Special Purpose Entities that Enron engaged in. This
type of work only serves to help management get around the rules.
I also believe that the audit committee --not company management--
should preapprove all other consulting contracts with the audit firm.
Such approval should be granted rarely, and only when the audit
committee decides that a consulting contract is in the shareholders'
best interests. I also propose that serious consideration be given to
requiring companies to change their audit firm--not just the partners--
every 5 to 7 years to ensure that fresh and skeptical eyes are always
looking at the numbers.
More than three decades ago, Leonard Spacek, a visionary accounting
industry leader, stated that the profession could not ``survive as a
group, obtaining the confidence of the public . . . unless as a
profession we have a workable plan of self-regulation.'' Yet, all along
the profession has resisted meaningful oversight. We need a truly
independent oversight body that has the power not only to set the
standards by which audits are performed, but also to conduct timely
investigations that cannot be deferred for any reason and to discipline
accountants. And all of this needs to be done with public
accountability--not behind closed doors. To preserve its integrity,
this organization cannot be funded, in any way, by the accounting
profession.
Finally, it has become clear that the reputation of our markets is
rooted--in part--in the quality of their regulation. Earlier this year,
Congress passed legislation to fix the disparity between compensation
for employees at the SEC and employees at other financial regulatory
agencies. Unfortunately, the Administration's budget doesn't include
funding for pay parity. We can ill afford--at a moment like this--to
allow inaction to implicate the quality of regulation and, as a direct
result, the quality of our markets. My message to the Congress and the
White House is simple: ``Fund pay parity.''
The rise of the baby boom generation, changing retirement patterns
and markets that sometimes defied the laws of gravity brought more and
more first-time investors into the markets. These are our friends and
neighbors, whose hopes and aspirations became inextricably linked to
the health and resiliency of our markets. We assault those dreams if
company executives sell out shareholder faith and if those purporting
to be independent are anything but. Enron, like every other financial
failure before it, proves that investors bear the ultimate cost. It is
time to repair what has been lost.
Thank you very much.
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PREPARED STATEMENT OF RICHARD C. BREEDEN
Chairman, U.S. Securities and Exchange Commission
1989 to 1993
February 12, 2002
Chairman Sarbanes, Senator Gramm, and Members of the Committee. It
is a great pleasure to appear once again before this Committee. I was
privileged to serve as Chairman of the Securities and Exchange
Commission from 1989 -1993. In total I served for nearly 10 years in
Government posts spanning the Administrations of Presidents Ronald
Reagan, George H.W. Bush, and William J. Clinton.
I began my career in New York City as a corporate finance lawyer.
For the past few years I have served as the bankruptcy trustee
unraveling what is thought to have been the largest ponzi style fraud
in U.S. history,\1\ with petition date liabilities to creditors of just
over $1 billion. When the case is closed later this year I expect total
recoveries will exceed $700 million. As part of that case I built up a
public company controlled by our bankruptcy estate and served as its
CEO for several years. That company was sold yesterday for just over
$100 million for our creditors and other shareholders.\2\
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\1\ The Chief Financial Officer of Bennett Funding was sentenced to
30 years imprisonment after conviction on more than 60 felony counts.
\2\ This company owned two ``special purpose entities,'' or
(SPE's), although our SPE's were fully disclosed and included in our
financial statements.
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After leaving the Commission in 1993, I spent 3 years as a Senior
Partner at Coopers & Lybrand, LLC, where I coordinated the financial
services industry program. I currently serve as an outside director on
two boards and audit committees of publicly-traded companies, and my
firm works as an intensive care specialist for companies experiencing
financial distress or crisis. Thus, during my career I have had the
occasion to consider the issues of accounting, disclosure, and
corporate governance as a lawyer, business executive, outside and
inside director, accounting firm principal, and, of course, as a
regulator.
In 1989, while serving as Assistant to the President for President
George H.W. Bush, it was my great privilege to work with the Members
and staff of this Committee to craft the landmark legislation that
ended the savings and loan crisis in America. That was an example of
the utmost level of bipartisan cooperation to solve a financial threat
to the American economy, and to the savings of tens of millions of our
citizens. As a result of our work, the United States was able to
eliminate the threat to the financial system and to put the savings and
loan industry back on the path to solvency.\3\ Though I do not think
anyone involved in that effort received much credit, from President
Bush who provided strong leadership to the Members of Congress who
worked closely with us and made forthright decisions for America's
future. However, we successfully repaired a system that had been
devastated by financial corruption, extremely poor business and lending
practices, and in some cases outright criminality. Today, America has
the strongest banking system in the world, and our savings institutions
are strong and healthy due in no small part to the legislation that we
created together.
---------------------------------------------------------------------------
\3\ The savings and loan reform legislation contained a mix of
changes to criminal and to civil liability statutes, additional
resources for the FBI and Justice Department to search out and
prosecute fraud on insured institutions, and changes to enhance the
authority of the regulatory system to require strong capitalization and
prudent practices. We took the best of the existing system, and then
made bold reforms where necessary to fix problems that had occurred. We
also made sure to vindicate the public trust by bringing to justice
those who had enriched themselves through fraud and other unlawful
acts, and doing our best to make sure that the problems could not
reoccur in the future.
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With this example in mind, I am optimistic that this Committee has
the capacity to play a vital leadership role in devising responses to
the events that took place at Enron Corporation and Arthur Andersen
(Andersen). The collapse of Enron and the parallel shredding of
documents and audit failures at Andersen have highlighted weaknesses in
our corporate governance, accounting principles, auditing practices,
disclosure standards, pension systems and bankruptcy laws, to say
nothing of the ethics of some of the major actors.
While it is easy to condemn the abuses that occurred at Enron /
Andersen, the difficult task is to design successful reforms. Improving
transparency of information in the market, producing better accuracy in
audited financial statements and encouraging better governance of both
accounting firms and corporations are worthwhile goals, but the trick
is how to actually accomplish these objectives. Also, we need to make
any improvements without damaging the systems we already have in place,
or creating unnecessary costs or overbroad regulation. A group of
specific possible improvements are included in this testimony for your
consideration. These are phrased as things that the Committee should
consider, since there are pros and cons associated with every step,
though in my experience they would improve our current system. However,
before describing the specific steps, I would like to outline the
overall philosophy that I bring to this analysis to give context to the
problems these recommendations are meant to address.
Overview
Overall, the United States has the finest system of accounting and
disclosure for publicly-traded companies of any country. Our equity
markets have historically provided a wonderful opportunity for
democratic capitalism that has allowed tens of millions of investors to
participate in a broad-based ownership of our economy. For decades
public policy in the United States has mandated a rule of law for the
market to prevent price manipulation, financial fraud, insider abuses,
and other forms of market corruption. In doing that, the Federal
Government has sought not to limit free markets, but to protect their
integrity by precluding attempts to rig markets or dilute market forces
through fraud. We have more comprehensive disclosure of business
practices, risks and results than any other marketplace, and that
policy of ``transparency'' has served our Nation well.
Since the SEC was created in 1934, both Republicans and Democrats
have been willing to put teeth into the commitment that our markets
will function within the rule of law, and to achieve the values that
are embedded in those laws. We believe our markets should be fair and
open to all participants, from the smallest individual investor to the
largest institutions. We also believe that it is morally wrong to lie,
and to seek to profit based on misleading others concerning the truth
of your financial statements. We have made such conduct unlawful both
because such market corruption is inconsistent with our values as a
Nation, and also because this conduct harms our economy by driving
investors and their liquidity away from the market where it can finance
jobs and growth.
Trading on insider information, for example, was unlawful in the
United States while it was an Olympic sport in other countries. We have
not only formally required transparency, but also we have devoted real
resources to policing the accuracy and relevance of financial
statements and the adequacy of disclosure. All of us who have served at
the SEC have had the job of putting aside any consideration other than
protecting honesty and integrity in our markets, and vindicating the
trust of Americans of all walks of life in the fundamental fairness of
our markets.
In the Enron /Andersen case, the trust of investors and employees
alike was subverted principally by senior executives seeking to enrich
themselves by painting a picture of an Enron that evidently did not
exist. While the real Enron had lost hundreds of millions of dollars
speculating in stocks of other companies and through bad investments of
one kind or another, the Enron shown to investors had nothing but
successes to its credit. They were supermen not because of good
performance, but because they were good at hiding ``income statement
volatility,'' also known as losses, behind a wall of accounting tricks.
Indeed, with the savings and loans we used to criticize ``smoke and
mirror'' accounting. In those terms Enron burned down the forest, and
employed the entire Hall of Mirrors.
The interests of employees, retirees, and investors across the
country were thrown under the Enron bus, and from the facts we have
seen this appears to have been done deliberately. Of course, someone
always has to light the fire before the books can be cooked. The
spectacle of insiders aware of the deadly risks of the ``Raptors''
selling securities while encouraging their employees to invest has
aroused the indignation of millions, as has the flagrant breach of
trust that some of the Enron executives displayed in plundering their
own company.
More threatening to the economy than the personal dishonesty of
individual executives is the rising question in the markets of whether
the accuracy of financial statements can be trusted. If the market
loses the ability to trust the accuracy of the financial presentations
that auditors certify, the result could be very significant risk
premiums or lack of liquidity for other companies. This is serious
collateral damage for investment markets, and we have seen this effect
in the market over the past few weeks.
Given the stakes, it is very troubling that Andersen is reported to
have had very serious doubts about the potential for massive inaccuracy
in the statements. Yet they apparently sat on their hands when they
could have shared their doubts with the audit committee or refused to
acquiesce in the company's proposed financial presentations. The fact
that Andersen had accepted millions of dollars in fees to help design
the accounting for the partnerships creates a considerable question of
conflict for Andersen in making its audit decisions.
Enron may have won its favorable accounting treatment in part by
failing to disclose all the facts to Andersen, or Andersen may have
adopted a ``hear no evil, see no evil'' approach to its audit to avoid
the risk that management might have dumped it from an extremely
lucrative audit assignment. The timing of the destruction of documents
by the Andersen audit team suggests that these individuals may have
thought they had something to hide. At a minimum Andersen was unable to
put aside its economic interests to stand up to Enron.
The Critical Role of Auditors
Accountants play a unique role as the scorekeepers of the market
economy. While companies in the United States do not have to employ a
law firm, an underwriter, or other types of professionals, Federal law
requires a publicly-traded company to hire an independent accounting
firm to perform an annual audit. In addition to this shared Federal
monopoly, more than a hundred million investors in the United States
depend on audited financial statements to make investment decisions.
This imbues accounting firms with a high level of public trust, and
also explains why there is a strong Federal interest in how well the
accounting system functions.
Auditors are there to get the numbers right, not to help CEO's or
CFO's hide debt, artificially inflate income, and conceal risk. The
ultimate objective of the system is for investors, creditors, and other
participants in the market to have a full and fair picture of the
financial condition of the company and its results. Market participants
need to be able to understand a company's risk posture and trends in
its results. To do that, they have to be able to see the entire picture
of a company's financials, not carefully selected pieces. Auditing a
financial statement is supposed to be an exercise in sober reality, not
abstract art.
Our tools in getting the numbers right include accounting
principles that accurately reflect economic substance (GAAP or
Generally Accepted Accounting Principles), auditing standards that
detect false numbers (GAAS or Generally Accepted Auditing Standards),
and trained and capable accountants proficient in the application of
GAAP and GAAS, backed by firms with sophisticated software, and
multiple layers of internal review. The system also relies on the
auditor's independence and integrity to apply GAAP and GAAS
competently, and irrespective of pressure from the issuer. Enron has
exposed weaknesses in every one of these areas.
Part of the problem in Enron was the abysmally poor quality of FASB
pronouncements concerning off balance sheet liabilities, and the
latitude that exists to ``accrue'' profits out of mathematical models
without adequate safeguards to test the validity of the results. The
poor quality of these standards gives wide scope for mischief in their
interpretation. Another part of the problem, however, was that those
with responsibility for insisting on full and fair disclosure by the
company appear to have ignored their duties to the investing public.
Even as accounting firms have steadily consolidated into some of
the largest businesses in the world, earnings restatements and blown
audits appear to be happening with more frequency, and getting bigger.
Each of the Big 5 has had huge cases where reported earnings either
were nonexistent or were substantially overstated. This suggests that
there is something in the internal dynamics of the firms themselves
that has gotten in the way of audit accuracy and integrity. Clearly, we
can do a better job and everyone should work together toward that
objective.
Summary of Reforms
As described above, I recommend that this Committee should consider
a number of steps to make our financial reporting and disclosure system
better and more resilient. These would include:
I. Improving Government Oversight of Accounting and Disclosure
1. Strengthen the SEC's resources through expanded budget authority
(offset by increased user fees), immediate and continuing funding of
pay parity provisions, and addition of 200 new accounting positions. A
new division within the SEC, not another private sector body, should be
formed to oversee performance of auditors and their firms.
2. Add surveillance and prosecutorial resources at the Justice
Department to oversee accounting fraud cases.
3. Simplify criminal and civil standards so that there will be
realistic deterrence against accounting abuses through speedy and
effective disciplinary cases.
4. Give the SEC authority to suspend accounting firms from
accepting new audit clients for limited periods (e.g., 6 months
suspension) where repeated and flagrant audit failures from the same
audit firm suggest failure of internal supervision and training. SEC
should also have the authority to bar an accounting firm from accepting
the renewal of a specific audit engagement where large restatements or
other problems have occurred.
5. Give the SEC authority to mandate the retention of ``books and
records'' of accounting firms relating to the audit of publicly-traded
companies. Make destruction of documents relating to audits of public
companies a criminal offense, and failure to supervise compliance with
SEC requirements as well.
6. Mandatory review of all audits when any company files for
bankruptcy within defined period of receiving a ``clean'' audit
opinion, or when major restatements occur.
7. Give the SEC enhanced authority over the setting of accounting
standards themselves, without politicizing standard setting. SEC should
have authority to mandate deadlines, or to establish standards (or
utilize standards from international accounting standards board or
other authorities) where it finds FASB pronouncements not to be in the
interest of investors.
II. Enhancing Performance and Accountability for Accounting Firms
8. Accounting firms that audit publicly-traded companies should be
required to have a board of directors with a majority of outside,
nonindustry directors in a manner similar to current governance of
stock exchanges.
9. Consulting activities by accounting firms should be prohibited,
save for activities determined by the SEC to be closely related to
auditing and that can be performed in a manner determined by the SEC.
10. Cooling off periods should be established for senior auditor
personnel prior to employment at audit clients.
11. Risk management and audit quality control programs should be
improved within audit firms.
12. Enact statutory affirmative duty to supervise audit personnel
for management of audit firms.
III. Improved Accounting and Disclosure Standards
13. Enhance disclosure of ``off balance sheet'' transactions and
debt.
14. Enhance disclosure of accrual profits.
15. Enhance disclosure of specific impact of alternative accounting
principles.
16. Enhance disclosure of use of ``special purpose entity''
(SPE's). All SPE's doing business with an issuer, or whose results will
affect the financial statements of the issuer, should be disclosed.
Issuers should be required to disclose regularly the identity of any
employees who perform services for an SPE, or who receive compensation
from, or hold direct or indirect investments in, any SPE. Where any
issuer has an SPE that is not accounted for as part of the issuer's
financial statements, the issuer should publish its balance sheet,
profit and loss statement, and cash flow statement as they would appear
if the SPE was treated as an ``on balance sheet'' entity.
17. Enhance disclosure requirements for acts raising conflict of
interest concerns involving senior financial personnel or corporate
leadership, irrespective of standard ``materiality.''
18. Speed up disclosure of all stock transactions by senior
corporate executives.
19. Consider increased use of cash flow in accounting principles
and disclosure.
IV. Corporate Reforms
20. Prohibit or require disclosure of conflicts of interest by the
CFO or by other financial officials.
21. Enhance audit committee independence and role.
22. Disgorgement of profits from insider stock sales within certain
periods of time of corporate bankruptcy filing.
23. Prohibit use of stock or stock options to repay loans to
executives or require immediate 8-K disclosure. Require compensation
committee explanation in proxy statement of all loans to executives,
specify amounts drawn down or repaid, and require shareholder
ratification of any loans above a certain level.
V. Bankruptcy Reforms
24. Consider mandatory trusteeship for large bankrupt companies.
25. Strengthen the power of the bankruptcy trustees to bring
actions against professionals, including accountants and lawyers,
through express grant of standing irrespective of procedural hurdles at
common law.
VI. Other Steps
26. Enhance rating agency integrity.
27. Improve independence of stock analysts.
Specific Reforms
Improving Government Oversight
Substantially increase SEC resources, particularly focused on the
accounting area. Add 200 new positions dedicated to detection and
prosecution of accounting abuses and discipline of professionals, and
provide full funding of pay parity.
For decades the SEC has provided taxpayers with a great value per
dollar expended. However, there has been chronic underfunding of the
number of trained accounting examiners to review 34 Act filings, as
well as to provide other vital oversight over the performance of
auditing firms and their personnel. While 100 million Americans invest
their savings in the market, and investors in Enron alone lost nearly
$80 billion in market value, we spend less than $500 million per year
on protecting the market with SEC oversight. The overall budget should
ideally be doubled, with new resources directed to accounting
specialists and examiners. Among other steps, implementing pay parity
is vital, and this should be funded immediately to lower the ruinous
rate of attrition among the most experienced accountants and analysts
who are most capable of detecting a sophisticated problem.
Our markets are bigger and faster than at any time in history, and
our oversight resources have not kept pace with growth in the size of
the market and the number of investors. This is particularly true with
respect to the resources to analyze financial statements and to
challenge accounting presentations that are not justified. Like other
big public companies, Enron's regular filings were sampled every 3 or 4
years, while as events showed financial condition can change
substantially in a much shorter period. The SEC should have enough
staff in the accounting area to review new offerings and periodic
filings, as well as to support enforcement cases in the accounting
area.
Chairman Pitt has recently recommended a new private sector body to
oversee the performance of auditors and accounting firms. A new body to
supplement the SEC's activities may be useful. However, I believe that
oversight of the performance of auditors must ultimately come from the
SEC itself. The history in this area is quite clear that private sector
oversight has failed to make a meaningful impact on audit quality. The
big firms will not challenge each other, and neither will the AICPA.
Any new private sector group would be inherently too weak to take on an
Arthur Andersen and /or a giant issuer. The pressure in any large case
involving the major firms is enormous, and this is such serious
business that the institutional strength of the SEC is absolutely
necessary. An experimental new board, however qualified its members,
will have virtually no chance to win the large cases of accounting
failure that even the SEC has achieved only rarely over fierce
opposition from the industry. Of course increasing the budget at the
SEC is not the only answer to the Enron problem, but it happens to be a
necessary and vital step in putting better protections in place for
investors in these vital markets.
Add surveillance and prosecutorial resources at the Justice
Department to oversee cases involving accounting fraud.
One temptation to cook the books in a large public company is a
possible gain measured in tens or hundreds of millions of dollars. It
is essential that exposure to jail time be a realistic deterrent
backing up the SEC's efforts. Accounting cases are long and complex for
the Justice Department, and require extensive pretrial preparation.
These cases also benefit trustees in bankruptcy, and the creditors of
failed firms who may recover more funds due to cooperation from
criminal defendants. With multiple cases such as Enron and Global
Crossing occurring after a long bull market, additional prosecutorial
resources would be extremely helpful.
Simplify legal standards and clarify authority to discipline
accounting firms and their personnel, and increase potential penalties.
During my time at the Commission, the SEC sought to suspend two
partners of Coopers & Lybrand who had been found to have misapplied
GAAP by allowing a company to capitalize expenses that should have been
expensed, thereby overstating earnings. The audits in question occurred
beginning in 1981 when John Shad was Chairman. The disciplinary case
brought by the SEC extended from his tenure through 1998, when it was
finally dismissed after at least three hearings at the Commission and
two appeals to the D.C. Circuit Court of Appeals. Endless litigation
took place over the standards the Commission was required to use to
discipline accounting professionals. This type of challenge has also
been raised in cases seeking to use cease and desist authority to
discipline accountants who have failed to properly apply GAAP or GAAS.
If disciplinary cases can be tied up in court for 17 years, the law
should be clarified so that the Commission can provide realistic and
timely discipline in its oversight process.
Give the SEC authority to bar accounting firms from accepting new
audit engagements for temporary periods, or to order the replacement of
an audit firm or to bar it from the next annual renewal of an auditing
engagement where there have been large restatements or other serious
problems, or the SEC determines that there has not been adequate
adherence to GAAP or GAAS.
Where an audit firm experiences repeated audit failures, and has
failed to install adequate safeguards for internal controls to prevent
blown audits and restatements, the Commission should have the power to
suspend the firm's ability to accept new audit engagements until the
SEC is satisfied that the internal quality controls of the firm are
adequate. This is comparable to the FAA's authority to revoke an
airline's license to provide service, or to ground a type of airliner
due to repeated problems. Where a major bankruptcy or restatement has
occurred, the SEC should have the ability to require a mandatory
rotation of accountants, or to bar the incumbent firm from accepting
renewal of the audit mandate.
Give the SEC specific authority to set minimum standards for
``books and records'' retention by auditors of publicly-traded
companies.
Given the shredding of documents that transpired at Andersen, the
auditing firms should not be allowed to determine what documents they
will preserve. These documents may prove vital to both SEC
investigations, and also to investor or creditor actions against a
company or its auditors in cases of fraud. The SEC should have the
authority to specify minimum retention periods for various types of
documents by auditors of publicly-traded companies, in the same manner
as the SEC can prescribe such record retention for broker-dealers. The
destruction of documents other than in compliance with SEC rules should
be a criminal offense, as should be failure to supervise such
compliance. Shredding of vital potential evidence should never be
allowed.
Mandate reviews of audit performance in any case of bankruptcy or
major earnings restatements.
When there is an airplane crash, the NTSB investigates the cause of
the crash. Similarly, when a publicly-traded company files for
bankruptcy or makes a major restatement of earnings, within a specified
period of receiving a clean audit opinion, either the SEC or some
alternative body should be mandated to conduct a review of the
compliance of the audit with GAAP and GAAS and to make its finding
public.
Enhance SEC authority over the establishment of accounting
standards.
Without politicizing standard setting, the SEC should have greater
say in the establishment of accounting standards by the FASB. Among
other things the SEC should have the ability to designate priority
actions and to set binding deadlines for FASB action. In addition, the
SEC should be able to adopt international accounting standards or
standards drafted by other authorities, as well as its own staff, where
it finds that FASB standards are not in the interest of investors. The
FASB is too slow, standards are too complex, and it is not sufficiently
accountable for action.
Enhancing Performance and Accountability of Accounting Firms
Require audit firms to have boards of directors with a majority of
outside directors.
Getting to the heart of these problems involves shifting the
balance of priorities inside the auditing firms in the direction of
greater concern for getting the numbers right, and for creating healthy
governance structures that will open up the highly insular big firms.
One way of shifting internal dynamics in favor of the public trust
would be to require that, as a condition of satisfying the
``independence'' requirements, an auditing firm for a public company
must have a board of directors with full power to remove management, to
determine compensation, and to set overall policy. At least a majority
of the members of such a board should be from outside the firm. As with
stock exchanges, there should be a minimum number of ``nonindustry''
directors on each board representing the interests of shareholders and
users of the markets. Officers of audit clients should not be eligible
to sit on such boards.
For historic, licensing and other reasons, the Big 5 operate as
limited liability partnerships rather than as corporations. They are by
far the largest private business organizations that do not have a real
board of directors. Internal governance comes from various committees
drawn from within the firm, whose members are elected or chosen by the
partners or the CEO. They are generally subordinate to the CEO, not
independent of him or her. While it is an axiom of good corporate
governance to have a majority (and typically much more than a majority)
of independent directors who can among other things hold the CEO
accountable for performance of the firm, the large accounting firms may
not have ANY independent directors to provide a wider public
perspective or to have the power to remove the CEO.\4\
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\4\ PricewaterhouseCoopers has recently announced it would add
three outside directors to its board, a definite step in the right
direction.
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A board composed of independent directors (with similar standards
for independence as a corporate director is required to have) would go
a long way to bringing a more balanced approach to how these firms
manage conflicts between their legitimate profit interests and their
public responsibilities. Ultimately the CEO of any Big 5 firm should be
subject to getting replaced if the board does not have confidence in
the firm's ability to deliver on its professionalism. There should be
accountability for performance in audit quality, not just profit per
partner, and that accountability at the top would be better exercised
by a board of directors rather than the Government. When Andersen was
agonizing over its doubts regarding Enron's potential accounting fraud
in February of 2001, discussing the issues with a board including
outside independent directors could certainly have given management a
better perspective on the decision they had to make and its potential
impact on investors, retirees, and others.
A good precedent for requiring the Big 5 and other auditors of
publicly-traded firms to create boards of directors can be found in the
operation of stock markets themselves. Though stock exchanges have
generally been mutually-owned institutions with many similarities to
partnerships, these organizations have a board of directors, with a 50/
50 balance of inside and outside directors. Independent boards is one
way we institutionalize a body within each Exchange that is directly
concerned with carrying out the exchange's responsibilities to the
public.\5\
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\5\ I served as a public governor of an exchange where the board
replaced the exchange's CEO because, among other things, he failed to
satisfy the board that he had taken strong enough steps to create an
effective legal compliance system. The successor CEO certainly viewed
building a robust system to stop compliance failures as a direct
mandate from the board, and understood that failure to make this a top
priority could cost him his job. Boards within the accounting firms
could help provide similar perspective and accountability for audit
failures, while still understanding the economic interests of a firm
and its business strategies.
Prohibit consulting activities by the audit firms except where
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closely related to the performance of audits.
As Chairman Levitt noted repeatedly during his tenure, the pressure
to win large consulting fees appears to have eroded auditor
independence and professionalism, and it certainly has diverted focus
and attention from the difficult job of auditing within the firms.
While each of the Big 5 has now announced that it will terminate
most consulting activities, the firms may differ in exactly what they
will do, and who they will do it for. Competitive pressures may cause
firms to minimize the services subject to voluntary restraints.
Congress can formalize the separation the firms have already announced
by limiting auditing firms to auditing services and other audit-related
services as defined by the SEC. At a minimum, the auditing firms should
be prohibited from providing financial structuring, investment banking,
internal audit, data processing systems, and legal services for audit
clients, and perhaps for any client. Audit committees should have the
ability to authorize hiring the auditor for consulting services that
are audit-related, such as using the auditors for tax or employee
benefits planning so long as the fees for such services do not exceed
10 to 15 percent of the audit fee itself.
Consider Mandatory Rotation of Audit Engagements
Though restricting the unhealthy pressure of auditor consulting
makes sense, this step alone is not a magic bullet that will fix the
deeper problems of the system. We have not yet seen evidence that
Andersen's acquiescence to Enron's accounting decisions or its frenzy
to destroy documents were driven by the consulting business Andersen
performed for Enron, though this was most likely an element of the
picture. However, the economic pressures relating to the audit fee
itself are just as serious a threat to independence of the auditor,
particularly if the firm is stripped of consulting businesses and
becomes substantially more dependent on audit revenues than it is
today.
There aren't many audit engagements in the world that pay $25
million each year in perpetuity, so Andersen management probably would
have stretched as far as it thought was possible to maintain that
lucrative annuity. Enron's audit fees to Andersen were probably large
enough to make the Enron engagement partner at Andersen one of the
firm's highest paid auditors. Thus, even if Andersen had been
prohibited from everything other than auditing Enron, Andersen's
decisions on the Enron audit could well have been influenced by many of
the same pressures.
One means of insulating the audit firms from the pressure of
keeping the audit engagement would be to provide for mandatory limits
on audit engagements to a specified period of time, such as 5 to 7
years. This would cause considerable costs and dislocation, and could
also have an adverse effect in some cases lay displacing knowledgeable
audit teams. A less drastic alternative would be to mandate that the
audit committee conduct a formal reproposal process at least every 4 to
5 years, but leaving the decision up to the management and board.
Cooling Off Periods
Both Lincoln Savings and Enron hired senior personnel from the
audit team in senior financial position. The reward of a senior job
could easily weaken audit independence. While we should not create
excessive employment barriers, a cooling off period for a senior
auditor hired by the issuer for its finance department in a senior
capacity would be a defense against subtle pressures resulting from
recent service together at the audit firm.
Investing in Audit Quality and Internal Controls
Another issue is the basic organization and control systems of the
major firms. Ironically, while most of the firms provide consulting
services to evaluate corporate ``internal controls,'' risk management
as a discipline is far less developed within the audit firms than would
typically be true at a bank or broker-dealer. There are large numbers
of analytic measures that could be developed to focus a firm's auditors
on areas of special risk. For example, if profit growth is
significantly higher than that of a peer group, auditors should at
least seek to determine why, and whether extraordinary profits are
located in any one area, as was the case with the Kidder Peabody
problems a few years ago. If so, the accounting for outsized profits
should be double-checked. Where total liabilities off balance sheet
exceed a particular amount, such as 5 percent of assets or debt, then
the firms should target special reviews of the qualification for off
balance sheet treatment. Other financial ratios, or swings beyond a
certain size depending on the outcome of any particular accounting
issue, should also be considered for use in trying to identify audit
engagements where supplemental resources, including potentially an
entire new audit team, should be considered. Congress should encourage
the audit firms to do much more in this area, such as by subjecting
firms that do not satisfy an SEC review of their quality control
program to additional remedial requirements.
Duties to Supervise
Another step would be to adopt statutory duties for accounting
firms to supervise the conduct of their audit professionals in a manner
parallel to the express duty to supervise that broker-dealers have for
their personnel. This duty to supervise is a very effective tool in
overseeing brokerage firms, and it creates accountability for providing
oversight that works. Where a firm repeatedly fails to supervise the
conduct of audits properly, the SEC should have authority to require a
broad range of remedial steps, including suspending the senior
supervisory personnel.
Accounting Principles and Disclosure Requirements
Enron shows a weakness both in our accounting principles for off
balance sheet transactions, and also in our disclosure policies. The
FASB has long had a tortuously slow process for writing accounting
standards, somewhat comparable to the pace of a glacier trying to run
uphill. In recent years those standards have become enormously
complicated too. This leaves a great deal of room for engineered
solutions by those seeking to paint a particular picture.
Creative investment bankers and users of derivatives have spent the
last 10 years developing ways to move financial obligations off the
books of corporations in conformity with highly complex standards.
Teams of investment bankers and accountants may work years on
developing structured transactions to accomplish a form of financing
with attractive costs but that is not required to be shown on the
balance sheet. Companies may hope that such off balance sheet debt will
not be counted by rating agencies or noticed by investors. This does
not mean that such activity violates GAAP or is wrong. Asset backed
financing provides critical liquidity for many companies, and is very
positive for the economy. However, such financings should be shown
either on balance sheet or through supplemental disclosure.
From the perspective of disclosure policy, this may be the easiest
problem to fix. Just because GAAP doesn't require something to show up
in the financial statements doesn't mean it cannot, or shouldn't, be
disclosed. Where a company will have cash flow from a financing, it
belongs on its balance sheet, and should certainly be disclosed. Where
a debt has to be paid directly or indirectly from a company's cash flow
(or is diverted from cash flow the company would otherwise receive),
that debt should be on the balance sheet and disclosed. More realism
and less artificiality in financial statements was something I
consistently pursued with the FASB during my tenure at the SEC, though
I am not sure we made too much progress. Following the cash is a good
way to get to the bottom of many mysteries, and highlighting cash flow
earnings could provide more reality for investors. Where a company has
contingent liabilities, such as Enron's obligations to deliver stock to
some of its partnerships to maintain certain values, the nature of
those obligations should be disclosed comprehensively, and the impact
of such contingencies under various scenarios should also be disclosed.
Some of Enron's financing vehicles appear to have been structured
to let the company report income that had never occurred, and that
might never occur, while essentially arming a neutron bomb in its
financial structure. That this was not clearly disclosed, and that
nearly 50 percent of Enron's assets could have been held off balance
sheet, demonstrates that both GAAP and SEC disclosure standards need an
expedited review and some fast corrective action to increase
transparency. The SEC and FASB should work together to structure an
appropriate combination of policies, with more on balance sheet
treatment and vastly more disclosure.
Obviously at some point an asset may be sold, with no right to get
it back, and without any potential future impact on the Company's
future earnings or operations. However, where transactions are
financings in one guise or another, with cash ultimately being realized
by a company that in one form or another will be repaid (or that might
have to be repaid) out of future operations, then the overall
transaction and the risks it entails should be shown either on the
balance sheet, or in clear schedules included with the financial
statements.
Real Profits, Not Accrual
Sometimes accounting standards are constructed in ways that may be
theoretically elegant but work to the disadvantage of investors and
give too many opportunities for mischief in the real world. One example
of this is ``accrual'' of profits that have not yet arrived in fact,
such as ``gain on sale'' and ``mark to model'' accounting. Under gain
on sale, profits from the spread between interest earned and interest
paid over a loan with a term lasting many years are rolled forward to
the present when the loan is ``sold.'' The accounting rule takes profit
that might never occur and reports it today as if it already happened.
A similar problem exists with many derivative instruments,
particularly the long duration contracts that are one of a kind,
without a trading market to provide a valuation. Enron created many
such instruments, and it booked enormous profits on some contracts
based on theoretical models that purported to value the cash flows that
might occur pursuant to the contracts as much as 10 or more years in
the future. Of course if the assumptions that the model uses are bad,
the answers will be too --``garbage in, garbage out.'' An auditor has a
difficult job to test the realism of the assumptions used in such
valuations. An investor cannot evaluate those assumptions, or know how
one company's models may differ from another's. The result is that
management can use unrealistic assumptions to pump up earnings,
possibly enormously. Here earnings will not be comparable from one
company to another, due to the differences in modeling that are
impossible for investors to spot. Perhaps here all such ``profits''
should only be taken into income as the assumptions actually occur and
the Company realizes the cash flows.
To the extent possible, the FASB needs to promote the reporting of
profits that have already occurred, and to preclude reporting of
profits that haven't happened in fact. Cash flow is a wonderfully
``'real'' barometer of when profit or loss should be recognized, not
the ethereal and unreliable ``profits'' that we allow to be rolled
forward and reported today even though they may ultimately never occur.
Corporate Reforms
Prohibit specific conflicts of interest by the CFO or similar
finance officials without full disclosure.
The CFO of a publicly-traded company occupies a uniquely sensitive
position. Both the outside auditors and the audit committee will rely
on the CFO to provide financial information, and to highlight areas of
concern. If the CFO has a personal financial interest contrary to the
Company, or even potentially so, this can defeat our entire system of
controls. While State corporation law typically defines the fiduciary
duties of officers, Congress should consider prohibiting certain types
of financial interests by CFO's and their subordinates, or at least
require immediate disclosure of all such interests through an 8-K
filing whether or not the amount would otherwise be considered
material. The interests created in Enron should never be allowed to
occur in a public company.
Enhance Audit Committee Independence and Role
Audit committees won't solve every problem, but they play a very
important role. Their role in selecting auditors and overseeing
financial conflicts is very important, and overall their roles should
be strengthened wherever possible.
Disgorgement of profits from insider stock sales within certain
time frames of a corporate bankruptcy.
We have long required officers and directors to disgorge ``short
swing'' profits for purchases and sales within a 6 month period. We
should consider similar disgorgement to the company of any net proceeds
of stock sales or option exercises within 6 months or a year prior to a
bankruptcy filing.
Prohibit use of stock to repay insider loans or require immediate
disclosure.
The sale of stock back to a failing company to satisfy loans to a
CEO or other senior officer robs the company of cash, while shielding
such sales from public view and potential insider trading liability. It
is not clear why companies allow substantial loans to senior officers,
but where these exist repayment should be in cash, not stock. Where
stock is used, there should be contemporaneous filing requirements. The
SEC should require compensation committees to describe all loan
programs and their objectives, as well as collateral and repayment
terms, in the annual proxy statement.
Bankruptcy Reforms
Consider mandatory trusteeships for bankruptcies of major size.
Where a bankruptcy above a certain size occurs, the Congress should
consider whether investors and creditors would not be well served with
a mandatory requirement for appointment of a trustee or other fiduciary
to oversee reorganization. Alternatively this could be a requirement
only if an interim CEO is not appointed by the board. However, where
there has been wrongdoing, leaving the incumbent management in place
may create new risks, particularly to employees and other unsecured
creditors.
Strengthen the power of bankruptcy trustees to bring actions
against accountants, attorneys, and former officers notwithstanding
common law procedural barriers.
In some Circuits, the current law restricts the ability of trustees
representing defrauded creditors from suing the accountants or lawyers
for a company that collapses due to fraud or other wrongdoing, even if
the conduct of such professionals violated professional standards, was
negligent, or otherwise damaged investors. Actions by trustees or other
fiduciaries should provide a major deterrent against professionals who
assist someone in defrauding investors and employees, and should not be
blocked on common law procedural grounds such as ``in pari delicto'' or
similar defenses relating to the imputation of the company's wrongful
actions to the trustee suing on behalf of victims.\6\
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\6\ The Committee should be aware that I am appealing dismissal of
several such actions as a trustee, and hence could be said to have an
interest in this recommendation. However, this is an area in which
professionals may be insulated from accountability to the victims of a
fraud, weakening deterrence of such conduct in a major way.
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Other Steps
Enhance rating agency integrity.
Consider whether standards should be created to protect or enhance
the integrity of rating agency decisions.
Improve independence of stock analyst recommendations.
Analyst recommendations should be driven by analysis and
fundamentals, not the pursuit of investment banking business for their
firms. This is a similar problem to auditors and consulting. New rules
have been proposed to address this situation, which the SEC and the
industry should continue to pursue until investors have clear
disclosure of potential pressures and insofar as possible the integrity
of analyst opinions is safeguarded.
Conclusion
To be sure, most of the men and the women who work in public
accounting are talented, hardworking, and honest. Nonetheless, there
will be bad apples in any barrel, and there is certainly a need to make
sure that we have an adequate practical ability to detect abuses and to
provide accountability for performance of audits in accordance with
professional standards. We cannot afford to take the risk that anyone
auditing major publicly-traded companies believes they are beyond
accountability for their auditing performance, to say nothing of
ethical lapses or even criminal conduct.
Even better would be to follow President Bush's call for a broad
national effort to enhance the quality of our accounting and disclosure
system. This effort is too important to leave to the accounting
profession alone, though all concerned should contribute every idea to
the debate so Congress can determine the best mix of policies for the
future.
PREPARED STATEMENT OF DAVID S. RUDER*
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*Chairman of the Securities and Exchange Commission 1987-1989;
Professor of Law, Northwestern University School of Law 1961-present
(Dean 1977-1985); Member Board of Trustees, Financial Accounting
Foundation; Member Board of Trustees, International Accounting
Standards Committee Foundation; Member Board of Governors, National
Association of Securities Dealers Inc. (1990 -1993); Chairman,
Securities and Exchange Commission Historical Society.
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Chairman, U.S. Securities and Exchange Commission
1987 to 1989
February 12, 2002
It is a pleasure to appear again before the Committee on Banking,
Housing, and Urban Affairs.
General Comments
The Enron tragedy calls for investigation, identification of wrong
doers, the imposition of penalties, and reform. I strongly believe that
allocation of blame should not be made until the facts are known.
Nevertheless, based on newspaper accounts of the Enron matter, I
believe some reforms are needed.
Summary of Conclusions
Accounting Regulation
Auditor Independence
The Commission's new Auditor Independence Standards promulgated in
November of 2000, should be monitored and improved, particularly in the
nonaudit services areas of information systems and internal audit.
Supervision of Accounting Audit Practices
The current accounting audit supervisory system now in place under
the direction of the Public Oversight Board should be expanded and
improved in a setting independent from the accounting profession.
Funding should come from the preparers and users of financial
statements. Congressional action to secure funding will probably be
needed.
Accounting Standards
Promulgation of accounting standards by the Financial Accounting
Standards Board under the supervision of the Financial Accounting
Foundation works well, but an independent source of financing is
desirable.
Disclosure
The SEC's disclosure requirements are a great strength of our
capital markets. The Commission is moving promptly to create
improvements in areas related to the Enron matter.
Corporate Governance
The managers of the U.S. corporations need to embrace a corporate
culture emphasizing compliance with accounting regulations and full
disclosure of financial conditions. The SEC and the stock exchanges
should take steps to encourage such practices. Congress should not
legislate in the corporate governance area.
The Enforcement Process
The investigations of wrongdoing by the Securities and Exchange
Commission and the Justice Department will be thorough and will
eventually yield the true facts and appropriate punishment.
Pensions
Congress or the Department of Labor should take steps to prevent
401(k) plan over-investment in employers stock by employees.
Derivative Instruments
Congress should consider regulating the over-the-counter markets in
derivative instruments.
Regulation of Accounting
In the United States, the accounting profession plays a crucial
role in the disclosure process. The investing public has learned to
rely upon the accuracy of corporate financial statements prepared and
certified by accountants. The regulation of the financial statement
preparation and the audit process in this country is the strongest in
the world, and I believe the public should continue to have faith in
the system. Not only is the current system strong and reliable, but
also the theory that the faulty financial disclosures in the Enron
matter demonstrate an accounting system that is broken and an
accounting profession that cannot be trusted is simply wrong. If
individual accountants have failed their duty they should be punished,
but wayward activities of a few is not proof that the accounting
profession is dishonest or negligent. If the accounting regulatory
system has faults it should be corrected, but fault finding does not
demonstrate that the regulatory system is not working. Nevertheless, it
is important to examine current regulation of auditor independence,
auditing standard setting, audit practices, and accounting standard
setting and make needed changes.
Auditor Independence
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 spin-offs, 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.
If an accountant is not recognized by the SEC as independent, the
accountant cannot certify a corporation's financial statements. Without
a certification those statements cannot be filed with the Commission
and the corporation will find it nearly impossible to raise capital.
The SEC has taken steps to increase auditor independence. In November
of 2000, the SEC published revised Auditor Independence Standards
specifying circumstances under which the Commission will not recognize
an accountant as independent. (SEC Rel. Nos. 33-7919 and 34-40602,
November 21, 2000) The Commission also adopted requirements forcing
registrants to disclose for each fiscal year the amount of audit fees
and the amount of fees paid to the auditor for nonaudit services in two
categories: Financial information system design and implementation, and
all other fees. It also required registrants to disclose whether the
audit committee had considered the question whether the provision of
nonaudit services affected auditor independence.
The Commission specified broad categories of circumstances that
will cause an accountant to be treated as not independent. The
categories include financial relationships, employment relationships,
business relationships, contingent fees, and nonaudit services. In the
latter category the Commission identified the specific categories of
prohibited activities (with certain exceptions): Bookkeeping services,
financial systems design and implementation, appraisal or valuation
services, actuarial services, internal audit services, management
functions, human relations
(executive search), broker-dealer services, and legal services (but tax
advice is not
included in this category).
The new independence and disclosure rules represent a strong
improvement in addressing the auditor independence problem. I believe
that the new rules should be given a chance to work. There are
categories of nonaudit work that create efficiencies for corporations,
such as tax advice and opinions rendered in connection with registered
offerings. These categories should be monitored to see whether they
impede independence, and in two areas steps should be taken now to
strengthen
the rules.
The area of financial information services and design is the area
most likely to generate the largest nonaudit fees. Recently four of the
major accounting firms announced their intention to abandon or severely
limit information technology services for audit clients.
The Commission's current rules recognize that there may be benefits
to the accounting control system if the auditor is allowed to plan,
design, and implement internal accounting controls and risk management
controls. These areas are fundamental to good accounting systems, and
strong arguments can be made that a corporation's auditor should be
able to design and to install such systems. The Commission should
continue to monitor this area.
The Commission's current rules permit design and implementation of
a system that aggregates source data underlying the financial
statements, but the rules contain significant restrictions on the
design and implementation of such systems. This area is not likely to
justify exceptions, and the Commission should consider prohibiting this
activity.
The Commission's rule regarding internal audit services seems to
recognize that outsourcing the internal audit functions to the
company's external auditors creates conflicts or appearances of
conflicts because the external auditor eventually will be auditing its
own work. The Commission should monitor this portion of the rule
carefully and consider prohibiting external auditors from engaging in
internal auditing, with exceptions for small businesses.
The Commission is to be commended on its new independence rules.
Changes in the rules should remain the responsibility of the SEC.
Legislation in this area is not needed.
Supervision of the Accounting Audit System
We need to build on the accounting audit supervisory system already
in place and expand it to achieve greater independence, with better
financing.
Prodded by the SEC, the accounting profession last year reorganized
its process for overseeing the audit process. The American Institute of
Certified Public Accountants (AICPA), expanded the power of its Public
Oversight Board, an independent body, to control the auditing process
in the United States. The Board is composed entirely of five public
members with no connections to the accounting profession, and is
currently headed by Charles Bowsher, the former Comptroller General of
the United States, who was head of the General Accounting Office for 15
years. It is financed through the AICPA budget. Although in January the
Board announced its intention to disband, it should remain in
existences until other audit supervisory measures are in place.
The POB has power to oversee the promulgation of Generally Accepted
Accounting Standards (GAAS) by the AICPA's Auditing Standards Board. It
has power to oversee the AICPA's system of monitoring accounting firms
compliance with auditing requirements. It has the power to oversee the
AICPA's peer review system which requires a triennial review of each
firm by a firm of comparable stature. It also has power to oversee the
AICPA's Quality Control Inquiry Committee which investigates charges of
audit failure and disciplines violators.
The POB has functioned well in the past, and there is much to learn
from its organization and its 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 that the POB oversight system should become truly
independent. The audit standard creation process and audit review and
disciplinary process should be transferred to 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.
Until that transfer is completed, the POB should remain in existence
and the AICPA, including its funding from the AICPA, should provide it
with greater financial support.
A new separate Audit Supervisory Board should be modeled on the
private sector Financial Accounting Standards Board (FASB) and its
supervisory body, the Financial Accounting Foundation. The Board should
be subject to oversight by the SEC, which in turn should cooperate with
the Board in the investigative area.
The Board should be composed entirely of public members not
associated with the profession. It should have appointive,
administrative and budget powers, and should oversee three separate
functions.
First, an Auditing Standards and Ethics Board composed of persons
independent of the accounting profession should promulgate both
auditing and ethical performance standards.
Second, an Auditing Quality Control Committee, composed of
professional staff members reporting to the Audit Supervisory Board,
should oversee internal audit firm practices designed to improve the
audit process such as the rotation of audit engagements and an internal
system for making controversial audit decisions. This unit should also
supervise a peer review system conducted by the accounting profession.
A peer review system requiring audit firms to inspect the internal
audit practices of firms of comparable quality should not be discarded,
but that system should be independently inspected and supervised. The
accounting profession peer review system has long been supported by the
SEC and should continue to be a strong part of the audit regulatory
process.
Third, an Audit Disciplinary Committee, also composed of
professional staff members reporting to the Audit Supervisory Board,
should have the power to inspect firm compliance with audit standards
and procedures, investigate allegations of audit failures, impose
disciplinary sanctions, and refer matters to the SEC for investigation
and discipline. The information it gathers should be privileged from
outsiders. Information gathering and privilege questions might be
addressed through cooperation with the SEC.
Independent and adequate funding is crucial. An independent body
that depends upon sporadic voluntary contributions from industry or the
financial community may risk loss of financial support if it takes
positions seen as contrary to the best interest of those it regulates.
The financing problem should be addressed by requiring payments by
preparers of financial statements (the corporations) and by users of
financial statements (institutions such as mutual funds who buy and
sell securities, and brokers who advise others regarding securities
transactions). The Audit Supervisory Board should have the power to set
its own budget subject to oversight by the SEC. Congressional action to
secure funding will probably be needed.
I believe in a system of private regulation rather than SEC
regulation in the audit area. I am proposing a voluntary private
independent organization independent from the accounting profession. If
a voluntary private system cannot be established, then Congress should
create such a system. In any event I believe the new audit regulatory
system should be designed with input from the profession, with strong
input and guidance from the SEC. The system should be subject to SEC
oversight.
Promulgation of Accounting Standards
Generally Accepted Accounting Principles are promulgated in the
United States by the Financial Accounting Standards Board, an
independent standard setting organization to which the SEC has
delegated power to create accounting standards. High quality,
transparent, and comparable accounting standards promulgated by the
FASB have played a major role in making the U.S. financial markets the
very best in the world. The FASB private independent standard setting
model has been adopted internationally by the private International
Accounting Standards Committee, which has appointed an independent
International Accounting Standards Board. I have observed the
operations of the FASB closely during the last 5 years as an at large
member of its supervisory body, the Financial Accounting Foundation and
I am a member of the International Accounting Standards Committee
Foundation, which supervises the IASB.
The Chairman of the SEC and others have recently complained that
the FASB's process for creating standards is too slow, citing that the
Board's failure to deal extensively with lease financing, special
purpose entities, and other off balance sheet financing vehicles.
Delays in promulgation are in part due to the care taken by the Board
to hear the views of affected parties, especially the business
community. The Board can increase the speed of its deliberations, and
it is considering ways to do so. It must continue to assess the effects
of its proposed standards on business operations.
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 that the solution to the financial pressures on the FASB
would be to provide a system of financing similar to that which I have
suggested for a new POB. FASB should be financed by payments by
preparers and users of financial statements. If a voluntary system
cannot be established, the Congress should enact legislation creating
financing for the FASB. If a solution to funding for a new POB can be
found that will protect the POB's independence, a similar solution
should be found for the FASB.
Disclosure Regulation
As a result of the Enron matter some have questioned whether the
SEC's disclosure rules and procedures are adequate. As you know, the
Commission's disclosure regulations are very detailed and are widely
acknowledged as one of the great strengths of our capital markets.
These regulations are not static, and are constantly being improved by
the Commission. Chairman Pitt has recently called for changes including
a current disclosure system, plain English financial statements,
transparent disclosure of key accounting principles and policies, and
better description of the relationship of pro forma earnings to
earnings reported under GAAP. The Commission recently released a
statement about management's discussion and analysis of financial
conditions and operations (MD&A), calling for better disclosure,
especially in the area of off balance sheet contracts, trading
activities involving nonexchange traded contracts, and contracts with
related parties. (Rel. 33-8056, January 22, 2002). I believe the
Commission is moving promptly to create improvements in areas related
to the Enron matter. No legislation is needed in this area.
Corporate Governance
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.
In one sense, the Enron failure is due to a flawed business model.
The company followed a path in its energy trading business that was too
risky and too dependent upon relationships with other traders and
creditors. We may be dealing with a late evidence of the excesses of
the technology boom.
However, in another sense 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.
In recent years, the SEC has urged corporate Audit Committees to be
more responsible, has criticized corporate attitudes toward financial
reporting, and has brought enforcement actions regarding management of
earnings, over emphasis on pro forma earnings, and failure to follow
accounting standards. The SEC's urgings, criticism, and enforcement
actions are important, but the SEC faces difficulties in overcoming
management disregard of accounting and financial disclosure
obligations. Most of our corporate managers know that the purpose of
accounting rules is to create transparency, not obfuscation. Hopefully
they know, as Enron teaches, that failure to disclose negative
information eventually will cause a severe market reaction. The
managers of all of our corporations need to reject a philosophy that
seeks to skirt the edges of accounting rules and instead need to
embrace a corporate culture of full financial disclosure.
As the investigation of Enron continues, the role of Enron's Board
of Directors will be closely examined. What did the Board know and
when? What did the Audit Committee know and when? These after the fact
questions will seek to assess blame, but they also raise more
fundamental questions regarding the proper supervisory roles of the
Board and the Audit Committee. I believe that the role of the Audit
Committee is particularly important. The Audit Committee should
understand the corporation's business, ask management hard questions
about its strategies, accounting policies, and disclosures, and seek to
ensure that disclosures to investors are accurate and complete.
As you know, the Federal Securities Laws do not give the SEC the
power to intervene directly in the internal affairs of corporations. In
recent years the SEC has urged good corporate governance practices and
in some areas, such as executive compensation, has sought improvement
by forcing disclosure. I believe that the Commission should continue to
examine possibilities for improving conduct by imposing disclosure
obligations. The stock exchanges have power to force good governance
practices through their listing agreements, and they too should be
examining possibilities for increasing good corporate governance.
Unfortunately, in the area of corporate governance we are dealing
with attitudes. I do not believe it is possible for the Government to
legislate good morals, and I believe that efforts to do so may stifle
innovation. Congress should not legislate in this area.
The Enforcement Process
The newspapers and media have been swift to assess blame on those
whom they believe are responsible for the Enron problems. Most of the
assertions seem to be based upon facts that have yet to be proven.
The Securities and Exchange Commission (SEC), the Justice
Department, and the Congress have all launched investigations which
eventually will yield the true facts. My experience at the SEC teaches
me that the Commission will conduct a thorough investigation, using
whatever resources are necessary to complete that task, and that it
will cooperate with the Justice Department's criminal investigation.
When its investigation is complete, the Securities and Exchange
Commission will bring administrative and judicial actions against the
wrongdoers. The Justice Department may seek criminal penalties.
Much concern has been expressed about alleged insider trading by
officers of Enron. In the Enron case insider trading allegations will
involve buying or selling securities based upon nonpublic, material
corporate information in violation of a fiduciary duty. It may be that
the insiders in this case will seek to invoke newly adopted Rule 10b5-1
which provides an affirmative defense if the person entered into a
binding contract, plan, or instruction with an independent third person
to buy or sell securities. This defense may or may not be available. A
condition to using that defense is that the person charged with insider
trading was not aware of the material nonpublic information at the time
of entering into the contract, plan, or instruction. With regard to
sales by the Enron officers the question will be whether they were
aware of material nonpublic corporate information either at the time of
sale or at the time of entering into a Rule 10b5-1 arrangement.
I believe the Commission has sufficient resources to conduct its
Enron investigation and that the Federal Securities Laws provide
sufficient basis for successful imposition of sanctions. Allegations
regarding misleading statements to the securities markets by Enron, its
management, and its accountants are actionable under the SEC's Rule
10b-5. Insider trading allegations are also actionable under that rule.
Allegations regarding poor accounting can be treated by the Commission
under Rule 102(e) of its rules of practice and other rules. No
legislation is needed in this area.
Employee 401(k) Plans
According to newspaper accounts the 401(k) retirement accounts of
many Enron employees contained extremely large amounts of Enron common
stock. When the Enron stock declined, many employees lost most of their
retirement savings. During one period of approximately 30 days the
employees were not able to sell their Enron stock because of a change
in plan administrator.
The Enron employee pension plan losses resulted from the swift and
dramatic fall in Enron's market values. The risks that Enron employees
faced because of their retirement investments in Enron stock were
typical of employees in many U.S. corporations. Many of our
corporations encourage their employees to choose company stock as their
primary retirement investment. Some companies match purchases of
company stock in 401(k) retirement accounts and require that the
company contributed stock remain in the retirement accounts for
specified periods. Some companies restrict sales of company stock in
401(k) accounts until the employee reaches a specified age.
Although the various restrictions may have prevented a sale of
Enron stock during certain periods, the primary problem reflected in
the Enron matter is that employees have invested a disproportionate
amount of their retirement funds in Enron stock. In doing so they
ignored diversification--a fundamental principle of investing.
Financially sophisticated investors understand that it is exceedingly
risky to invest a large percentage of an investment portfolio in one
company because of the risk that the company's stock may suffer large
declines. The Enron employees either did not know this theory, chose to
ignore it in the belief that Enron stock would continue to climb, or
experienced express or implied pressures from the company to own Enron
stock.
Retirement funds should not be invested in a risky manner that
avoids standard portfolio diversification theory. Employees should be
protected from their ignorance, their gambling instincts, and company
pressure. Legislation should be passed or rules should be adopted
prohibiting employees from owning more than a specified percentage of
their company's stock in their retirement accounts, and companies
should be prevented from imposing long-term restrictions on the sale of
stock held in retirement accounts.
The Enron retirement account problem also calls into question
proposals to allow workers to manage the investment of a portion of
their Social Security accounts. Should such a proposal be adopted,
workers would be subject to problems of ignorance or bad judgment, and
would find themselves subject to pressures regarding investment choice
from eager brokers or investment advisers who may not be facilitating
the best interests of persons attempting to invest Social Security
retirement monies. The Congress should not adopt a Social Security plan
under which worker retirement benefits would be subject to the risks of
the securities market.
Regulation of Derivative Instruments
Although the subject is beyond the scope of this testimony, I
believe off exchange (over the counter) derivative instrument trading
presents both systemic and individual risk. Congress should consider
whether legislation is needed in this area.
----------
PREPARED STATEMENT OF HAROLD M. WILLIAMS
Chairman, U.S. Securities and Exchange Commission
1977 to 1981
February 12, 2002
Mr. Chairman and Members of the Committee:
Thank you for the invitation to bring my perspective as a former
Chairman of the Securities and Exchange Commission to the current
concerns about accounting and investor protection issues and their
impact on the functioning of our financial markets. I served as Chair
of the SEC from 1977 to 1981, having been appointed by President Jimmy
Carter. Prior to my service as Chair of the Commission I served as a
member of the SEC Advisory Committee on Corporate Disclosure. From the
time I left the Commission until 1998 I served as President and Chief
Executive Officer of the J. Paul Getty Trust headquartered in Los
Angeles. Since then I have been dividing my time between various public
service and public policy activities, primarily in education, the arts,
and health care, and being Of Counsel to the law firm of Skadden, Arps,
Slate, Meagher & Flom. The views I express are personal and do not
necessarily reflect the views of the firm, or its individual members.
Further, as a consequence of the firm's involvement with corporate
clients in a number of related matters it would not be appropriate for
me to comment, directly or indirectly, on any specific situation.
My comments today will focus on a crisis of confidence unlike any I
have experienced in my 50 plus years of involvement in the corporate
and the financial world. Questions are being raised about the adequacy
and the integrity of financial reporting by public companies and about
whether our financial reporting system can be trusted. Trust is
critical to the functioning of the financial markets and the efficient
allocation of capital and, ultimately, to the willingness of the public
to invest. This is a crisis that cannot be ignored.
Let me begin by disclosing that I am a strong believer in self-
regulation coupled with rigorous oversight. The principle is well
established in the structure of the self-regulation and SEC oversight
of the stock exchanges. Self-regulation, aggressively overseen, can be
much more effective in enforcing the spirit of the rules than can a
policing agency of Government. However, it is evident that the existing
structure is not adequate to the task and needs to be redesigned and
strengthened. It needs to address auditor independence, accounting
standards and rulemaking, the composition and duties of corporate
boards and audit committees and the objectivity of security analysts
and all others whose behavior impact the integrity of our financial
markets.
Auditor Independence and Consulting Services
At the center of the crisis--but not alone--is the accounting
profession. Events have heightened concerns about whether the
profession has, in fact, the requisite degree of independence to
discharge its auditing responsibility.
The American Institute of Certified Public Accountants begins its
code of conduct with the statement ``The distinguishing mark of a
profession is acceptance of its responsibility to the public.'' Indeed,
the profession's auditing responsibility is a quasi-public one, deeply
infused with the public interest. This raises critical issues. Can an
auditor be independent when his client is paying the bill? Can the
auditor withstand pressure from the client? What if doing so would mean
losing the client for the firm? What would that mean for the firm and
for the auditor? Does the provision of consulting services further
impair independence or the perception of independence?
I am sympathetic to the difficulties involved in the audit process.
Auditing has become much more difficult as corporate structures and
financing techniques have become more complex. For example, the pricing
of risk or the laying off of risk has become an increasingly
sophisticated high-technology business and it is increasingly difficult
for auditors and regulators to assess the risks being assumed by any
single institution. I even wonder whether some members of the
profession are up to understanding and dealing with the increased
complexity. Certainly, the increased complexity requires greater
exercise of judgment and makes auditor independence and insulation from
pressures that could compromise it all the more essential.
The case for insisting that an auditor not provide other services
to the client it audits is a strong one. Accounting firms have come
increasingly to look beyond their traditional audit role to consulting
work for their revenues and profitability. In part this is in response
to corporate pressures to hold down audit costs and in part to the
growth in consulting as a very profitable market. Whether providing
consulting services actually impairs independence calls for access to
the auditor's state of mind and is virtually impossible to determine.
However, the perception that it may is of such concern that it cannot
be ignored. Perception is now as important perhaps more important--than
reality.
While I was Chair of the Commission, we introduced a requirement
that the proxy material calling for shareholder approval of the
selection of the audit firm include information on the nonaudit
services performed for the company in the prior year. It reflected the
Commission's and my concern about the issue at the time. The
requirement was eliminated by my successor. It was reintroduced
recently under Chairman Levitt.
Even if the auditor does not provide other services to the
companies it audits, given who pays the bill, the incentive to keep a
well-paying audit client happy would remain powerful.
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.
Even this proposal would not avoid the issue of providing
consulting services to audit clients and the perception that it
compromises auditor independence. One solution would be that consulting
work not be offered to an audit client. Another would be that the
revenues and profits from the audit function and from consulting be
segregated so that those engaged in the audit function could not
benefit, directly or indirectly, from the profitability of the
consulting practice. Still another would be to restrict the consulting
services to those few fully consistent with the audit function and
independence.
The Public Oversight Board
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. The peer review has proved itself insufficient.
Particularly as the Big 8 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.
I consider Chairman Pitt's public statement encouraging in its
recognition that more rigorous and disinterested oversight of the
profession is essential. However, the statement needs more definition
before we can judge its adequacy or its likely effectiveness.
Disclosure and Accounting Principles
The disclosure model itself lacks the necessary clarity and
transparency and needs to be critically reviewed and enhanced by the
Commission. Our financial accounting and disclosure requirements have
not kept up with the rapid evolution of our capital markets and
corporate finance. The existing requirements worked well when auditing
traditional assets such as plants and equipment, accounts receivable
and inventories. They work much less well when dealing, for example,
with intangibles and sophisticated financial instruments.
It is not only a matter of numbers. The disclosure of what lies
behind the numbers should make transparent and comprehensible the
businesses, the risks involved, the economic substance and the
accounting methods employed. The company and its auditors should
disclose and discuss all significant accounting decisions, choice of
accounting methods and judgments affecting the reported results.
Part of the responsibility for inadequate disclosure lies with the
accounting principles themselves and the functioning of the Financial
Accounting Standards Board (FASB) --the body responsible for
establishing accounting principles. GAAP--Generally Accepted Accounting
Principles--needs to be reviewed and standard setting improved and
accelerated. I believe the functioning of the FASB could be
significantly enhanced if its independence could be protected, to
withstand the pressures of the business community, the profession, and
even the Congress. A source of financing that is dependable and not
beholden to the profession or to the corporate community would increase
the ability of the Board to address more difficult and critical issues
in a timely manner.
Rule making itself is very difficult particularly as financial
activity and economic transactions become increasingly complicated and
sophisticated. For example, the FASB has engaged for a number of years
in an effort to create a clear standard for disclosing off-the-books
transactions and special purpose entities. They have not been able to
come up with a rule acceptable to the business community and the
profession. That acceptability should not ultimately be the determining
factor.
Some rulemaking amounts to ``closing the barn door.'' Obviously,
this is not something that the corporate community takes lightly
because of its potentially negative impact on earnings. An example is
the pressure exerted by corporations thru Congress in the mid-1990's,
that forced the FASB to back down on a proposal to make companies take
account of the cost of awarding employee stock options.
I believe the Board should consider and redefine the very amorphous
concept of ``materiality.'' Otherwise significant matters can become
``immaterial'' if the company is large enough.
The crisis in financial reporting is perhaps best captured by the
need to reduce the complexity of corporate earnings every quarter to
the magic--but uninformative --number called ``earnings per share.''
While at the Commission I thought often of how wonderful, but
impossible, it would have been to get rid of it. Perhaps the time has
come to consider doing so. Indeed, the very concept of ``earnings'' has
become diluted by the proliferation of use and abuse of ``pro forma
earnings,'' ``operating income,'' and ``restructuring charges.'' Cash
flow becomes, in many respects, a more sensitive measure of corporate
performance.
Regulating Coherence
A separate issue is the lack of regulatory coherence, particularly
since the enactment of the Gramm-Leach-Bliley Act allowed financial
services companies to cross the barriers that had existed between firms
that could undertake commercial banking, securities underwriting, and
insurance. A new kind of financial services entity has been authorized,
but the regulatory system has not adapted to it. As you know, there are
a number of Federal regulators. The Federal Reserve licenses a new kind
of institution--the financial holding company, but other regulators
continue to supervise the individual business units that make it up.
The securities markets have the SEC, the commodities and futures
markets have the Commodity Futures Trading Corporation, and insurance
companies are monitored at the state level. Finally, derivatives are
unregulated. Innovations in finance have blurred the historic
distinctions between the various institutions. As a result, the
supervisory process has not kept up with the changes that have occurred
in the financial system. This is a situation that inevitably will
create problems unless the various Federal regulatory agencies share
and implement a common understanding of the rules and behavior expected
of the various players who collectively make up the financial markets
and determine its integrity and efficiency.
A Caution
As we go about exploring regulatory or statutory solutions, we need
to be reminded that the more that problems lead regulators or the
legislators to impose prescriptive rules, the more people will settle
for fulfilling the letter of those rules rather than responding to the
broader purpose that they are designed to serve. Rules inevitably leave
loopholes that can be exploited if the attitude is allowed to persist
that form is more important than substance or that complying with the
letter of the law rather than the spirit is acceptable. At the other
extreme, too general a rule lacks guidance and invites overly generous
interpretations.
Ultimately, any system can be subverted if the parties undertake to
do so, or if the various players in the system let down their guard and
fail to act responsibly. In the final analysis, the system works as it
should only when all the players honor the spirit, as well as the
letter of the law.
When everyone involved--management, board members, investment
bankers, and security analysts--are caught up in and benefit from a hot
stock, no one is inclined to the thorough questioning that could raise
troublesome issues or to be willing to be the skunk at the picnic. The
corporate community needs to accept its responsibility to be
informative and more forthcoming in its disclosure. Corporate boards of
directors and audit committees, the accounting profession, security
analysts, stock exchanges and rating agencies, as well as the
regulators, each have an essential role to play--a duty--to be alert,
to ask the difficult questions, to hold each other to account and be
held to account and thus assure the adequacy and integrity of the
financial information upon which our financial markets depend.
I will be pleased to respond to questions from the Committee.
----------
PREPARED STATEMENT OF RODERICK M. HILLS
Chairman, U.S. Securities and Exchange Commission
1975 to 1977
February 12, 2002
Introduction
Twenty-six years ago I sat before this Committee to explain what
the SEC was doing about a corporate scandal that caused a public uproar
at least as loud as that now directed at the Enron matter. The focus
then was on some 400 U.S. companies that were compelled to disclose
that they had made bribes or questionable payments to foreign officials
to secure corporate favors. Twenty million dollars said to have been
given to the Japanese Prime Minister forced his resignation.
In response, the SEC caused the birth of the mandatory audit
committee, substantially increased the auditor's responsibility and
mandated new internal controls. There should be no doubt but that those
steps greatly advanced the cause of good corporate governance. However,
the continuing spate of accounting problems makes it clear that much
more is needed.
I have no view to express with regard to the question of whether
Enron or its auditors violated any existing regulation or law in the
presentation of Enron's financial position. The view I do have is that
there are substantial weaknesses in our regulatory system. My testimony
will:
Identify those weaknesses.
Suggest steps that can be taken to reduce or eliminate
them.
Ask that other steps not be taken.
I speak with 32 years of experience with corporate governance: As a
former regulator who dealt with those U.S. companies that made
questionable payments to foreign officials and with the auditors who
failed to cause the disclosure of those payments; service on 14 boards
of directors, as a member of 14 audit committees and as Chairman of 7
such committees; and participation in the termination of 8 Chief
Executive Officers. Six times we had to report that over $100 million
of income had been improperly reported. On one occasion the sum
exceeded $3 billion (Appendix A). These corporate mishaps will continue
until we identify and address the very serious weaknesses that our
regulatory system has produced and tolerated for far too long.
First, 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 FASB 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 Weaknesses
The Financial System
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 the 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.
For example, news reports are that Enron spent millions of dollars
on Wall Street bankers and management consultants to create a corporate
structure that apparently had the effect of keeping both debt and
losses out of its own financial picture. The audit partner tasked with
understanding such a structure is way over matched. Unless he can find
a precise rule or interpretation that frustrates that sophisticated
corporate architecture, those Wall Street wizards will prevail.
NYU's accounting department is correct: The existing system,
developed over some 70 years by the FASB, the AICPA, and the SEC
produces rules at horse and buggy speed while the global economy moves
at light speed, developing new and exotic financial instruments and
corporate structures.
The ultimate weakness is that the system suffers from too many
rules. Roman Weil, Professor of Accounting at the Graduate School of
Business of the University of Chicago Business School has pointed out
that today auditors, confronted with a somewhat different transaction,
ask either the FASB or the Emerging Issues Task Force (created by the
FASB and the SEC) for a new rule. Instead of making their own judgment
drawn from a conceptual framework, they seek the comfort of specificity
(Appendix B). The system has been so precise so many times in saying
what cannot be done that it has created an implication that whatever is
not prohibited is permitted. In law school this phenomena has long been
known as: ``Expressio unius exclusio alterius.''
This maze of rules has become a challenge to innovative minds to
create corporate structures that wend their way through the maze,
satisfying all the rules but frustrating the objective of our
securities laws.
The sad truth is the profession has lost sight of the significance
of the signature line of the opinions they give to all their clients.
That line reads: ``In our opinion, the financial statements [prepared
by management] fairly present, in all material respects, the financial
position of the company.'' Today, that broad statement means only: ``We
have looked but have found no material violation of applicable rules
and regulations.''
Auditors should be more willing to qualify their opinion by saying:
``The company has satisfied all the rules but its financial statements
do not fairly present its financial position.'' Today, any auditor
tempted to qualify his opinion in such a fashion faces the reality that
a competing accounting firm may be quite willing to sign an unqualified
opinion.
Corporate financial papers also suffer from their reliance on two
flawed assumptions: (1) That the present value of assets can be derived
reliably from historical costs; and (2) That corporate earnings can
smoothly move from quarter to quarter without large ups and downs.
The fiction of the first point should be self-evident. That is
particularly so today when so large a part of all corporate assets is
intangible.
The ``smoothing'' of earnings has been encouraged by analysts and
tolerated by regulators for many years. To avoid disruptions that are
inevitably created by unforeseen circumstances, companies create
reserves in flush periods that can fill the gap in a down quarter. When
major changes appear on the horizon, companies establish large
restructuring reserves to cover the shortfalls in future years.
Investors are often puzzled when the stock of a given company
plummets simply because it missed Wall Street forecasts by only a penny
or two. The reason, of course, is that analysts know that healthy
companies always have a few extra pennies of earnings in their
corporate ``cookie jar.'' If the company cannot find a penny in that
jar, the analysts assume the company is in far worse shape than known.
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 some top-level adjustments that
accounted for 40 percent of the company's total income and that led to
a corporate admission that billions of dollars of income had been
improperly reported.
The Accounting Profession
Any effort to reform the system must understand that the accounting
profession is in trouble. It has been caught in a changing world
economy in a system that inhibits change. The profession is not at all
blameless, but the blame is not all theirs. The fact that the work
product of the profession has become a commodity means it is almost
impossible for firms to get the same margins on their auditing work as
they get on their consulting work. The problem is exacerbated by the
fact that too many audit committees see their job as reducing the
auditor's fee rather than increasing the quality of the work. Too many
auditing jobs have been bid at a loss with the belief that the loss
could be made up by the consulting jobs likely to be given to the firm
that has the audit.
One result is that accounting firms cannot attract today the same
level of talent that entered the profession 20 or 30 years ago.
Significant numbers of graduates from our more prestigious business
schools regularly became accountants. No more! Neither the salaries
paid nor the career offered is competitive with the future available in
management consulting firms, law firms, investment banking, or
corporate financial offices.
The combination of financial pressure to keep a client and the
difficulty of finding a precise rule to deal with an ingenious
corporate structure has too often caused an audit partner to allow a
questionable accounting policy to be adopted. Once such a policy is
implemented, it can become increasingly difficult for the audit partner
to throw it out.
It is so often the case that the questionable policy is of no
particular significance when it first passes the auditor's scrutiny.
Whatever transactions are based on such a policy in those years are so
small that the audit partner can take comfort in the fact that,
overall, the true financial position of the company has not been
distorted. After a few years, however, the transactions can multiply
and present the audit partner with the realization that a significant
corporate risk has been hidden from the public. If he blows the
whistle, he will be blamed for allowing the policy in the first place
and he will surely lose the client. So, he implores the company to
unwind the policy by selling assets at a profit that can offset the
concealed losses and hopes for the best.
I do not know if the scene I just painted occurred at Enron. I only
know that it could have happened; and I do know that it is an accurate
view of events at four companies in which I was involved and that with
respect to those companies, we were required, with a restatement, to
write off over $100 million of assets that had been improperly recorded
as income in prior years. On one of those occasions the write-off
exceeded $2 billion.
By no means am I suggesting that the auditors should be excused for
such misbehavior because of the pressures on them. What I do argue is
that auditors should not allow themselves to be in such a situation. An
accounting firm should not accept an engagement unless its partners are
certain that the audit committee will protect them from undue
management pressure. Seldom will an accounting firm tell the audit
committee about a problem first. They try to work out a compromise with
management. Often the audit committee does not even know that there was
a problem. In short, the accounting firms have demonstrated far too
often that they have more fear that management will replace them than
confidence that the audit committee will protect them.
The Directors of the Audit Committee
Since 1977, the investment world has looked to the audit committees
of publicly-traded companies to protect the integrity of financial
disclosure. As I said earlier, the mandatory audit committee was born
out of the foreign payment scandals of the early 1970's. Since that
time, the audit committee has evolved into an important element of
corporate governance. However, the shortcomings are evident:
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.
In short, most audit committees do not understand that the auditors
will not be truly independent unless they confer that independence on
them by the manner in which they oversee the audit process.
What Should Be Done?
About the System
A careful but substantial overhaul of the existing regulatory
system is of paramount importance. Failure to act effectively and soon
will continue to erode the reputation of our capital markets and
further weaken the accounting profession. The SEC, with the support and
direction of Congress, must lead a wholesale revamping of the system
that regulates the profession. As Professor Weil has written: ``I want
accountants to use fundamental concepts in choosing accounting methods
and estimates. I want accountants not to hide behind the absence of a
specific rule. Whatever the detailed rules accountants write, smart
managers can construct transactions the rules do not cover'' (Appendix
B).
His call is for a major change in the basic nature of the audit. It
would require companies to be far more candid in explaining the real
value of their companies; it would place far less emphasis on
historical values and far more focus on intrinsic values. The
``smoothing'' of earnings would end.
A far different oversight structure would be needed, and the
training of analysts and particularly accountants, would change.
Ideally, a system would be created that made the audit of real
value to management, which would pay far more attention to the quality
of the people performing the audit and less attention to its cost.
Such change will not come easy and not early.
There are, however, substantial steps that can be taken
immediately, changes that will dramatically reduce the number of Enron
type debacles in the future.
Action by the SEC
The SEC needs to make it absolutely clear that the failure to have
a competent independent audit committee by itself constitutes a
material weakness in the internal controls of a reporting company. A
simple statement in any speech by a SEC Chairman will do the job. This
unequivocal statement will force the auditors to look into the question
of both the independence and the competence of the audit committee.
With respect to sitting directors, the auditors would necessarily send
a memo to each one asking:
How did you come to be elected to the Board?
What social or business relations have you had or do you have
with any officer or director of the company?
What percentage of your annual income is derived from your
service on this Board, and from any other boards on which you sit?
What experience or education have you had that is relevant to
the responsibilities of an audit committee?
Who appointed you to the audit committee and who selected the
Chairperson of the committee? Etc.
When such a questionnaire is sent, the company's lawyers will
undoubtedly advise the company that an independent nominating committee
is necessary to both select new directors and to make appointments to
the audit committee. If such does not occur, the SEC Chairman can make
another speech.
Second, the SEC should widely broadcast the significance of its
December 12, 2001 release that gives ``Cautionary Advice Regarding
Disclosure About Critical Accounting Policies.'' This release may be
the most significant SEC step with respect to corporate governance in
decades. In effect, this release requires the auditors to carefully
explain the various accounting policies that have been selected by
management, the estimates that management is making, and how the
selection of different policies or estimates could cause the reporting
of materially different financial results (Appendix C).
This explanation is to be made to the audit committee and is to be
placed in ``Management's Discussion and Analysis'' (the ``MD&A''). Had
this rule been understood by Enron, its audit committee and Andersen
years ago, the current Enron debacle may not have happened. It
certainly would have been discovered years earlier.
Third, the SEC must make it quite clear to audit committees that
they have the responsibility of protecting the independence of the
auditors. This is not a passive assignment. The audit committee must:
Understand the fee negotiations.
Lead any effort to select a new firm.
Initiate interviews for a new audit partner in charge.
Insist that all disagreements between the management and the
auditor be exposed to them.
Insist that they be made to understand any alternative
presentations of the company's financial position that would lessen
earnings or debt.
In short, the audit committee's most important task is to make the
independent attesting auditor believe that its retention depends solely
on the decision of the audit committee.
Audit committees must have latent authority to hire their own
consultants with or without consultation with management. They must
insist that all allegations of financial misconduct be conveyed to them
immediately. The complaint by Ms. Watkins to Enron's CEO should have
been given directly to the audit committee, which should have hired its
own counsel to investigate her complaint.
In short, the SEC must give the accounting profession the
responsibility and the courage to tell management that: ``Its financial
statements DO NOT fairly present the Company's financial position
whether or not there is a rule preventing such presentation.''
Action by the Profession
The accounting profession must be made to trust the audit
committee. Before taking a new engagement, a firm should be satisfied
that their relationship is with the committee, and that all real
problems must involve the committee. A firm should not take an
engagement unless it is certain of the committee's independence and
resolve. The accounting firms must understand that the failure to have
an independent, competent audit committee constitutes a material
weakness in a company's internal controls. They do not need to wait for
the SEC to tell them.
The profession must raise its sights with respect to the new hires.
It must offer salaries that are competitive with other professions. The
profession needs MBA graduates from our better business schools and it
needs many of the better students that now go to law, investment
banking, and management consulting.
The stark fact that our business community must accept is that the
profession needs to raise the cost of the audit to get better-educated
personnel. However, until management and Wall Street analysts
understand the need for a better trained accountant and the value of a
``better'' audit, it will be difficult to secure the needed talent for
the accounting profession.
Finally, the accounting firms must work with the SEC to create a
materially different regulatory structure. Until that day comes, the
firms must have the competence and the resolve to qualify their opinion
when they believe that, notwithstanding the fact that all rules are
satisfied, the financial presentation is lacking.
Action by Audit Committees
Audit committees do not need any releases from the SEC or
legislative direction to substantially increase their role. As noted
above, audit committees have both the authority and the responsibility
to take over the audit process. Any audit committee that wishes to do
so can assert that it is solely responsible for the selection and
retention of the outside auditor.
In short, all the weaknesses identified above in the manner in
which audit committees are managed can be corrected with a simple
change of direction.
The Need for Legislation
All the weaknesses referred to above could be corrected by a
concerted effort of industry, the SEC, the FASB, and the AICPA. And
there are current efforts to do so. Russell Palmer, the former Dean of
Wharton and I, with the encouragement of Chairman Levitt, have formed a
steering committee (Appendix D) to assist the American Assembly at
Columbia University to conduct an Assembly on the future of the
accounting profession.
However, the pace of change for corporate governance has been
painfully slow. It may well need a legislative push. Congress, with the
Administration, could mandate the formation of an informed, effective
commission to prepare a reform program within the year.
Congress may wish also 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.
What Should Not Be Done?
In recent days there have been calls for various legislative
changes in our securities laws that, in my view, should not be made.
They would:
Prohibit any firm responsible for the annual audit of a firm
from performing any consulting type services for the same firm.
Place term limits on how long accountants can work for a
client.
Require that an independent organization pay for company
audits.
The principal objection to all three proposals is that each of them
would erode the authority and the responsibility of the audit
committee. For 26 years, audit committees have become more independent
and more assertive. As a result, there has been a steady, albeit slow,
improvement in corporate governance. Each of the above listed proposals
would inevitably erode both the authority and the responsibility of the
audit committee.
The more specific objections to each proposal are these:
Consulting
There are four compelling reasons to resist efforts to ban
accountants from doing any consulting work for their audit clients:
(1) Such a rule will not help the problem and it will divert
attention from action that will help. An audit partner who is
threatened with the loss of his client is just as likely to
yield to undue management pressure whether or not his firm is
receiving large consulting contracts. If he or she loses that
audit client his or her career is likely at an end. Twelve
years ago, I felt compelled to launch a proxy fight to take
control of a small NYSE company. I questioned the auditor after
we prevailed in the proxy fight and learned from the auditor
that there were a large number of questionable policies that he
had accepted because of his fear that he would lose the client
if he persisted in opposing them. The annual audit fee was
under $500,000.
(2) The profession is already having a difficult time in
attracting qualified personnel. If college graduates are told
that there is a blanket prohibition on all ``consulting work,''
they will surely conclude that their work as an accountant will
be limited.
(3) There is no valid reason to restrict management from
using its auditors where their experience with the company can
be of real assistance. An alert audit committee can easily
protect the company from the pressure of a management that
implies that the accountant will lose lucrative consulting fees
if it opposes the management's accounting policies. The audit
committee should, of course, oversee all consulting work done
by the external auditing firm. Each committee should require
that its approval be necessary before any consulting contract
of size is given to the external auditors.
(4) We must have some patience. Just last year the SEC
required considerable disclosure about consulting fees paid to
the external auditor. That rule has caused companies to rethink
the manner in which they engage consultants and auditors to
decide what kinds of services they wish to offer. At the very
least, we should wait to see how these new requirements work
before we overtake them with new rules.
Term Limits
Forcing a change of auditors can only lower the quality of audits
and increase their costs. The longer an auditor is with a company the
more it learns about its personnel, its business and its intrinsic
values. To change every several years will simply create a merry-go-
round of mediocrity.
An effective audit committee can mandate a rotation of partners in
the same firm that can achieve the same result as changing firms.
Payment of Audit Fees by an Independent Organization
There are over 10,000 publicly-traded companies in the United
States. The overwhelming number of them have a satisfactory
relationship with their auditor and their financial statements are all
anyone could ask for in terms of fair presentation. To force all these
companies to change their relationship with their auditors because of
the misbehavior of a relatively small number of companies would be
foolish. We cannot possibly know now whether the change would produce
better financial presentations. Again, the problem seen in cases like
Enron can be dealt with if the role of the audit committee is carried
out properly.
Conclusion
The accounting profession is of enormous importance to the United
States and to the increasingly global economy in which we exist. It is
an absolutely essential force in the evolution of so many companies in
the emerging economies that seek capital from the developing world. As
we acknowledge the deficiencies of the accounting profession, we should
also acknowledge the responsibility we have to assist it reform itself.
EXHIBIT A
RODERICK M. HILLS
Government
Chairman, Securities and Exchange Commission, 1975-77
Counsel to the President of the United States, 1975
Law Clerk to Justice Stanley F. Reed, the Supreme Court of the United
States, 1955-1957
Board of Directors (Present & Former)
Orbital Sciences Corporation, Audit Committee Member, 2001-
Regional Market Makers, Director, 2000-
Chiquita Brands International, Inc., March 8, 2002-
Federal-Mogul Corporation, Chairman Governance Committee and former
Chairman of Audit Committee, Audit Committee Member, 1977-2002
Per-Se Technologies, Chairman of Audit Committee, 1999-2001
Waste Management, Inc. (merged with USA Waste and renamed Waste
Management, Inc. in July 1998), Chairman of Audit Committee, 1997-
2000
Oak Industries Inc., Vice Chairman and Chairman of Audit Committee,
1985-2000
Mayflower Group, Inc., Audit Committee Member, 1993-96
Sunbeam-Oster, Audit Committee Member, 1991-96
Drexel Burnham Lambert, Inc., Member, Oversight Committee, 1989-90
Alexander & Alexander Services, Inc., Chairman of Audit Committee,
1978-87
Anheuser-Busch Companies, Inc., Member, Audit Committee, 1977-89
Santa Fe International, Chairman of Audit Committee, 1977-86
Republic Corporation, Chairman, Audit Committee Member, 1971-75
Beck Industries, Audit Committee Member, 1970
Current Employment
Founder and Partner, Hills & Stern, Attorneys at Law, 1996-
Chairman, Hills Enterprises, Ltd. (formerly The Manchester Group,
Ltd.), 1984-
Academic Experience
Distinguished Faculty Fellow & Lecturer (International Finance), Yale
University, School of Organization & Management, 1985-87
Professor, Harvard University, School of Law & School of Business,
1969-70
Lecturer in Law (Visiting), Stanford University School of Law, 1960-70
Education
Stanford University, B.A. 1952, LL.B. 1955; Order of the Coif, Comment
Editor, Stanford Law Review, 1953-55.
EXHIBIT B
FUNDAMENTAL CAUSES OF
THE ENRON ACCOUNTING DEBACLE:
``Show Me Where It Says I Can't Do It''
Imagine an asset [for the moment think of rights to use a patent on
a drug that defeats anthrax] purchased by a dozen different companies
for a total of $500 million. Now suppose that the Congress passes laws
saying that any other company who so chooses can use that patent to
produce the anthrax-defeating drug free of royalty to the owners.
What do you suppose the accountants for the firms that had
purchased those patents for $500 million would do? They would write off
the assets to zero, recognizing a collective loss of $500 million,
before taxes, on their income statements. Would you suppose that
accountants would need to look into their GAAP rule books to find out
if that write-off were necessary? [Not necessary, wouldn't you think--
it is obvious.] If they did look and could not find such guidance, do
you think they would write off the assets anyway, recognizing the
attendant losses? [Of course.]
What has this to do with the state of accounting reflected in the
current Enron /Andersen shambles? A lot.
In 1980, the events of the first two paragraphs happened: The
Congress passed deregulating legislation liberalizing the granting of
trucking rights, effectively given any trucker the right to carry any
commodity between any two points. Prior to that deregulating
legislation, Congress, acting through the Interstate Commerce
Commission, had limited those rights. The issued rights traded in the
marketplace and, once purchased by a trucking firm, appeared on the
firm's balance sheet at cost. When Congress effectively destroyed the
value of those rights by allowing any trucker the right to carry the
goods previously protected by monopoly rights, what did trucking firms
do? They wrote off the value of the trucking rights on the balance
sheet, recognizing an amount of loss equal to their then-current book
value.
Did the trucking company accountants need a specific accounting
rule telling them to write off those trucking right assets? You
wouldn't think so, would you? But the Financial Accounting Standards
Board [FASB] felt compelled to pass a rule [Statement of Financial
Accounting Standards No. 44, 1980] saying just that. This was a first
step on the road to the Enron accounting debacle. [The underlying
economic debacle has little to do with accounting and a lot to do with
gambling, although the accounting likely allowed the gambling to go on
longer than it otherwise would have.]
Since the early 1980's, an aggressive company's management engages
in a transaction not covered by specific accounting rules, accounts for
it as it chooses, and challenges the auditor by arguing, ``Show me
where it says I cannot do it.'' The auditor used to be able to appeal
to the first principles of accounting. Such principles suggest, for
example, that post-deregulation trucking rights are no longer assets.
Now the aggressive management can say, ``Detailed accounting rules
cover so many transactions and none of them covers the current issue,
so we can devise accounting of our own choosing.'' And they do.
Accounting rulemaking has become increasingly detailed as auditors
plead with the standard setters for specific rules to provide backbone:
``Dear FASB or EITF [Emerging Issues Task Force, created by the SEC and
the FASB], give us a rule for this new transaction.''
So, Enron transferred assets, reporting current profit and,
simultaneously, and promised to give Enron shares to the purchaser if
the transferred assets later turn into losers. Enron recognizes profits
and challenges its auditor to ``Show me where it says I cannot do it.''
The auditor cannot. The auditor considers nixing the profit recognition
but simultaneously considers the consequences of saying, ``No'' to
aggressive management: We might lose this client.
The working majority of the rule-setting FASB comes from high-
powered audit practice and those members bring to the Board a mindset
that the accounting profession needs, and wants, specific guidance for
specific transactions. Three of them can meet privately and can
effectively, if not formally, guide, perhaps even set, the agenda for
the Board. A minority of the Board has spent careers dealing with
fundamental theory. This minority, with more faith in the conceptual
basis for accounting, appears to prefer to set rules based on appeal to
the fundamental axioms of accounting, which the FASB developed in the
early 1980's in its conceptual framework. The majority from auditing
practice, those with experience in asking for and applying detailed
rules for specific problems, less interested in deriving rules from
conceptual principles, appears to win most of the battles.
The emphasis on specific rules for specific issues gets more
pronounced over time. I concede these specific rules for specific
issues leads to more uniform reporting of the covered transactions, all
else equal, a good thing. That uniformity comes at the cost: Practicing
accountants have less need for informed intelligence and judgment. I
concede that part of the pressure on standard setters for specific
rules for specific transactions comes from the current litigation
environment. Auditors, in a rational pursuit of a full purse, want
unambiguous rules to stand behind when, inevitably, the trial lawyers
sue them for accountant judgments and estimates, made in good faith,
that turn out to be wrong.
That some good results from specific rules for specific
transactions does not make such rules a good idea. These rules have a
cost: Show me where it says I cannot do it, says management; give me
more rules for these new transactions, says the auditor, so I can
combat aggressive management; completing the cycle, the increasing
number of specific rules for specific transactions strengthens
aggressive management's belief that if a rule does not prohibit it,
then it is allowed.
I want accountants to use fundamental concepts in choosing
accounting methods and estimates. I want accountants not to hide behind
the absence a specific rule. Whatever the detailed rules accountants
write, smart managers can construct transactions the rules do not
cover.
What else do we need to reduce the likelihood of more accounting
debacles?
I think that we need audit committees to exercise the power the SEC
has given them. Thirty years ago, Rod Hills, then Chairman of the SEC,
conceived the powerful modern audit committee. He has written that the
audit committee's most important job is to make the independent,
attesting auditor believe that the auditor's retention depends solely
on the decision of the audit committee. Most often, it doesn't work
that way.
Most audit committees consist of independent, smart but financially
illiterate members, with rarely more than one financial expert. [If you
do not believe me, look at the accounting qualifications of the audit
committee of any large company you follow. Then, look at how seldom the
large corporations change auditors.] Audit Committees usually depend on
management to recommend the independent auditor and changes in the
auditor. The auditor learns to take its guidance from management, not
from the audit committee. The SEC has empowered the audit committee;
now, it should provide incentives to those committees to use the power
and it should devise ways to discipline those committees who do not.
Management typically views audits as adding no value, purchased
merely because regulation requires them. Hence, management typically
wants the most cost-effective job it can get to satisfy the
regulations. This doesn't mean the cheapest audit. Capital markets will
guide a Dow Jones Industrial firm not to hire me to do its audit, but
to hire one of the Big 5. Once that firm decides it needs a Big 5
auditor, it will prefer to spend less, not more, for the service. The
auditor has the incentive to price the audit low, to get the
engagement, and hopes to profit from consulting jobs that grow out of
the expertise developed during the audit.
The audit committee could say, ``We are going to pay top dollar for
a high quality audit.'' To the auditor it could say, ``Make a decent
profit on the audit; do not count on consulting fees to make up for
thin margins on the audit.'' This will drive up the cost of both the
audit and the consulting services, because the outside consultant will
not have the head start in understanding the client's specifics that
the auditor has. Management won't like this. The audit committee,
charged to be concerned primarily with the audit, should be unconcerned
about the higher cost of consulting fees. When did you last hear of an
audit committee asking for a higher-priced audit?
Does this require a regulation forbidding the auditor from
consulting? No, we already have regulations empowering the audit
committee to act, independent of management. Now, we need the
incentives for it to do so.
Professor Roman L. Weil
Roman L. Weil is V. Duane Rath Professor of Accounting at the
Graduate School of Business of the University of Chicago and Director
of its Directors' College, which aims to teach board members how to be
more financially literate, thus better qualified for audit committee
service. He served a 4 year term on the FASB's Financial Accounting
Standards Advisory Committee.
EXHIBIT C
SECURITIES AND EXCHANGE COMMISSION
[Release Nos. 33- 8040; 34 - 45149; FR- 60]
Agency: Securities and Exchange Commission
Action: Cautionary Advice Regarding Disclosure About Critical
Accounting Policies
Summary: The Securities and Exchange Commission is issuing a statement
regarding the selection and disclosure by public companies of critical
accounting policies and practices.
For Further Information Contact: Robert A. Bayless, Special Assistant
to the Chief Accountant, 202-942- 4400.
Supplementary Information:
As public companies undertake to prepare and file required annual
reports with us, we wish to remind management, auditors, audit
committees, and their advisors that the selection and application of
the company's accounting policies must be appropriately reasoned. They
should be aware also that investors increasingly demand full
transparency of accounting policies and their effects.
The reported financial position and results often imply a degree of
precision, continuity, and certainty that can be belied by rapid
changes in the financial and operating environment that produced those
measures, As a result, even a technically accurate application of
Generally Accepted Accounting Principles (GAAP) may nonetheless fail to
communicate important information if it is not accompanied by
appropriate and clear analytic disclosures to facilitate an investor's
understanding of the company's financial status, and the possibility,
likelihood and implication of changes in the financial and operating
status.
Of course, public companies should be mindful of existing
disclosure requirements in GAAP and our rules. Accounting standards
require information in financial statements about the accounting
principles and the methods used and the risks and uncertainties
inherent in significant estimates.\1\ Our rules governing Management's
Discussion and Analysis (MD&A) currently require disclosure about
trends, events, or uncertainties known to management that would have a
material impact on reported financial information.\2\
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\1\ See, e.g., Accounting Principles Board Opinion No. 22,
``Disclosure of Accounting Policies'' (April 1972); AICPA Statement of
Position No. 94 - 6, ``Disclosure of Certain Significant Risks and
Uncertainties'' (December 1994).
\2\ The underlying purpose of MD&A is to provide investors with
``information that the registrant believes to be necessary to an
understanding of its financial condition, changes in financial
condition and results of operations.'' Item 303(a) of Regulation S-K
[17 CFR 229.303(a)]. As we have previously stated, ``[i]t is the
responsibility of management [in MD&A] to identify and to address those
key variables and other qualitative and quantitative factors which are
peculiar to and necessary for an understanding and evaluation of the
company.'' Securities Act Rel. No. 6835 (May 18, 1989) [54 FR 22427]
(quoting Securities Act Rel. No. 6349 (September 28, 1981) [not
published in the Federal Register]).
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We have observed that disclosure responsive to these requirements
could be enhanced. For example, environmental and operational trends,
events, and uncertainties typically are identified in MD&A, but the
implications of those uncertainties for the methods, assumptions and
estimates used for recurring and pervasive accounting measurements are
not always addressed. Communication between the investors and public
companies could be improved if management explained in MD&A the
interplay of specific uncertainties with accounting measurements in the
financial statements. We intend to consider new rules during the coming
year to elicit more precise disclosures about the accounting policies
that management believes are most ``critical''--that is, they are both
most important to the portrayal of the company's financial condition
and results, and they require management's most difficult, subjective
or complex judgments, often as a result of the need to make estimates
about the effect of matters that are inherently uncertain.
Even before new rules are considered, however, we believe that it
is appropriate to alert companies to the need for greater investor
awareness of the sensitivity of financial statements to the methods,
assumptions, and estimates underlying their preparation. We encourage
public companies to include in their MD&A this year full explanations,
in plain English, of their ``critical accounting policies,'' the
judgments and uncertainties affecting the application of those
policies, and the likelihood that materially different amounts would be
reported under different conditions or using different assumptions. The
objective of this disclosure is consistent with the objective of MD&A.
Investors may lose confidence in a company's management and
financial statements if sudden changes in its financial condition and
results occur, but were not preceded by disclosures about the
susceptibility of reported amounts to change, including rapid change.
To minimize such a loss of confidence, we are alerting public companies
to the importance of employing a disclosure regimen along the following
lines:
1. Each company's management and auditor should bring particular
focus to the evaluation of the critical accounting policies used in the
financial statements. As part of the normal audit process, auditors
must obtain an understanding of management's judgments in selecting and
applying accounting principles and methods. Special attention to the
most critical accounting policies will enhance the effectiveness of
this process. Management should be able to defend the quality and
reasonableness of the most critical policies, and auditors should
satisfy themselves thoroughly regarding their selection, application,
and disclosure.
2. Management should ensure that disclosure in MD&A is balanced and
is fully responsive. To enhance investor understanding of the financial
statements, companies are encouraged to explain in MD&A the effects of
the critical accounting policies applied, the judgments made in their
application, and the likelihood of materially different reported
results if different assumptions or conditions were to prevail.
3. Prior to finalizing and filing annual reports, audit committees
should review the selection, application, and disclosure of critical
accounting policies. Consistent with auditing standards, audit
committees should be apprised of the evaluative criteria used by
management in their selection of the accounting principles and
methods.\3\ Proactive discussions between the audit committee and the
company's senior management and auditor about critical accounting
policies are appropriate.
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\3\ See Codification of Statements on Auditing Standards, AU
Sec. 380, Communication with Audit Committees or Others with Equivalent
Authority and Responsibility (SAS 61). SAS 61 requires independent
auditors to communicate certain matters related to the conduct of an
audit to those who have responsibility for oversight of the financial
reporting process, specifically the audit committee. Among the matters
to be communicated to the audit committee are: (1) methods used to
account for significant unusual transactions; (2) the effect of
significant accounting policies in controversial or emerging areas for
which there is a lack of authoritative guidance or consensus; (3) the
process used by management in formulating particularly sensitive
accounting estimates and the basis for the auditor's conclusions
regarding the reasonableness of those estimates; and (4) disagreements
with management over the application of accounting principles, the
basis for management's accounting estimates, and the disclosures in the
financial statements. Id.
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4. If companies, management, audit committees, or auditors are
uncertain about the application of specific GAAP principles, they
should consult with our accounting staff. We encourage all those whose
responsibility it is to report fairly and accurately on a company's
financial condition and results to seek out our staff 's assistance. We
are committed to providing that assistance in a timely fashion; our
goal is to address problems before they happen.
By the Commission.
Jonathan G. Katz
Secretary
Dated: December 12, 2001
EXHIBIT D
AMERICAN ASSEMBLY STEERING COMMITTEE
Roderick M. Hills, Hills Enterprises, former Chairman,
Securities and Exchange Commission
Professor Derek Bok, former President, Harvard University
Robert E. Denham, former Chairman of Solomon Brothers Buffett
and now a partner at Munger, Tolles & Olson; public member of the
Professional Ethics Executive Committee of the American Institute
of Certified Public Accountants
William Henry Donaldson, Founder of DLJ and former Chairman of
NYSE
Arthur Levitt, former Chairman, Securities and Exchange
Commission
William J. McDonough, President, Federal Reserve Board of New
York
Russell E. Palmer, Chairman, The Palmer Group and former Dean,
Wharton School
Katherine Schipper, Member Financial Accounting Standards
Board and former L. Palmer Fox Professorship of Business
Administration at Duke University's Fuqua School of Business
Washington SyCip, Founder of SGV & Company
Sir David Tweedie, Chairman, International Accounting
Standards Board
Paul A. Volcker, former Chairman, Federal Reserve
Clifton R. Wharton, Jr., former Under Secretary of State
Roman L. Weil, Professor of Accounting at the Graduate School
of Business of the University of Chicago
ADDENDUM
HILLS & STERN--ATTORNEYS AT LAW
February 19,
2002
Mr. Steve Harris
Majority Staff Director
United States Senate
Committee on Banking, Housing, and Urban Affairs
534 Dirksen Building
Washington, DC 20510
Dear Steve:
I offer these thoughts about a legislative/regulatory program that
can, arbitrarily, be divided like Gaul into three parts: (1)
Restructure of the regulatory system; (2) Strengthen the SEC's
enforcement capacity; and (3) Reinforce both the authority and the
responsibility of the audit committee.
The Regulatory System
FASB needs significant restructuring. Legislation is needed that
will:
Create a Federal Corporation with an initial board appointed
by agreement between Congress and the Administration. Some members
of FASB Foundation could be on the initial board. Their mandate
would be to seek a FASB type agency that would have more neutrals
than does FASB today.
Funding for this new Corporation would be fixed either by a
permanent surcharge on audit fees or SEC filings or, perhaps, by an
endowment. Conceivably an endowment could be established with
matching funds: The profession, the industry, and the Federal
Government, for example, could each put up \1/3\ of the total.
The legislation could establish policy guidelines that will
aim for the establishment of fundamental concepts in choosing
accounting methods and estimates rather than to continue the policy
that causes auditors to rely upon a multitude of specific rules.
The AICPA needs some burnishing:
It needs to have an effective disciplinary system that will
investigate claims of misconduct and provide sanctions. AICPA rules
today may prevent the AICPA from ``auditing an audit.'' If so, a
change is needed.
It may be that AICPA can reform itself, but it may take
legislative pressure to get it underway.
The SEC
The SEC has indicated that it will bolster its enforcement in
accounting by taking three steps:
Its December 12 release states that auditors will be required
``to discuss the likelihood of materially different reported
results if different assumptions are used.'' The requirement that
such alternate assumptions and estimates be displayed in the MD&A's
will require significant attention to those filings by the SEC.
On February 13 the Chief Accountant for the SEC's Enforcement
Division was reported as stating: ``One can violate the SEC laws
and still comply with Generally Accepted Accounting Principles.''
In essence he is noting that accounting practices have moved away
from the overriding principle of fairly presenting financial
performance to a growing dependence on specific rules.
Chairman Pitt has orally suggested that he believes a company
must have an independent, competent audit committee or it will have
a material weakness in its internal controls.
I have every confidence that the SEC will establish these three
principles, but the fact is that these principles are not in place now.
I am reluctant to suggest legislation when the same result can come
from regulatory action. Nonetheless, the three matters would go so far
to eliminate Enron type problems that the strength of legislation is
needed. There is some precedent for Congress endorsing with legislation
action already taken by the SEC. In the mid-1970's, the SEC established
the requirement of internal controls for the first time. Congress
thereafter mandated that corporations must have such controls.
The accounting profession will have an understandable concern about
their need to qualify statements that the auditor believes does not
fairly present a companies financial position even though it satisfies
all rules. They will fear lawsuits from third parties claiming that in
a given case the auditor should have said the presentation was not
fair. That concern will be lessened if the legislation provided that
only the SEC can bring an action for such a failure.
I recommend also that the Senate Banking Committee request that the
SEC develop guidelines for the regulation of consulting services
performed by the external auditor. Such guidelines should have terms
like the following:
The external auditor may not perform work for a client if its
audit tests the efficacy of such work.
Consulting fees cannot exceed the audit fees 2 years in a row
and cannot ever exceed them without a certification by the audit
committee that it is in the company's best interest to allow such
work.
Consulting fees may never exceed 5 percent of the cost of the
audit without an explicit approval by the audit committee that must
be specific about the reason for selecting the external auditor to
do such work.
Significant time was spent during the hearing on February 12 about
the need to provide added funding to the SEC. It is of critical
importance that a significant amount of that funding be used to improve
the capacity of the SEC to read and comment on filings such as the 10K.
By mandating that the MD&A's be more explicit about alternative ways of
showing the company's financial position, the SEC will need to
effectively read far more 10K's then are now read.
Accordingly, a specific amount of the new funding should be
designated for the development of a computer driven capacity to sort
out the companies that have the greatest risk of an accounting problem.
Each of the Big 5 accounting firms has developed information systems
that identify their ``high-risk'' clients. That methodology could be
used by the SEC to identify the same companies.
All companies so designated should have their 10K's read and the
SEC should subject some to a targeted audit.
The Audit Committee
I particularly recommend that Congress mandate that independent,
competent audit committees must be present on all boards of companies
whose stock is held by more than some minimum number of shareholders.
At 25 years of age, the audit committee deserves a legislative
endorsement. As stated above, the SEC can be directed to secure
guidelines from the audit committee on a number of issues; but, the
audit committee's authority, as well as its responsibilities, needs the
strength of legislation. That legislation can declare that auditors can
only be fired or hired by the audit committee, with the requirement
that the decision to hire an audit firm must be confirmed by a
stockholder vote at the next annual shareholders' meeting.
Because I believe it is highly unlikely that an audit committee
will be sufficiently independent without an independent nominating/
governance committee, I believe such a committee will also need a
legislative mandate. Such committees would be responsible for
establishing the board's policy with respect to director tenure,
director replacement, and director performance. The committee would be
required to judge the efficacy of the other board committees, designate
which members will sit on which committees and either appoint committee
heads or be certain that each committee select its own chair person.
Such legislation should also state that a majority of directors of
companies that have a minimum number of shareholders must be
independent.
Other Legislation
While I oppose mandatory changes of auditors, I do believe that a
more extensive examination of the performance of auditors is needed at
regular intervals. The best idea advanced so far is a meaningful review
of the auditor's performance every 3 years. Legislation could state
that no firm of a certain minimum size can keep the same auditor for
more than 3 years unless the audit committee has commissioned a
thorough review of the auditor's work with competent outside assistance
and has certified that the continuation of that auditor is in the best
interests of the shareholders.
Many have called for the imposition of a ``cooling off '' period
before a company that is the auditor's client can hire an auditor's
employee. I suggest that any such legislation should allow the SEC to
waive the rule. An Andersen employee in Atlanta who has never worked on
the audit of a client in Seattle should not have his or her job
opportunities unnecessarily limited.
Finally, accounting firms should be required to have independent
directors on their board and to have an independent committee of the
board responsible for investigating mishaps by the firm.
Summary
The above represents my own views of what can be done now to
improve the performance of the audit process. I will read the written
testimony of the other witnesses to see if there are other proposals
that I can endorse.
With best regards,
Roderick M. Hills
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM RICHARD C.
BREEDEN
Q.1. Regarding the issue of auditor independence, do you feel
that there has been ample time to review the new SEC rules that
went into effect just 1 year ago?
A.1. Yes.
Q.2. With changing technology and innovations in finance, what
additional information would be useful to the investors when
companies disclose financial information? Is enough currently
being disclosed?
A.2. I believe that the SEC is the proper body to define
specific disclosure requirements. However, one positive change
in current requirements would be comprehensive disclosure
concerning ``off balance sheet'' instruments. Greater
transparency regarding cash flows would also be desirable.
Q.3. Can information be put in terms that the average investor
would be able to understand?
A.3. It is possible to write a clear description of anything,
and information that is being disclosed should be set forth in
clear and straightforward terms. At the same time, complex and
hard to understand information is also important, even if every
individual investor may not be able to understand it, Good
disclosure needs to provide comprehensive information to the
market, where it can be factored into the price discovery
process. 10K's and prospectuses are never going to be as simple
as comic books, though every effort should be made to require
information to be presented in the most understandable form.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM DAVID S.
RUDER
Q.1. Regarding the issue of auditor independence, do you feel
that there has been ample time to review the new SEC rules that
went into effect just 1 year ago?
A.1. As I indicated in my testimony, I believe the
responsibility for reviewing the effect of the new SEC rules on
auditor independence should rest with the SEC. I believe there
has not yet been ample time for the SEC to review those rules,
particularly in light of the public concern expressed regarding
Enron.
Q.2. With changing technology and innovations in finance, what
additional information would be useful to the investors when
companies disclose financial information? Is enough currently
being disclosed?
A.2. Changing technology will permit companies to disclose
information on a relatively current basis. The SEC is currently
considering the possibility of requiring such disclosure, but
it must cope with problems relating to the definition of
materiality and with liability concerns. Each company should be
required to make greater disclosure about its significant
accounting policies and about its plans and visions for the
future. The SEC should review its disclosure policies to
determine what other additional disclosures should be required.
Q.3. Can information be put in terms that the average investor
would be able to understand?
A.3. Information can be put in terms that the average investor
can understand, and the SEC has already initiated a ``plain
English'' policy. However, there are some areas that are
inherently technical and complicated that may not lend
themselves to simple explanations.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM HAROLD M.
WILLIAMS
Q.1. Regarding the issue of auditor independence, do you feel
that there has been ample time to review the new SEC rules that
went into effect just 1 year ago?
A.1. Yes, I do. Further, I do not believe that the new rules
are adequate to address the problem.
Q.2. With changing technology and innovations in finance, what
additional information would be useful to the investors when
companies disclose financial information? Is enough currently
being disclosed?
A.2. Current disclosure is inadequate. The standard should be
that the economic substance of the transaction should be
disclosed and that technical compliance with the rules is not
acceptable. When alternative methods of accounting are equally
acceptable, the one elected should be disclosed.
Q.3. Can information be put in terms that the average investor
would be able to understand?
A.3. I believe so. However, the reality is that it is investing
on the part of sophisticated institutional investors that
largely determines the market and the evaluation of securities.
Information that serves to fully inform them would go a long
way toward solving the problem.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGEL FROM RODERICK M.
HILLS
Q.1. Regarding the issue of auditor independence, do you feel
that there has been ample time to review the new SEC rules that
went into effect just 1 year ago?
A.1. I do not believe we have given the new rules time to work.
I do know from my service on four different boards during this
period that the new rules have had a substantial effect on
boards of directors. Much more scrutiny is being given to
consulting contracts given the external auditor and all four
boards now require audit committee approval of any contract to
the external auditor that is more than a minimal amount.
The Senate Banking Committee may wish to ask the SEC to
require all reporting companies to set forth in their 10K their
policy with respect to consulting work done by the external
auditors and to require that audit committee approval is needed
for any payments for consulting work that exceed something like
10 percent of the fee for the external audit.
Q.2. With changing technology and innovations in finance, what
additional information would he useful to the investors when
companies disclose financial information? Is enough currently
being disclosed?
A.2. On December 12, 2001 the SEC issued a release that
requires auditors and reporting companies to both consider and
display any alternative ways in which the company's financial
position can be depicted if an alternative would produce a
materially different financial result. This requirement should
substantially reduce the possibility of future Enron type
debacles.
The Enforcement Division of the SEC has also stated
recently that auditors and reporting companies cannot satisfy
the securities laws and regulations simply by complying with
all rules. They must also be certain that their financial
statements fairly present the companies financial position
whether or not all rules have been satisfied. This new emphasis
on a fundamental principle of the law will also substantially
reduce the possibility of future Enrons.
Q.3. Can information be put in terms that the average investor
would be able to understand?
A.3. Yes, but the task will not be easy to complete. We
appointed a blue ribbon group 26 years ago to attempt the task.
The group included Warren Buffet, a long-time champion of plain
reading. I believe we improved the system somewhat but there is
still much to be done. The current Chairman of the SEC, Harvey
Pitt, has the capacity, experience, and resolve to improve
reporting. I am optimistic about his chances for success.
ACCOUNTING REFORM AND
INVESTOR PROTECTION
----------
THURSDAY, FEBRUARY 14, 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 Committee on Banking, Housing, and
Urban Affairs holds the second in a series of hearings which we
will be carrying on for the balance of this month and well into
next month, on accounting and investor protection issues which
have been brought into sharp focus by the collapse of Enron
Corporation.
But these issues affect other public companies as well, as
we are learning daily, and many of the issues that are posed
are not new issues.
They include, of course, the integrity of certified
financial audits and corporate financial disclosure, accounting
principles, the regulatory oversight system for accountants,
auditor independence, questions of conflicts of interest, and
corporate governance.
As we heard on Tuesday, when we had a panel of five former
Chairmen of the Securities and Exchange Commission, we need to
fundamentally reexamine these subjects, and there is, I think
it is fair to say, a crisis of confidence.
Today's witnesses are especially well placed to assist us.
I think it is fair to say that Paul Volcker needs no
introduction to Members of this Committee. Few combine the
perspectives which he can bring to bear on economic issues.
Consumers of financial reports know him as the former Chairman
of the Federal Reserve Board. He now Chairs the Trustees of the
International Accounting Standards Committee Foundation. And he
has recently undertaken, without compensation, I understand, to
head up an outside oversight board to examine Arthur Andersen.
Sir David Tweedie is an experienced national accounting
regulator, who is now leading the international effort to
formulate meaningful cross-border accounting standards for the
global economy. In 2000, he became Chairman of the
International Accounting Standards Board, the IASB, which is
funded and overseen by the International Accounting Standards
Committee Foundation. Before that, Sir David spent 10 years
heading the Accounting Standards Board of the United Kingdom.
In little more than two decades, the world's capital
markets have been transformed by the global expansion of
business and technology. Companies now can pursue capital in
securities markets the world over. Well over 1,300 foreign
companies are now listed on U.S. securities exchanges. This
compares with a figure of just over 300 in 1986, 15 years ago.
The force of this expansion is revealed in the proliferation of
new business arrangements, the securitization of credit and
novel financial instruments. All of these developments make
corporate structures more intricate and traditional accounting
notions more difficult to apply.
Given the global market's critical need for timely and
trusted
financial information, Chairman Paul Volcker stated recently
that, ``the problems besetting the accounting and auditing
professions, building over a period of years, have now exploded
into a sense of crisis.''
This, as I note, was already a common theme expressed on
Tuesday by the five former SEC Chairmen.
Two years ago, the SEC listed four essential elements for
any financial reporting system: High quality accounting and
auditing standards, audit firms with effective quality
controls, profession-wide quality assurance, and active
regulatory oversight, including rigorous interpretation and
enforcement of accounting and auditing standards.
If any of these elements is lacking or is perceived to be
lacking efforts must be made to restore them.
The Committee, in the course of these hearings, must
consider the best practices and most advanced thought worldwide
as we examine the challenge of reforming our own system. And
this is particularly why we welcome Chairman Volcker and Sir
David this morning. We are looking forward to their testimony.
But before I turn to them, I yield to my colleagues for any
statements they may have.
Senator Gramm.
COMMENTS OF SENATOR PHIL GRAMM
Senator Gramm. Mr. Chairman, thank you very much.
Paul, we are very happy to have you in front of the
Committee. I want to thank you very much for your life-long
service to America. If I started making a list of people who
had made contributions to this country, the list would not be
very long before your name would be on it.
Sir David, we are very happy to have you before the
Committee.
I have always believed that it was important to have
homogeneous accounting standards, at least in the developed
world, and ultimately, worldwide. A question I have always had
is how do we get from where we are to there.
I guess like most Americans, Sir David, you won't be
surprised to hear me say that I always thought that the
quickest way to do it was to adopt American standards
worldwide.
[Laughter.]
But in any case, I applaud what you are doing.
Let me also say, having just asked Paul if he was an
accountant--he assured me he wasn't--but I did want to say
since we have one CPA on this Committee, and an important part
of our jurisdiction has to do with accounting standards.
I would say in this era, when one normally speaks of the
troubled accounting profession, that if I had to choose between
a preacher and a politician and an accountant, selected at
random in America, to protect the sanctity and safety of my
children and my wife, I would choose an accountant.
[Laughter.]
So, I wanted to be sure I got that on the public record
here.
[Laughter.]
Chairman Sarbanes. All preachers and politicians take note.
[Laughter.]
Senator Gramm. I am not saying there are not some good
ones.
[Laughter.]
But you are being selected at random in my example and on
that basis, I will take an accountant.
In any case, Mr. Chairman, I am awfully proud of your
leadership as we try to deal with this issue. There are many
committees holding many hearings on many subjects that brush
around our jurisdiction. But at the end of the day, when we
decide to do something in looking at accounting standards, it
is going to be this Committee that does it. And your leadership
and our ability to work together on a bipartisan basis gives me
confidence that we are going to do more good than harm.
Chairman Sarbanes. Thank you very much, Senator.
Senator Stabenow.
COMMENTS OF SENATOR DEBBIE STABENOW
Senator Stabenow. Thank you, Mr. Chairman.
I would submit my full statement for the record.
Let me just thank you for this second day of hearings. When
we had the former SEC Chairmen with us, it was extremely
insightful and I know today's hearing will be insightful as
well.
We are in a global economy. We need to be looking globally
at our approaches. I appreciate the fact that you are with us.
We want to do everything possible to make sure that we have
rules and oversight that make sure that debacles like the Enron
situation cannot happen, or at least we do everything possible
for them not to happen.
We appreciate your input as we look at this globally today.
Chairman Sarbanes. Senator Enzi.
STATEMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. Thank you, Mr. Chairman. I appreciate your
holding this hearing. I do have to note that on Senator Gramm's
list, that he did not even have attorneys on it.
[Laughter.]
Senator Gramm. Well, that went without saying.
[Laughter.]
Senator Enzi. This is a time of financial concern, and
particularly a crisis for accountants. But it is also a
particular time of opportunity for accountants because there is
hardly anybody in the United States that understands what they
do and how they do it and how important that is. And they are
coming to realize a little bit of the importance now. If the
accountants take advantage of this opportunity, they will also
come to understand exactly what the job is.
Rather than promote the normal accountant outlook or
viewpoint of accountants, I think it will bring more people
into the profession and actually strengthen it, as we work our
way through this crisis. Of course, I guess you have to realize
that in order to be in the U.S. Senate, you have to be an
eternal optimist.
I do appreciate the willingness of the Chairman to have
this hearing and the two distinguished witnesses that we have
testifying today.
As we know, the economy is becoming more globalized all the
time. Multinational companies are operating in hundreds of
countries, which requires them to be subject to different laws,
regulations, accounting standards in each jurisdictions. And
that provides for an extremely inefficient use of resources.
Efforts to streamline this process is needed. The
International Accounting Standards Board is the product of that
realization that these standards must become more uniform.
However, they must have the support of the leading nations when
setting their standards. Without this support, the Board will
be unable to complete the most difficult task of standardizing
these rules.
Each nation is going to have to show willingness to
compromise their individual rules for the betterment of all
societies as a whole. I think it is a prime time to be talking
about that.
I firmly believe that the IASB should look to countries
whose policies have been at the forefront and whose economies
have reacted positively. They should follow the rule of, if it
is not broken, do not fix it. I think this mentality would go
far in expediting their process and improving the rules as they
are proposed and as they are implemented.
As we have seen through the Enron debacle, we may need to
do a review of current accounting standards or requirements.
I believe the United States should look to other countries
to see if we can find ways to improve our current methods of
accounting and regulation of accounting.
I do appreciate your holding this hearing today and I look
forward to working with you and the Members of the Committee as
we continue to oversee these issues dealing with accounting,
and I look forward to the great experience of these witnesses.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you very much, Senator Enzi.
Senator Bayh.
COMMENTS OF SENATOR EVAN BAYH
Senator Bayh. Thank you, Mr. Chairman.
My appreciation to our panelists for being here today.
I listened with interest and amusement to Senator Gramm's
comments. And Phil, I would only momentarily rise to the
thankless task of defending the honor of Congress by quoting
Will Rogers, who I think once said, ``Not to forget that every
so often, an innocent man is sentenced to do time in the United
States Congress.''
[Laughter.]
So, we do good work from time to time as well, which I know
you would agree with.
Just briefly, Mr. Chairman, I would say two things. First,
this hearing is important. We exist in a global economy today
and transparency and reliability of financial data is
critically important to the functioning of the global economy.
This has significant effects upon the United States. Our
standards must be consistent with those abroad if we are going
to do business with our trading partners. We are affected by
the reliability--or lack thereof--of financial accounting
standards abroad. And our country, as we have seen several
times in the last decade, can be affected by financial shocks
abroad, occasionally brought on by a lack of financial
transparency in some other markets.
So this is an important topic. I look forward to having the
benefit of your thoughts. It is something that I am keenly
interested in, and I thank you for your time.
Chairman Sarbanes. Thank you.
Senator Crapo.
COMMENTS OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman.
I too want to thank our witnesses for being willing to come
and help us work through these issues today.
It seems to me that as we go through the details of the
Enron crisis and focus on that, that we must remember what our
role here is, which is to assure, at least with regard to this
Committee, that the financial management and standards that are
adopted and followed in this country are those that can give
investors the confidence and assurance that they are getting
accurate and timely data, so that their investment decisions
can be made in an arena in which there is a level of confidence
that can justify the strong markets that we hope to maintain.
It seems that one of the most significant impacts of the
entire Enron crisis is a lack of confidence in the investing
public in the information that they are now having to face to
deal with in making their investment decisions.
I thank the Chairman for being alert to this issue and
bringing in you as witnesses and focusing this hearing and
other hearings on the critical issues that we must face
relating to what level of regulation is necessary and how
should we approach the question of regaining the confidence of
the investing public in the information that is transmitted in
financial markets.
I look forward to the information, suggestions, and
recommendations that I am sure you will be able to provide us
with today.
Thank you.
Chairman Sarbanes. Thank you very much.
Senator Bunning.
COMMENTS OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman.
First of all, I want to thank you for holding this
important hearing and I would like to thank our two
distinguished witnesses for testifying today.
You cannot turn on a TV today without hearing someone talk
about the bankruptcy of Enron and, to a lesser degree, Global
Crossing. The collapse of these two large companies has shaken
a lot of confidence.
A stockbroker told me the other day that when he made a buy
suggestion to his client, that client asked him who the
company's auditor was. It was the first time in 35 years in the
business that a client had ever asked that question before.
We also have had substantial market losses in the beginning
of last week. Analysts have blamed the losses on a lack of
confidence, especially by our mutual funds in financial
statements.
We need to restore the Nation's confidence in our markets.
Investors from large mutual funds to college kids who put their
summer earnings into high-growth stocks must not even have the
slightest fear that investing in a listed company might be akin
to putting their money into some Ponzi scheme.
Critical to the overall confidence is the trust in our
accounting industry. I think we are getting a good idea of what
happened at both Enron and Global Crossing, but we are still
unsure on how that could have happened.
Hopefully, our witnesses today will be able to shed some
light on what we can do to make sure that nothing like this
happens again, and keep confidence in our markets.
Once again, I would like to thank the witnesses for coming
before us today. It is always good to see our good friend and
distinguished former Fed Chairman, Paul Volcker. I listened to
him many times in the House Banking Committee. I am also
pleased to get the international perspective from Sir David. I
look forward to hearing their testimony.
Thank you again, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Bunning.
We would now be happy to hear from our panel. Chairman
Volcker, why don't we start with you.
Welcome back before the Committee.
STATEMENT OF PAUL A. VOLCKER
CHAIRMAN, INTERNATIONAL ACCOUNTING STANDARDS
COMMITTEE FOUNDATION
CHAIRMAN, ARTHUR ANDERSEN'S INDEPENDENT
OVERSIGHT BOARD
FORMER CHAIRMAN, FEDERAL RESERVE SYSTEM
Mr. Volcker. Mr. Chairman and Senators, I certainly
appreciate the opportunity to meet with you this morning.
Chairman Sarbanes. I think you need to draw that microphone
in closer to you.
Mr. Volcker. And join with Sir David Tweedie, who Chairs
the International Accounting Standards Board.
I want to congratulate all of you for looking beyond the
immediate crisis for what the implications are for legislation
or otherwise, in this area that is so important to the
operation of financial markets and capitalism.
Senator Enzi referred to the importance of young people
coming into what we used to think of, anyway, as a noble
profession. I think that this kind of captures the heart of the
issue because I hear a lot of complaints that young people do
not want to come into this particular profession right now,
relative to the attractions of others. I think if we are going
to have a sound auditing and accounting system, it has to be
something that people do want to come into and serve.
When this session was arranged some weeks ago, the
intention was to concentrate mainly on the relevance of the
work of the IASB and its associated bodies to the evident
problems besetting the accounting and auditing professions.
Those problems, 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.
Those qualities, as some of you have emphasized, are
essential attributes of a capital market and financial system
in which investors can place confidence and which can
efficiently allocate capital. The implications extend far
beyond the shores of the United States.
We have long seen our markets, and our accounting systems,
as models for the world, as Senator Gramm indicated, a world in
which capital should be able to move freely to those places
where it can be used most effectively and it can become a
driving force for economic growth and productivity. In fact, a
large portion of international capital now flows through our
markets. We have been critical of the relative weakness of
accounting and auditing standards in many other countries,
arguing that those weaknesses have contributed to the
volatility, inefficiency, and breakdown of the financial
systems of so-called emerging economies.
How ironic that, at this point in economic history when the
performance of the American economy and financial markets has
been so seemingly successful, we are faced with such doubts and
questions about a system of accounting and auditing in which we
have taken so much pride, threatening the credibility and
confidence essential to well-functioning markets.
To my mind, we can extract some good news in all of this.
Our eyes have been opened to festering issues that have for too
long been swept aside or dealt with ineffectively. We now have
the opportunity for bringing our performance to a level that
matches our words--to practice what we preach.
For most of my professional life, I have been a consumer--
sometimes a very critical consumer--of accounting and auditing
reports rather than a participant in the process. That began to
change when I agreed to Chair the newly restructured
International Accounting Standards Committee some 18 months
ago. The main responsibilities of that Committee--modeled
substantially on the Financial Accounting Foundation in the
United States--are to appoint the standard setting body Chaired
by Sir David, to obtain finance for its work, and to exercise
broad oversight over the effort.
The Committee I Chair does not engage in the technical
work--we do not set, or advise on, the standards themselves. I
am not and never have been an auditor. But as Yogi Berra once
said, ``you can observe quite a lot just by watching,'' and
there has been a great deal to watch.
I have attached to this statement excerpts from two earlier
statements of mine that reflect my growing concerns. The fact
is the accounting profession has been hard-pressed to keep up
with the growing complexity of business and finance, with its
mind-bending complications of abstruse derivatives, seemingly
endless varieties of securitizations, and multiplying off
balance sheet entities. The new profession of financial
engineering is exercising enormous ingenuity in finding ways
around established accounting conventions or tax regulations.
In the rapidly globalizing world of finance, different
accounting standards and methods of enforcement in different
jurisdictions present increasing hazards.
Underneath it all, many have a sense that I share: In the
midst of the great prosperity and boom of the 1990's, there has
been a certain erosion of professional, managerial, and ethical
standards and safeguards. The pressure on management to meet
market expectations, to keep earnings rising quarter by quarter
or year by year, to measure success by one ``bottom line'' has
led, consciously or not, to compromises at the expense of the
public interest in full, accurate, and timely financial
reporting.
I think of good financial reporting as resting on three
pillars: First, accounting standards setting out with clarity
logically consistent and comprehensive ``rules of the game''
that reasonably reflect underlying economic reality. Second,
accounting and auditing practices and policies able to
translate those standards into accurate, understandable, and
timely reports by individual public companies. Third, a
legislative and regulatory framework capable of providing and
of maintaining needed discipline.
It is the first of those pillars with which I have been
directly involved over the past 18 months.
The general case for international accounting standards has
been clear for a long time. In a world of global finance, we
have strong interest in encouraging high-quality standards
every place our companies do business. We want to be sure
foreign-based companies desiring access to our well-developed
market provide the kind of information that our investors want
and need. We also want to avoid distortions in the
international flow of capital because of misinformation or lack
of information. Not least, a single set of standards would
minimize compliance costs for companies and, I believe, assist
enforcement.
Our American view has been that those objectives could be
substantially attained simply by insisting all companies
approaching our markets use U.S. GAAP--that is, American
accounting principles. But that approach could, in my judgment,
never be fully adequate. Other countries will not easily agree
``Made in America'' is necessarily best. Coverage will not be
complete or uniform. For instance, Europe will insist on
international standards, and many countries will simply be
incapable of, or drag their feet on, good quality national
standards.
Recent events drive home another point. Taken as a whole,
the U.S. standards may, indeed, still be the most comprehensive
and best quality in the world. But plainly, the auditing
processes and the standards in this country themselves need
review.
Much has been made of the time that standard setters take
adapting their standards to current business developments and
needs. Conversely, there are claims of inadequate consultation,
and those perceiving harm to their interests threaten
withdrawal of financial support or lobby their legislators for
preemptive action. In such a charged environment, one can see
that in the United States, as well as elsewhere, that change is
too slow and suspicions of political compromise damage
confidence in the process.
In this context, there is a real opportunity for a
reinvigorated international effort. A new highly professional
organization is in place, symbolized and led by Sir David here.
It has strong backing from industry and governments around the
world. Given its strong staffing and organizational safeguards,
the IASC framework should be able to maintain high credibility.
In its key components--the oversight committee I Chair, the
standard setting board Chaired by Sir David, its advisory
council and interpretations committee--it can command the best
professional advice, international representation, and not
least, appropriate independence.
Sir David will speak more directly to the substance and
priority of the work. However, I personally want to assure you
that our intent is to move beyond compromise among existing
standards or convergence for convergence's sake. Instead, we
will work with the FASB and standard setters in other countries
to choose among, and to adapt the best of, what exists. When
necessary, we will innovate and develop new approaches.
Time is a luxury that we cannot afford. We have known for
some time, the European Union will require publicly-traded
European Union companies to report their consolidated financial
statements according to international accounting standards by
2005. In other countries, there is an evident need for faster
progress. And now American experience underscores the urgent
need for a fresh look in some crucial areas.
As Sir David will report, the IASB already is considering
many of the items in the headlines today-- consistency in
defining operating earnings and pro forma statements, special
purpose entities, mark-to-market or ``fair value'' accounting,
and stock options.
You might ask where the FASB fits into the process I
describe. I do not believe that we face an ``either/or''
proposition between U.S. GAAP and international standards. In
fact, the FASB and IASB are working together on many of these
issues with the objective and expectation of reaching the same
conclusion. The result should be convergence and significant
improvement in both bodies of standards.
Broadly accepted, up-to-date international standards will
help discipline the auditing process and encourage effective
and consistent enforcement by national and international
authorities.
Yet there is no escaping the fact, in the end, the accuracy
and reliance of financial reporting lies in the hands of the
auditors themselves. They are the ones who must interpret and
apply the standards and protect their integrity. They are the
ones to which the investing public must look to ask the tough
questions, to demand the answers and to faithfully certify that
at the end of the day--or the quarter or year--the financial
results of a company are fully and clearly reported.
As you are aware, I have recently agreed with Andersen
International to Chair an Independent Oversight Board, with
broad responsibilities to work with the company in reviewing
and reforming its auditing practices and, if necessary, to
mandate such auditing practices and policies.
My hope is that, out of the current turmoil and
questioning, Arthur Andersen will again assume a position of
leadership in the auditing profession right around the world.
I do not minimize the challenge. Auditors individually and
in the auditing profession generally have been subject to
strong and conflicting pressures. Company management urgently
wants to meet market expectation to present results in the most
favorable light and to demonstrate a consistent pattern of
earnings.
Too often the emphasis is on finding ways to meet the
letter of the technical accounting requirements at the risk of
violating the spirit. Large and profitable consulting
assignments may, even subconsciously, affect auditor judgment.
Companies want to minimize accounting costs. Directors and
auditing committees may not be sufficiently knowledgeable or
attentive--that is, until it is too late.
All this raises questions of the internal management and
policies of auditing firms, matters with which I am only
beginning to grapple. How can the auditing functions and the
``technical'' accounting decisions be protected from extraneous
influence? Can strong safeguards be put in place against other
business interests intruding on the auditing process? What are
the appropriate limits on nonauditing services performed by an
auditing firm to avoid the perception or reality of an
unacceptable conflict?
Finally, high-quality standards and improved audit
practices should go a long way toward easing enforcement.
However, there are areas where it may be difficult or
impossible for any one firm to proceed alone. Hence, there is a
need for official regulation.
The United States has a framework for regulation and
enforcement in the SEC. Over the years, there have also been
repeated efforts to provide oversight by industry or industry/
public member boards. By and large, I think we have to conclude
that those efforts at self-regulation have been very
unsatisfactory. Thus, experience strongly suggests that
governmental oversight, with investigation and enforcement
powers, is necessary to assure discipline.
I can assure you in my roles both at the IASC and Andersen
that I will continue to work closely with Government officials
here and abroad in order to encourage more effective
enforcement. One imperative is for governments, including the
United States, to provide adequate financial resources to
regulators. I also believe this Committee will want to explore
means for providing more backbone for industry oversight,
either through legislation or by encouraging exercise of SEC
regulatory authority. Better means of identifying professional
misconduct, with the possibility of meaningful fines and
withdrawal of professional licenses, appears essential.
A positive step in this direction is being taken by the
European Union in its effort to rationalize their securities
laws and centralize their enforcement. We should encourage
other countries, through the International Organization of
Securities Commission and otherwise, to bolster enforcement
mechanisms in other countries, developed and emerging alike.
The crisis in the accounting and in the auditing
professions is not a matter of the failure of a single company
or perceived problems in a single audit. It demands attention
to fundamental flaws basically reflecting the growing
complexities of capital markets and pressures on individuals
and their companies to improve financial results.
To fail to respond to that challenge would, indeed, have
serious implications for maintaining confidence in markets, for
the cost of capital and for the global economy.
The United States has long had a leading role among the
world financial markets, in financial reporting, and in the
regulation and surveillance of these markets. Constructive work
of your Committee and the Congress will be vital in maintaining
that leadership. I also urge that you recognize, in an open and
interdependent world economy with increasingly fluid capital
markets, effective leadership, must necessarily involve close
cooperation with others interested in full, accurate, and
timely financial reporting. The development of truly
international accounting standards--building on the best that
now exists and responsive to new needs--can be and should be a
key element in the needed reforms.
The restructured IASC is in large part a result of
initiatives taken by the SEC itself and supported by the
leadership of FASB.
I trust that support will not weaken. Rather, as you
examine the implications of the current crisis and the range of
appropriate remedies, I hope that you will help reinforce the
effort to reach international convergence, recognizing its
potential for improving accounting and auditing practices in
the United States, as well as in other countries.
Thank you very much, Mr. Chairman.
Chairman Sarbanes. Thank you very much, Chairman Volcker.
Sir David, we would be happy now to turn to you. We very
much appreciate the very comprehensive statement you have
submitted to the Committee. The entire statement will be
included in the record. If you could summarize it so that we
can get to the question period, we would appreciate that very
much. I know that a great deal of effort went into it, and we
are most appreciative for that work.
STATEMENT OF SIR DAVID TWEEDIE
CHAIRMAN
INTERNATIONAL ACCOUNTING STANDARDS BOARD
FORMER CHAIRMAN
UNITED KINGDOM'S ACCOUNTING STANDARDS BOARD
Sir David Tweedie. Thank you, Mr. Chairman, Senators.
May I say what a great pleasure it is to be back in the
Colonies, and to----
[Laughter.]
--have an opportunity now to share my thoughts on----
Chairman Sarbanes. The witness's time has expired.
[Laughter.]
Sir David Tweedie. And to have an opportunity to share my
thoughts on some accounting matters that obviously have become
the focus of much recent attention.
As you say, sir, I have submitted a written document that
provides background information on the International Accounting
Standards Board, how we inherited the international standards
of our predecessor body, the International Accounting Standards
Committee, and how that body was converted into the
International Accounting Standards Board, due, as Mr. Volcker
has already said, in no small measure to the initiatives of the
FASB and the SEC. In fact, the Board would not exist without
those two bodies pressing for its creation.
Both of these organizations recognize that no matter how
good the U.S. accounting standards were, the international
community would be unlikely to accept that seven highly skilled
Americans sitting in Connecticut and subject to American
domestic considerations could set the rules for the rest of the
world.
If I could paraphrase a phrase of your own history, ``no
accounting without representation.''
[Laughter.]
For the sake of time, I hope you will excuse me if I do not
speak directly from my written submission, but I will just
mention one or two points and obviously be happy to answer any
questions.
Our objective is very straightforward. It is to work toward
a single set of high-quality global accounting standards
produced in the private sector and the principles of
transparency, open meetings and full due process.
We should make it clear that we have absolutely no
intention to water down existing standards in any jurisdiction,
and that of course includes the United States. Instead, we plan
to build a set of financial reporting standards that come to be
viewed as the gold standard worldwide.
Why did we set up the International Accounting Standards
Board?
Well, as the former Chairman of the United Kingdom's
Accounting Standards Board, and now as Chairman of the IASB, I
think that there are four reasons that led to the new
organization.
First, the existence of multiple and sometimes unknown sets
of accounting standards increases uncertainty and drives up the
cost of capital. Even if there were no systematic increase in
the overall cost of capital, the uncertainty created by
multiple sets of financial reporting standards would be likely
to lead to a misallocation of capital among market
participants. Capital tends to gravitate to the familiar.
Second, no individual national standard setter has a
monopoly on the best solutions to accounting problems.
Third, no national standard setter driven as it must be by
domestic considerations is really in a position to set
accounting standards that gain acceptance around the world.
Fourth, there are many areas of financial reporting in
which a national standard setter, because of political
pressure, finds it difficult to act alone.
We are under no illusion. Reaching broad agreement on high-
quality standards that are globally accepted is going to be
difficult. It will require a lot of work, consultation with all
of the interested parties, and will need to be guided by sound
reasoning to avoid the temptation for compromise for the sake
of satisfying our constituents. Out of our 14 board members, 12
are full-time and they have had to resign from their
occupations with no return guaranteed, just as they have to do
in the FASB. That is to safeguard their independence.
We should note that we are not immune from national
political pressures. We have just begun our work, but some
common refrains have already been heard.
Some commentators have argued that if an issue has been
debated in America, then it has been resolved and we should not
look at it. Others have decided that we cannot have standards
that are tougher than the American standards. We are going to
ignore both arguments.
American accounting standards cannot impose a ceiling on
our efforts. If we have perceived deficiencies in American
standards, we intend to ensure that the international one does
not have the same weaknesses.
We must be able to assess with open minds the major issues
facing accounting today and base our solutions on sound
reasoning, not political and national concerns. If we did not,
there is no reason to have an independent international
standard setter.
We have said if the U.S. standards are the ceiling, then
they should become the international standards because all we
could do is match them or even be worse. And we intend to do
better.
We are not going at this alone. National standard setters,
including the FASB, are a critical part of our activities. We
are looking to them and, in particular, seven of them. In our
board, we have a liaison member with each of the standard
setters of the United States, Canada, United Kingdom,
Australia, Japan, France, and Germany.
The American representative, Mr. Leisenring, is sitting
behind me on my left, unnervingly close, I might say, and he is
going to take our views from the international board into FASB,
discuss them with FASB, bring FASB's views back, and so we hope
to have an interaction with the national standard setters.
We are looking to the national standard setters for
research and counsel, to alert us to particular problems and to
help in our due process.
We are also going to ask them to be our partners in several
of our projects, enabling us to make use of their resources.
This is a worldwide, collaborative effort to improve financial
reporting in all countries, the USA included.
Of our 14 members, five are from the United States--two, I
may say, are British rejects, having been born in the United
Kingdom. But the United States is obviously heavily
represented.
How do international standards differ from American
standards?
Many stories in the press are focused on whether standards
other than those of the FASB would have stopped Enron's
collapse. I do not plan to comment on specific accounting and
auditing issues surrounding Enron, although there are many.
None of us in the United Kingdom knows enough about the
specifics of the transactions, the information available to the
auditors, the judgments involved, to form a solid professional
opinion.
As we learn more, we may find that the U.S. standards
should be improved. But we may find that the standards were
perfectly satisfactory and had not been implemented properly.
If so, we plan to learn from the case if improvements are
needed and to make sure that the international standards do not
have similar problems.
Many international standards are similar to U.S. GAAP. Both
international and American standards strive to be principle-
based, in that they both look to a body of accounting concepts.
American standards, however, tend on the whole to be more
specific in requirement and include much more detailed
implementation guidance. That is partly because of the
litigious nature of the USA. Auditors have demanded extra rules
to help them protect themselves. Companies have asked for rules
so that they know exactly where they stand. Regulators have
often liked bright lines so that they can regulate with
certainty.
For better or worse, many observing the standard setting
scene, have described this as the difference between principles
and rule-based standards.
The IASB has concluded that a body of detailed guidance
encourages a rulebook mentality of ``where does it say that I
cannot do that?'' We take the view that this is counter-
productive and helps those who are intent on finding ways
around standards more than it can help those seeking to apply
standards in a way that gives useful information. Put simply,
detailed guidance may obscure rather than highlight the
underlying principle.
To illustrate, it is often easier if you are trying to deal
with a particular transaction not to make a rule for that
transaction. If, for example, you said if A, B, and C happens,
the accounting is X, we know that before long, someone will
invent B, C, and D and say that they are not covered by the
standard. Rather, it is better to have a principle and use A,
B, and C as merely an example, and by that way, hopefully, you
will catch the following transactions.
We favor an approach that requires the company and its
auditor to step back and consider whether the accounting
suggested is consistent with the underlying principle. This is
not a soft option.
Writing standards in that manner requires a strong
commitment from preparers that their accounts provide a
faithful representation of all transactions and a strong
commitment from auditors to resist client pressures to accept
accounting that does not give a fair presentation. It won't
work without those commitments, commitments that can be
strengthened by a top-class enforcement organization such as
the SEC.
Under our system, there will be more individual
transactions and structures that are not explicitly addressed.
We hope that a clear statement of the underlying principles
will allow companies and auditors to deal with these situations
without becoming entangled in a web of detailed rules, rules
which can allow the unscrupulous to game the standards.
In the international standards, fair presentation is the
key. You can, as the standards are presently written, depart
from an international standard if obeying it would give false
and misleading presentation. But that is only in the unique
situation of the company, not because it prefers another method
which is not in the standard. The problem is policing that. In
some jurisdictions, companies may try to use that allowed
departure to avoid standards. We have to make sure that it is
complete exception rather than a common occurrence.
Our agenda--we began work officially in April 2001, but,
actually, by the time we got staff, in September of last year.
We intend to move in our work program rapidly.
In our first year, we are focused on improving the existing
corpus of standards. We are clarifying many to respond to
comments from securities regulators and national standards
setters.
We are removing alternatives where they weaken reporting
requirements. And we are trying, therefore, to bring the
standards we inherited into line with best international
practice.
We have a particular urgency, as Mr. Volcker has
highlighted, by the fact that European companies will have to
conform to these standards by 2005.
Other projects on our agenda aim toward leadership and
offer convergence or provide easier application of existing
standards. Many of the issues feature prominently in today's
headlines--business combinations, performance reporting, share-
based payments, including employee options, and insurance
contracts.
Our research agenda deals with 16 other subjects that are
being dealt with by one or more of our partner national
standard setters. We are working with them, monitoring their
efforts in order to ensure that differences among national
standard setters and with the IASB, are identified and resolved
as quickly as possible.
We expect to move several of these issues onto our active
agenda as time and resources permit. My written statement
elaborates on these research projects.
We are shortly to set up what we call a convergence working
party, which will look at the main differences in particular
between the American standards and international standards, to
see if we can agree which method is the better and, if not, if
neither are very good, finding another one.
There are common threads that run through most of the
topics in our active and research agenda. Each represents a
broad topic that has occupied the best accounting minds in many
countries for several years. It is now time to come to closure
on many of these issues.
The accounting issue that is prominent in people's minds is
the topic of off balance sheet items. During the last 20 years,
a number of attempts by companies have been to remove assets
and liabilities from balance sheets through transactions that
may obscure the economic substance of the company's financial
position. This is not just related to special-purpose entities,
but also to leasing transactions, securitizations, and
pensions.
Similarly, there are off income statement items. Under
existing accounting standards in many jurisdictions, a company
that pays for goods and services through its own stock or
through options does not record any cost for those goods or
services. The most common form of this is employee share
options.
In 1995, after what it called an extraordinary
controversial debate, the FASB issued a standard that in most
cases in the United States required disclosure of the effect of
employee stock options, but doesn't require a charge through
the income statement.
Most jurisdictions have no standards on accounting of
share-based payments, and use of this technique is growing
outside of the United States. We have still to reach
conclusions on this issue, but our early indications are that
we do believe that this is an expense that has to be charged to
the income statement.
Under existing accounting standards in most jurisdictions,
assets and liabilities are reported in amounts based on a
mixture of accounting measurements. Some are based on
historical transaction prices, perhaps adjusted for
depreciation. Others on fair values, using either amounts
observed in the marketplace or estimates.
Accountants refer to this as a mixed attribute model. It is
becoming increasingly clear that this mixed attribute model
creates complexity and opportunities for accounting arbitrage.
Some have suggested that financial reporting should move to a
system where all financial instruments are at fair value, and
we are obviously going to have to examine that.
Under existing accounting standards, the cost of an
intangible asset, a copyright or the like, purchased from a
third party is capitalized as an asset. This is the same as for
required tangible assets, buildings, and machines.
Existing accounting standards extend this approach to self-
constructed tangible assets, so a company creating its own
building capitalizes the costs. We do not, however, do that
with intangible assets. Many have criticized this
inconsistency, especially at a time when intangibles are
drivers of performance.
In conclusion, sir, as I said at the outset, our objective
is to work toward a single set of high-quality international
financial reporting standards. The international financial
markets clearly want a single set of standards that apply
worldwide.
We do not intend to water down existing standards in any
jurisdiction. This is not the lowest-common denominator.
Instead, we plan to build a set of financial reporting
standards that, as I said, are the gold standard. We intend to
pick the best of the available standards produced by national
standard setters.
No single group has a monopoly on the best of accounting.
We expect to learn from our colleagues. To the extent that the
underlying rationale in U.S. GAAP is the best available, we
intend to incorporate it into international standards.
To the extent that another standard has a superior
approach, we intend to adopt it. If no national standard
adequately addresses the problem, as may be the case of
accounting for leases or share-based payments, we plan to work
toward a new international standard that does.
We want to base our standards upon clear principles rather
than rules that attempt to cover every eventuality. I hope that
we can keep to the plan, but success will depend upon the
professionalism and judgment of financial statements'
preparers, auditors and securities regulators.
Our work is going to require tough decisions and unpopular
standards. Assets and liabilities that companies have moved off
balance sheet will more than likely move back on. Expenses that
today go unrecognized may be recognized in companies' income
statements. Measurements may move gradually from historical to
more current information.
The United States and, indeed, the whole world, has been
shocked by the scale and speed of the Enron collapse. We who
are on the outside learn a little more every day, but it still
remains to be seen whether financial reporting that preceded
Enron's collapse was the result of flawed accounting standards,
incorrect application of accounting standards, auditing
mistakes, or plain deceit.
We have an obligation to the investors, to the employees,
and to the others who suffered to ensure to the best of our
ability that the lessons are learned. If there are weaknesses
in accounting standards, we have to acknowledge that fact and
come forward with improvements.
In partnership with the FASB and the SEC and others, we
intend to change financial reporting. In some cases, that
change is going to be dramatic, especially for countries
without the advanced standards and financial infrastructure
found in the United States.
Most of those changes are going to be controversial, even
in this country. You and your colleagues will be asked to stop
their implementation, I am absolutely sure, in the United
States. I hope that you can resist these requests. Global
accounting standards do not create a national disadvantage and
we have to work toward solid, robust standards, not partial
compromises that investors can trust. The markets in the United
States and worldwide require and deserve no less.
Thank you, sir.
Chairman Sarbanes. Thank you very much, Sir David.
We have been joined by a number of our colleagues and I am
going to yield to them for their opening statements before we
go to the questioning.
Chairman Sarbanes. Senator Shelby.
COMMENTS OF SENATOR RICHARD C. SHELBY
Senator Shelby. I will be real brief. I was very interested
and I just want to repeat what was part of my opening
statement, what Dr. Volcker said.
He said: ``We have had too many restatements of earnings,
too many doubts about pro forma earnings, too many sudden
charges of billions of dollars to goodwill, 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.''
I could not say it as well as you have, Dr. Volcker.
Thank you.
Chairman Sarbanes. Thank you, Senator Shelby.
Senator Carper.
COMMENTS OF SENATOR THOMAS R. CARPER
Senator Carper. I have no opening statement. But I just
want to say welcome to Sir David and to Sir Paul. It is great
to have both of you here and we are delighted you are here.
Sir David, thank you for bringing your sense of humor with
you on this side of the pond.
Chairman Sarbanes. We cannot call him Sir Paul. Rudy
Guliani went over there and was knighted, but he cannot be
called Sir Rudy. It is contrary to American statute.
[Laughter.]
Senator Gramm. Sir Rudy does not sound right.
[Laughter.]
Chairman Sarbanes. I am not going to get into that
argument.
[Laughter.]
Senator Akaka.
COMMENTS OF SENATOR DANIEL K. AKAKA
Senator Akaka. Thank you, Mr. Chairman.
Across the country, expanded participation in the financial
markets has provided increased opportunities for individuals to
build wealth. In my State of Hawaii, like other places, over
half of all households own stock. Investing decisions are
already extremely complex. When information provided by
companies is false, investors are not given the opportunity to
make informed decisions. False information can lead to losses
which destroy the wealth of the investors.
Protecting investors from misleading financial statements
must be a global effort as direct investment barriers have
fallen and international markets provide additional
opportunities for capital appreciation and diversification.
Special purpose entities, pro forma profits, and opaque
bookkeeping practices have the potential to confuse and mislead
United States and foreign investors.
We must all work together to improve the transparency of
corporate activities and to ensure that investors are provided
reliable information to use in making their investment
decisions.
I want to thank Chairman Paul Volcker and Sir David Tweedie
for joining us today. I look forward to the questions and to
the recommendations on what can be done to restore the shaken
confidence of investors.
Thank you very much, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Akaka.
Chairman Volcker, I am looking at a newspaper headline
right here, a dangerous thing to look at on occasion: ``Volcker
Sought Enron Funds For Accounting Board.'' It is your effort to
obtain contributions to the International Accounting Standards
Board's Foundation to carry on its work. Of course, that
obviously raises the question, how do we fund these boards and
how do we gain their independence? Why don't you tell us a
little bit about this process and what your thoughts are?
Mr. Volcker. The basic question is how we fund these
boards.
The international arrangements were set up pretty much on
the model of FASB. There are two sources of income, including,
selling the standards themselves, and an explanation in our
case such sales are limited at this stage. In FASB, it accounts
for more than half of that revenues. Since many, many
accountants and auditors need to have these, it is a source of
revenue. The rest of it is financed by contributions from
industry.
We started fresh with contributions from industry. Just to
give you a picture of what we have done, we started at the end
of 2000, the beginning of 2001. We solicited approximately 300
of the largest companies around the world. I wrote to them, or
my associate trustees wrote to them in other countries. We are
in the process of soliciting actually an additional 150 now,
another tier. We have had a pretty good response.
Our expenses we estimated at about $15 million a year. We
have that covered in the early years from these initial
solicitations. About 150 almost, corporations have contributed.
The major accounting firms are picking up about a third of the
tab.
I might point out in connection with the interest in this
effort, we have contributions from over 30 central banks and
international institutions that are interested in this effort
and wanted to indicate their support with relatively small
contributions.
But together, that comes to over a million dollars.
We have a wide variety of contributors. We will be
publishing the list of contributors in our annual report that
will be out shortly.
Enron was one of the companies, as a big American company
that was routinely solicited in, apparently, the first wave of
letters that I sent out.
As it turns out, about a third of our funding comes from
the United States, about a third from Europe, about a third
from Japan, Latin America, and others.
I think it is apparent that it is pretty diffuse.
Consistent with what I said in the statement, I have always
looked at this international effort as providing better
protection against so-called special interests than even the
American approach, because of the variety of support and the
variety of the different countries participating. It is
supported by the official community very vigorously.
The concern about financing is kind of ironic because the
concern of the trustees during most of this period has not
been, whether we were sufficiently independent and insulated
from special interests, but whether there, in fact, would be
adequate consultation with preparers, users, and all the
interested parties.
We have gone to considerable efforts to make sure that the
Board, before acting, does extensive consultation. And there is
a particular official advisory body. We started out thinking
that would be about 30. These are industry people--preparers,
users, academics, and others. We started out thinking we might
appoint about 30 in an advisory body. We ended up with 50
because we wanted to make sure that people with a legitimate
interest will be heard and will interact with the Board so that
all points of view can be reflected.
I think that is essentially the story, Mr. Chairman.
Chairman Sarbanes. Let me ask both of you this question.
Shouldn't we give some thought to some way of financing
these activities that has an automatic nature to them. Some
levy that may be placed on one or another of the economic
transactions or economic activities that takes place which
would automatically engender a revenue stream, rather than rely
on contribution?
The FASB has to do the same thing. They go around with a
tin cup soliciting contributions and then, of course, you get
this sort of perception on the part of some, as some of the
Enron people obviously had, that this was going to give them
special access and special influence.
Mr. Volcker. I must say, I have gotten the answer since
yesterday. Enron, I understand, finally agreed to give us one
half of what we asked them for and suggested we send them along
an invoice. We sent them along an invoice. We have not gotten
any money.
[Laughter.]
I do not think there will be any undue influence on that
avenue.
[Laughter.]
The question you ask has obviously been on my mind. Some
people like to raise money. I find it distasteful when I have
to send out a lot of letters. But it raises the question, what
can you do?
I do not think the idea of official financing as a matter
of, say, Congressional appropriations, has seemed really
appropriate. I do not think we want a UN kind of situation.
The only other thing that anyone has thought of, I think,
is some kind of listing contributions--stock exchanges
contribute depending upon their listings or companies listing
might have a mandatory contribution.
I am not sure that this has been explored as much as it
might. But I will tell you there is no enthusiasm on the part
of stock exchange or listing companies to do it. And to do it
fairly, you would have to do it pretty comprehensively around
the world.
I think that is an avenue that could be explored.
Ultimately, we thought we would get effective financing
over a period of time from sale of the publications. We have
had a big hole blown in that possibility because the European
Union, which wants to adopt international accounting standards
and put it in European law, says once it is in European law, we
cannot charge--we cannot have our companies required to follow
the standard and have to pay to find out what the standard is.
We have had some rather elaborate negotiations with the
European Union as to how to preserve some kind of a copyright,
which are ongoing. But that will have an important influence on
our funding in the future.
Chairman Sarbanes. Sir David, how did the UK fund your
activities when you did the UK work?
Sir David Tweedie. Well, sir, the International Accounting
Standards Board, was funded from three main sources. The
government gave a third. That did not buy them influence. The
Chancellor, Gordon Brown, and I clashed on numerous occasions,
but there was never any threat to withdraw the money. A third
came from the accounting institutes, the equivalent of the
AICPA. And one third came from the City of London. That was
about half from the Bank of England, which is the central bank,
who collected it from the other banks. And the rest mainly from
the stock exchange. And I think they put a small levy on the
listing fees.
Chairman Sarbanes. I am interested in that small levy on
the listing fees. I am going to give heart pain to some of my
colleagues, but we just lifted fees to the tune of $15 billion
over 10 years. That is about $1\1/2\ billion a year if you
assumed it was constant. It may not be altogether a correct
assumption. A fairly tiny portion of that on a regularized
basis would fund these activities.
It seems to me that the UK arrangement sounds more likely
to produce independence and removal from either private
interest pressure or public pressure reflecting private
interest influence. We have seen that happen here.
Private interests go hard at FASB and if they do not seem
to be getting anywhere, then they go hard at the Congress to
get the Congress to go hard at FASB.
So, I think this is something that we need to give a lot of
thought to because if we can get a structure that sustains
independence, in terms of how it is chosen and who serves, and
a financing that maintains independence, it would be an
important contribution. That is one of the things that we have
to look at.
I have run over my time.
Senator Gramm.
Senator Gramm. Thank you, Mr. Chairman.
I want to thank both of you for your testimony. I thought
both testimonies were excellent.
When I was an accounting student, now a long, long time
ago, these issues seemed very simple. But when I came to the
Senate and started dealing with the question, at least hearing
from constituents and talking to FASB and my colleagues about
how you account for stock options. Should that be charged
against current income? Is it a dilution of ownership, and if
it is, how do you account for it?
The whole question of derivatives--closed-in or open-ended,
depending on whether the derivative is related to another
potential liability you have. And then the whole question of
auditor independence. These issues turned out to be a lot more
complicated than that accounting class I took in 1961 might
have suggested going in. Maybe I should have taken more
courses, but I hated that practice set you had to do in the
second course.
[Laughter.]
That determined that I did not want to be an accountant. My
mother did not think I had the personality for it.
[Laughter.]
But in any case, one of the positions that I have taken
consistently is that I have not always agreed with FASB, but I
have always believed that whatever FASB thought, I was more
confident in FASB setting standards than I was confident in
Congress setting standards.
I have not always agreed with the SEC. I thought our dear
friend, Arthur Levitt--and very few people who served in
Government I respect more than Arthur Levitt--was too involved
in accounting standards.
He once told me that he talked to the head of FASB all the
time, had his home number. I said to him, Arthur, the fact that
you know his home number to me I think is probably an
indication of a problem.
But I always made it very clear to Arthur Levitt that if it
came down to a choice between setting accounting standards in
Congress or having Arthur Levitt set it, whether I agreed with
it or not, I would rather Arthur Levitt set it than Congress.
So here is my question.
As we begin to look at reforms, ultimately, we are going to
have to ask ourselves how are we going to implement these
accounting reforms? Are we going to mandate new standards of
accounting in Congress?
I think there is one CPA in Congress. If there is more than
one, I do not know it. And that is our dear colleague here.
So are we going to try to give a directive to the SEC and
are they going to set accounting standards? Are we going to try
to find a way to insulate FASB so that they might be more
independent in setting standards? I would like to get your
thoughts on that. I do not think it is a trivial question. I
think it is one that we are going to have to come to grips with
as we get into this, and it is one that I have some concern
about.
Mr. Volcker. Let me take a crack at it. But, first, your
own experience reminds me I have a little card from my old
college roommate saying, finally, that course in Accounting 101
is paying off.
[Laughter.]
But it is not paying off very well because it was much
simpler, as you say, than what we have here.
[Laughter.]
Look, I think you need some mechanism for getting an
independent board, institute, whatever, to set the standards.
It is a very complicated matter. If what is going on now
doesn't illustrate anything else, it illustrates how
complicated this stuff is. And so, you need some kind of an
independent board. I do not know if anybody has come up with a
better framework than FASB. But now, on an international level,
which I do think gives by its very nature additional levels of
protection.
I have, maybe wrongly, not been so worried or worried at
all about influence of individual companies, which are so
diluted. But to the extent I, as Chairman of the Trustees of
this effort, have been under any pressure at all, it has come
through the political process.
And so, the international dimension I think does provide
some protection. We have kind of layers of protection. We as
Trustees are supposed to be protecting the independence of Sir
David's Board. The nature of the Board itself is experts. The
Constitution emphasizes again and again independence and
expertise. That is the basis for choosing these people.
I think by any evidence, people on the Board that Sir David
Chairs are accounting experts. As I say, part of our concern
was that these experts not be off there in an ivory tower so
insulated from the rest of the world, they are not listening to
the real problems of users and preparers.
So, we seek some kind of a balance. If we can get a better
financing system that makes people feel more comfortable and
requires me to write fewer letters, I would be all in favor of
that.
Senator Gramm. I appreciate your comments about
consultation versus independence. There are some people who
naively believe that the best way to have independence is to
have these decisionmakers never talk to anybody. That does
produce independence. On the other hand, it produces an
intolerable, unworkable system.
Mr. Volcker. Their meetings are in public and the meetings
with the advisory board are in public, which is I think an
additional element of protection that leads to cumbersomeness,
no doubt. But it is meant to provide additional degrees of
protection.
Chairman Sarbanes. Sir David, could you give the Committee
a short memo on the funding of the United Kingdom's Accounting
Standards Board, that we discussed right at the end of that
question. If it is not too much of an imposition, if you could
send us a piece of paper detailing it, I think that would be
helpful to us.
Sir David Tweedie. Certainly.
Chairman Sarbanes. Senator Carper.
Senator Carper. Thank you, Mr. Chairman.
Senator Gramm mentioned that he had taken that one
accounting course and his mom just said he did not have the
personality to be an accountant. I took one accounting course
myself in business school a few years ago, about the same time
that Phil Gramm was taking his course. I did not find it
especially simple at the time and God knows, it has gotten more
complex as time has gone by.
We are, for the most part by nature, generalists here in
the Senate, as you know. We have some people who do bring
particular expertises and, in the case of Senator Enzi, it is
in accounting and auditing. In the case of Senator Bunning, it
is a good fastball. And Senator Zell Miller over here is a
great writer. We all have our special strengths, but we are
generalists, for the most part.
I listened to your testimony and we are grateful for the
time and the thought that you have put into it. But we have to
assimilate what you are saying and what we are receiving from a
lot of other sources, and try to decide and convince our
colleagues what is the right thing to do.
And the incident, the focus of our attention, is Enron. But
as you know, there is a world of companies that have investors
nervous and the practices of auditing firms have us concerned.
Let me ask you to put yourselves in our shoes for a moment,
and just make it real simple for us. If you were in our role,
in our shoes, what would you do? Some are saying that we ought
to act regulatorily. The industry should police itself. There
are some things that maybe we should do legislatively. What
would you do, particularly with respect to the work of the
accounting firms of the world as it pertains to these issues.
How would you address them if you were in our shoes?
And Chairman Volcker, you said earlier, you were talking
about raising money from the firms around the country for a
good cause, and you mentioned how distasteful it was. I sat
here thinking, boy, he sure doesn't want to run for the U.S.
Senate.
[Laughter.]
Mr. Volcker. That is true.
[Laughter.]
Let me say what you can do. One thing is, it seems to me,
fairly obvious. I am not sure the SEC itself is sufficiently
funded and has a sufficient staff to do the review process that
it needs to do over reviewing accounting statements of
companies. That is my impression. You can look at it a little
further, but that is my clear impression. And that is something
Congress can do fairly immediately.
Chairman Sarbanes. I think that is absolutely right. And
the Chairmen who were here on Tuesday said as much. In fact, I
have written to both the President and to Chairman Pitt about
this very matter to see if we cannot immediately get a boost in
the SEC's funding, and get the funding of the provision to get
pay parity to the SEC employees with other Federal banking
regulators. They are hemorrhaging very experienced and
qualified staff because they do not have the pay parity.
Mr. Volcker. Second, I mention in my statement the need for
I think a stronger oversight board. I am no expert in this
area, but I get kind of dizzy reading reviews of the past
efforts. Whenever there has been an accounting problem in the
past, a new board is appointed and then another problem comes
along and we have another board. None of them seem to be very
effective by demonstrable lack of results, I guess.
I do think either by charge to the SEC or by direct
legislation, that there should be teeth put in an oversight
board that is not dominated by the industry, and that the board
has to have some kind of authority for punishment--for both
investigation and punishment to a degree that has not been true
in the past.
Whether the Congress should legislate on this other
controversial matter of what services should be provided by a
firm that does auditing, I think that is a critical issue, and
it is one that I have to struggle with a bit with my Andersen
hat concerns.
Some things may be fairly easy to say, but drawing the
margin between what is acceptable and desirable and what is not
is very subtle, I suspect.
I do not know how you legislate on it, but you may want to
legislate in that area and at least set some general
guidelines. But I think it is going to require administration
by other than a law because the precise guidelines are
difficult to define.
But those are the three areas I think of--money, oversight,
draw guidelines at least on what services and consultation
practices are appropriate and what are not.
I do not think you can legislate standards or you would be
in real trouble--complications, difficulties, freezing them in
place, all the rest. There may be other areas, but those are
the three that I can think of.
Senator Carper. Good, thank you.
Sir David.
Sir David Tweedie. Well, sir, I have been out of the
auditing firms for some 12 years. But the key question that I
think you have to look at is the independence of the auditor in
terms of the appointment.
Now who appoints an auditor? They are appointed normally by
the board of directors. Have they too much power in firing
them? What about the audit committee? Who appoints the audit
committee? Who is on the audit committee? How do you get on the
audit committee?
I think there is a big area, not just in the United States,
but a big area of corporate governance that has to be looked
at.
These problems have been around for 20 years. We have had
almost the perfect storm in Enron that suddenly, everyone is
looking at this issue.
I do not necessarily have the answers for you. We have had
similar problems in the United Kingdom. We have just newly set
up a new auditing foundation which has a majority of outsiders
on it. Previously, it was run by the profession and the
institutes. They have then set up a review board, which I think
is like your public oversight board, and underneath that comes
the auditing standards board, the ethics board, and the
discipline board, all of whom, if I remember rightly, have a
majority of outsiders.
So it is not as we used to call it in the UK, chaps
regulating chaps. It is actually outsiders looking at the
profession fairly hard, although there is obviously input from
the profession.
While there has been a great question mark perhaps over
U.S. standards, I think you probably need to know from the
outsiders' point of view that the United States has the best
corpus of accounting standards in the world.
That grieves me to say so, especially as I have been very
rude about some of them in the past. But, nonetheless, I think,
while not every single standard is the best, on balance, you
have a very good set of standards.
The International Board was modeled on the FASB. We have
the same due process, the same openness, and the same
independence rules. We will meet with individual companies, but
if there is more than, I think it is six board members, we must
meet in the open, so we cannot have a majority of members
present at a private meeting.
Another area that I think is very important, and I think
the Chairman rightly pointed to it, it is better if you can
keep the politics out of standards setting.
One of the advantages of an international board is we are
not subject to national political pressures. So if there were
to be a campaign, let's say, in Britain or the United States
against an accounting standard, it could not really affect us.
But it does affect the national standards setter.
I think FASB and probably the SEC regrets the situation in
1995 when they did not go ahead with what they thought was the
right standard for share options. From what I have gathered,
there was a similar problem over the savings and loans issues
where there were concessions made to the industry, which I
think independent people looking in would not have made. That
is one of the issues.
I do think it is important to keep an independent standard
setter who is going to come to the right answers, if he can. He
might get it wrong occasionally, we all do. But he is going to
try and do it without any pressure behind him. And if you can
preserve that, it is very, very important.
Mr. Volcker. I wonder if I can make just another point
here.
Chairman Sarbanes. Certainly.
Mr. Volcker. Because it occurs to me, there is an area
where you cannot legislate. Fundamentally, we are dealing with
a problem of attitudes and ethics. Why have we gotten off the
track?
It seems to be evident in the Enron situation and
elsewhere, there is great management pressure to cut corners.
How can you legislate against cutting corners?
You have a big problem of attitude here, which partly goes
to the organization of accounting firms themselves--and I put
on my Andersen hat here--this is part of what I am concerned
about, anyway. How is that company going to operate in a way
that, through its own internal attitudes and priorities, puts
emphasis on good accounting, good auditing, first and only.
Now, you just cannot pass a law and say that. You have to
have internal procedures. You have to have attitudes in that
company and attitudes by the companies that they audit.
But I would like to see growing out of this crisis a
reversal of what I think has been happening. Instead of a kind
of competition in laxity here, a competition in quality. People
should feel that they had better have a good auditing report or
the market is going to be suspicious of them and the accounting
firms that have the best reputation will get the business,
instead of the feeling you are looking for some way to cut
corners.
Senator Carper. Again, our thanks to both of you. Let me
just say in brief response to what you said, Mr. Chairman,
there is a temptation to cut corners. The leaders of our
businesses are under, in some cases, enormous pressure to
report earnings and report profits, and there just need to be
consequences when people do cut corners.
There could be consequences that could be legislative or
regulatory, but, maybe more appropriately, should be
consequences that will be brought by the market. There needs to
be consequences.
Thank you.
Chairman Sarbanes. Thank you very much, Senator Carper.
Chairman Volcker, I might note that, it seems to me the
kind of attitude you are seeking was reflected by Arthur
Andersen himself, the founder, when he established this firm.
He brought very high standards and had a vision about the role
of the accounting profession, which, unfortunately, the
institution he put into place appears to have departed from.
Before I yield to Senator Enzi, Sir David, I just want to
say, you are being very kind about U.S. standards and so forth.
But I am prompted to quote The Economist of January 19, just
not too long ago, that said: ``There is a lesson from British
experience in the 1980's when several audit scandals led to
both tougher regulation and more rigorous accounting standards.
The Enron scandal shows that America can no longer take the
preeminence of its accounting for granted.'' And I think that
is one of the challenges we are facing right now.
Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman.
I want to thank both of you for your outstanding
presentation. I also noticed from looking at the full text of
your testimony that there was some excellent coordination which
saves us a lot of time in reading it, but also gives us some
different insights.
Of course, as far as a question, my preference would be to
have Mr. Volcker just repeat what he said about ethics just a
minute ago because I think that has been one of the key
messages that has been underplayed in this whole process.
I do appreciate that both of you made comments about the
Enron situation, as far as Enron was concerned, that none of us
knows enough about the specifics of the transactions. That does
not stop the Congress from reacting, of course. I have noticed
some rules which is, if there is publicity involved, it is
worth reacting to. And then a further rule is that if it is
worth reacting to, it is worth overreacting to.
[Laughter.]
I appreciate that some actual information is being gathered
before our overreaction so we might place some constraints on
it.
I also want to congratulate the International Accounting
Standards Board for the 16 topics that are on their research
agenda and the fact that they made accounting by small and
medium entities and emerging economies one of those categories.
I do not think there is enough emphasis placed on small
business. And one of the things that I fear from what we are
doing here is that we are going to react to big business in
such as way that we are going to put small business out of
business.
And, of course, Government I think has forced business to
get bigger in order to meet governmental regulations and that
has led to some of the problems.
I always appreciate the special emphasis when it is given
for small business.
Sir David, I want to ask you, you mentioned the way that
IASB as opposed to FASB does their standards. Could you give us
a little more insight into the principle and example that you
mentioned, rather than the 800 pages of detail? I think that
was a point that you were making. Could you give us some more
insight on that?
Sir David Tweedie. Well, sir, the sort of situation that we
are thinking about is that, if you look at some, say, the
special purpose vehicles, now I do not know whether the U.S.
standards had a problem in that. We are not sure that the
international standards might not have a similar problem. We
are looking at that to see if we would have done that.
We certainly wouldn't claim for one minute that Enron could
not have happened under international standards.
I think the difference would be, perhaps, that when we are
looking at what we mean by the principle, when we try to
consolidate under international standards, as in the United
States, we go for the principle of control. Do you control the
company?
Now, in the United States, that is mainly looked upon, do
you have majority ownership?
We tend to go a bit further than that because we would say,
well, we are actually after control. So it is not just majority
ownership. Is there an agreement by which you have control? You
may have less than 50 percent of the voting shares. Even if
there is no agreement, do you have power to control the
financial and operating policies of the company? Do you control
a majority of the board appointments, the majority of the votes
on the board? If you have that, you have control and you
consolidate.
Similarly, we have situations whereby companies, as we
discovered in the United Kingdom, ran on auto-pilot. They would
give away the shares in an off balance sheet subsidiary to some
charity. The charity would have all the shares.
So, technically, the company did not own the so-called
subsidiary, but in fact, control was predetermined. The
shareholders could do nothing about it and got a minor
donation. And the aim was to go past the requirements, if you
like, of the law. We had then to say the principle is control--
if you run this, it is yours.
Now it does lead to subjectivity, and that is the issue.
So, you can have your choice, in a sense. Is it enough to say,
if you get the benefits, if you run the risks, it is yours? Or
do you have to say, what exactly do you mean by that?
And once you get into, what exactly do you mean by that,
well, if somebody has so many percent of the residual, their
equity, then it is off balance sheet. There is the rule.
Instantly, people game it.
We have a problem, if you like, with lease accounting. The
lease accounting standards worldwide are converged and none of
them work.
You have all been in aircraft, but none of you will have
been in an aircraft that is on an airline's balance sheet. They
look more like taxi companies than airlines. The reason leased
aircraft are not on balance sheets is that worldwide, the
standard more or less says, if you have the rights and benefits
of the asset over its lifetime, then it is on your balance
sheet.
We put a rule in which says, that means if you look at the
payments that you are going to make under the lease and the
present value of these equals 90 percent of the fair value of
the asset at the beginning of the lease, then it is on balance
sheet. Well, they all come in at 88 percent. So, they are off
balance sheet.
[Laughter.]
If we dropped it to 80, they would come in at 79, because
the leases are designed that way. That is the problem of a
rule. And that is not blaming the USA because we have it as
well.
When you look at it, the airlines, for example, they do not
lease an aircraft for its life. It is probably 7 years and a
penalty clause if they do not do another 7 years and so on. And
they can legitimately say, we are nowhere near 90 percent. We
only have 7 years.
But if you come back to the principles of accounting, and
we adopted these from the United States, from FASB, it is what
is a liability? Well, it is an obligation that leads to
resources leaving the organization. And you can then say to the
airline, well, have you an obligation to pay? Sure. I have 7
years to pay. Can we measure it and set it out in a contract?
Of course, we can measure it.
Well, you have a liability and on the other side, the
rights to a 747 for 7 years.
Now the leasing industry thinks this would be the end of
Western civilization as we know it. But basically, what it
would do is show you the liability that is at present off
balance sheet. That is the principle we should have.
Have you an obligation? Book it. Ninety percent rules do
not work. And we are in the UK as guilty as anybody else. That
is the thing that we are trying to change.
Senator Enzi. I really appreciate that. That was just about
as exciting as ESPN to me.
[Laughter.]
I did notice there were a few eyes that were glazing over
here.
[Laughter.]
Sir David Tweedie. We are sad people, Senator.
[Laughter.]
Senator Enzi. You made the statement in your testimony that
IASB was going to be going with principles and listing examples
and then asking the overall question of do you meet the
principle or not? I think that is some of the testimony that we
had the day before yesterday from the SEC Chairmen as well.
I really appreciate that approach and the effort that you
put into it. I see that my time is expired.
Chairman Sarbanes. Thanks, Senator Enzi.
Senator Akaka.
Senator Akaka. Thank you very much, Mr. Chairman.
Chairman Volcker, I know you have been in very high places
in the industry and in our country, so let me ask you this
simple question which goes out to the average investor. What
can be done to make financial statements easier for the average
investor to understand and utilize when making investment
decisions?
We have discussed, in prior meetings here, the need for
financial literacy and a greater understanding of the language
of the industry. My question is what can be done to make
financial statements easier for the average investor to
understand?
Mr. Volcker. That is a very good question that I have been
struggling with because I get that question from the auditors
when I think about reform of auditing. And they say, there is a
great conflict. Everyone wants simplicity. They want an answer
and they want a black and white answer. You either get whatever
the rote expression is about conforming with Generally Accepted
Accounting Principles, or you do not.
You may be conforming only in some technical or even
stretched interpretation, and it sounds just like if you are
the A-plus company in the world and full conformity. You both
pass. And if the accountant says you do not pass, the company
is probably sunk.
So there is a certain incentive to give you a passing mark,
but it does not give you the whole story. But that is
simplicity. And you look at the one profit figure.
I think the answer I have to give you in this world is that
the auditing cannot be simple, that and its more and more have
to reflect--they are going to give you an overall mark--but
they are going to more and more have to reflect in the various
notes and footnotes some of the subtleties and complexities.
Take this off balance sheet question.
Suppose something is off balance sheet. I do not think that
excuses the auditor or the company from giving a full
explanation of what the potential liability or risks may be of
participation in that off balance sheet entity. I take it from
some of the news reports that the Enron reports were not
reflecting that. That makes it more complicated.
Then, I think you have to rely upon the analyst who will
have better information and can take all the complexities into
account to give you the honest evaluation of the company, and,
of course, that has been an issue, too.
But I think it has to be a two-step process. I do not think
the auditors themselves can be expected to give you a go or
stop answer. That is not good enough. And to give something
other than go or stop, it gets more complicated. Somebody else
has to interpret that for you.
That is not a very satisfactory answer, maybe, but I think
that is reality.
Senator Akaka. Thank you for that, Mr. Chairman.
Sir David, I have been reading something about your country
and about the industry there. Again, my question is a simple
one, but it is of interest to me and the Committee. The
question is how does the collapse of the British coal mining
company, Burnett & Hallamshire, compare with the collapse of
Enron?
Sir David Tweedie. Well, sir, the scale, of course, is
rather different. But that certainly shook us. That was in the
late 1980's when that happened. That was caused by off balance
sheet deals. There were several of them. They were all hidden
in the accounts. There was off balance sheet investments of
various descriptions.
One of the problems we had was that the deals were
perfectly legal. I often use the example of the whiskey
distilleries. It was not the Burnett & Hallamshire issue. But
one of the things that you cannot do, at least I do not know
what bourbon is like, but real whiskey from Scotland----
[Laughter.]
You cannot drink it after 1 year because if you do, you
lose the bouquet and the flavor, but more likely, your power of
speech.
[Laughter.]
Basically, what happens, the distillery will sell it to a
bank, and the bank will have an option to put it back to the
distillery at the price it paid, plus interest at normal
lending rates up to the time of repurchase. And the company
would have a call option to call it back under exactly the same
terms.
A legal sale, the inventory would disappear, cash would
appear, there would be a small profit. And yet, if you looked
at what had happened, and this is where we leaned on the United
States and the FASB's concept statements, where does the
benefits lie in this asset?
Well, if the price rises, the distillery is going to take
it back to get the gain. If the price falls, the bank will
shove it back to avoid the loss. It never left the distillery
and they paid the interest quarterly. And yet, the lawyers
would tell you it was a sale.
That was just a loan secured on inventory. And that is in a
way where we had to come past and say, well, what is actually
happening here? What are the economics? Never mind the
legality.
Accounting has moved in that direction, I think, the same
way in America as it has in the United Kingdom. Burnett &
Hallamshire was a wake-up call to us, as Enron is for all of
us. We have to check and make sure that what we are doing is
right.
We are cooperating with the FASB on these special purpose
vehicles. We are looking to see what they are doing. We are
going through a series of cases that the FASB has produced to
say, would our standards stop these problems?
We may find those weaknesses, in which case we will have to
fix it. But we will almost certainly do it together.
Senator Akaka. Thank you very much. My time is expired.
Chairman Sarbanes. Thank you, Senator Akaka.
I am now going to yield to Senator Bunning for his
questions. Sir David, I would just note that Senator Bunning is
from the State of Kentucky, the home of bourbon.
[Laughter.]
Senator Bunning. Scotch, what?
[Laughter.]
Sir David Tweedie. Nectar.
[Laughter.]
Senator Bunning. Earlier, we discussed Accounting 101 and
102. I was also forced to take those classes to get an
economics degree out of Xavier University, the most boring two
classes that I have ever had in my life. Thank God there were
other things that interested me.
We quoted Yogi Berra earlier. He also has a quote: ``It
ain't over 'til it's over.'' And that is what we are trying to
get to, past what we have in front of us, past the Enron, and
past the accounting.
And in dealing with human beings, we have fraud, we have
greed, and we have plain dishonesty.
Now, I do not know how in the world that we are going to
legislate against that. I think we can come up with an
international or national standard and make them much tougher
and make, as you said, Mr. Volcker, penalties for doing those
things.
Sir David, how long do you think it would take to implement
international accounting principles and educating the Mike
Enzi's and all of those who have CPA degrees here in the United
States of America, to come up to standard, in other words? My
daughter-in-law, for instance, is a CPA. Could you give me a
clue to how that could be done and how we could come up to
standard that we could live by?
Sir David Tweedie. Well, sir, I think you are absolutely
right. We can have as many standards as we like. If there is
dishonesty and deceit, then we are in trouble. A lot of the
issue that is before us today is corporate governance, and that
is a big area, partly on the control of companies within audit
committees.
I remember when I was an auditor, sir, we had terrible
trouble with one of our major clients, one of the top 100
British companies. And as the technical partner of what was a
Big Eight in those days, firm, I remember the chairman of the
audit committee, he was an outside nonexecutive director,
asking a very sensible question, such as, where do the
accounting policies of this company fall on a scale from
totally unacceptable to the best?
We said, just within acceptable. We had a terrible fight
within the company to make sure that they did come within
acceptability. We were asked to leave. What had happened was,
the nonexecutives, well-known British industrialists, had
threatened to resign unless the company fixed the problem. So,
they fired the CFO. We had no problems the next year.
I think a lot of it is very difficult.
While you have hidden numbers in the accounts, too, I think
there are problems because part of the issue is, are you
actually reflecting what happens?
In response to your question, how long would it take, we
are identifying the differences, if you like, between American
standards and international. Now because of the U.S. work in
the 1970's and 1980's, the fundamental foundations of
accounting worldwide are based on the conceptual bases laid
down in the USA.
We adopted them in the UK. Internationally, they have been
adopted. And because of that, we have a common philosophical
core. That makes it a lot easier.
But we do have differences. What we are trying to do now is
we have highlighted probably the top six differences. We want
to try and kill those off in 3 years. And a lot of it, quite
frankly, is getting away from the old accounting, you might
have learned in your courses, which is what is called defer and
match. It is the sort of thing that leads to a situation
whereas, if, for example, a company has a final salary pension
scheme and suddenly, the stock market falls and ends up with a
deficit in the scheme, under present-day accounting in the
United States and around most of the world, you would only see
a fraction of that appearing in the accounts because it is
spread, say, over 10, 15 years.
In the UK, you would see it all, bang, very volatile.
Now that has caused a fair amount of disquiet in the UK,
but actually, it is what has happened. What I think accounting
has to do more is to tell it as it is, so we get away from
these smooth numbers, which you could not explain to your
grandmother. We have to have something that you can explain.
Show what has happened. Now let the company then say, but
this deficit in the pension fund is a temporary blip. The stock
market is going up next year. Well, let's see if people believe
them.
I think we could do quite a lot by 2005, bringing the two
sets of standards together, though, if I want to be blunt, it
does take the United States to move, as well as the
international community.
It does not have to be one way. Some of your standards are
not as good as others worldwide and we are not going to take
them.
Where does the United States go? You have to come our way
if we are going to get these harmonized. I cannot force you.
That is really entirely up to you.
But the intention is there. We have certainly had great
expressions of support from the FASB and the SEC that this
should happen. We still have to see it because we are only just
starting to produce our standards. It could be done fairly
quickly. And I think you would find that, okay, there will be
six or seven major changes. But your whole world is not being
torn apart because you have a very good set to start with.
Senator Bunning. Thank you.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator.
Senator Miller.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. Thank you, Mr. Chairman, and thanks to our
witnesses this morning.
My first question--I hope I can get two in here--my first
question is to Mr. Volcker.
As you probably know, we heard from the former SEC
Commissioners on Tuesday. One of them suggested a new division
within the SEC, not another private-sector body. What do you
think about that?
Mr. Volcker. I do not think I really know enough about it
to comment, what is meant by that. I was thinking more along
the lines of a Nasdaq regulatory authority which I think has
some advantages of bringing in practitioners. But it has to
have a strong public backbone. There is no question about that
in my mind. But I do not know enough about that particular
proposal to comment intelligently.
Senator Miller. I guess what he was getting at is that one
of the things that you would not have to do, it would not have
to be funded by the industry. It would be within the SEC. But
let me ask you this because this really is something that I
wanted to get at.
I did not hear your testimony, and I apologize for it, but
I have read both your statements. Sir David, in your statement
that I read, you said that the auditing process requires a
strong commitment from auditors to resist client pressures. I
think we could all agree with that.
Mr. Volcker, in your statement, you asked the key question,
can strong safeguards be put in place against other business
interests intruding on the auditing process?
May I ask you just in a few minutes, both of you, to
elaborate on that a little bit more, still looking at this
auditor independence, this subject of auditor independence? I
know you have already talked about it a lot. I would like to
hear some more.
Mr. Volcker. Well, I do not know just what to add, except
that I do believe, and the only reason I am involved in this
thing with Andersen, for instance, is that we have to restore
the status and honor, so to speak, priority to the auditing
profession, as a really indispensable ingredient in a well-
functioning financial market.
To the extent that this priority is distorted, diverted,
weakened, softened, by other interests in the firm, we have a
problem.
Just how to define that and draw the precise borderlines is
something I guess I am going to be pretty deeply involved in. I
do not know the answer in great detail, but I know this is a
problem. I sense it is a problem. It is something that, by
their self-interest, by what I think is a national interest,
whether it is a matter of legislation is another thing, has to
be paid attention to.
Let me just put this in its widest context. Again, when I
was listening to the Senator over here, I think we have a
societal problem. We have been through the greatest boom in all
of history maybe, a great bubble. And it creates--it is nothing
new in the history of the world, I guess--you get a great brew
of greed and hubris and excesses and financial wishful
thinking, and that adds up to a weakening of the auditing
process.
So all of this is kind of contrary to conservative
auditors. They have been infected. And we have to reverse that
process.
I think the behavior of markets is helping that and this
kind of scandal opens our eyes to it, so we have a chance of
creating a better balance. And that is what this is all about,
I think.
Senator Miller. Thank you, sir.
Chairman Sarbanes. Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Thank you, Mr. Chairman.
I welcome the witnesses. I have great respect for their
contributions both nationally and internationally and I respect
their judgments. Let me also apologize for not being here. We
have three hearings going at the same time. If I ask questions
that have been asked, I apologize for that.
Chairman Sarbanes. It is to Senator Corzine's credit,
though, that when he has three hearings at the same time, he
tries to get to all three of them. Some just throw up their
hands and do not go to any of them.
[Laughter.]
Mr. Volcker. But this must be the most interesting one.
[Laughter.]
Senator Corzine. Absolutely.
Chairman Sarbanes. It may be the most important, I think.
Senator Corzine. I identify with this culture of
gamesmanship or erosion of culture and a need for ethics as
much as anyone.
I would love to hear your general comments with regard to
corporate governance rules in the United States, because we
have different structures than you do in Britain, and whether
there has been a discussion comparing and contrasting about the
disciplines that are associated with that, which apparently
have broken down in some serious way, at least in the most
visible cases, and one can question whether they work
appropriately.
Then I would like to ask rapid-fire: How do you feel about
the separation of auditing from consulting? Do you feel that
rotations of auditors makes sense? Is a cooling-off or time-out
period between auditors working at an auditor and going to work
for the client something that, good thing/bad thing?
I would also love to hear your views about option
accounting. We certainly hear a lot about the erosion of
quality of income statements based on income recognition, but
expense recognition is almost equally an important issue.
And if that is not enough, I would love to hear Chairman
Volcker talk about derivative accounting.
[Laughter.]
Chairman Sarbanes. That is a good list. If you could run
through it, we are at the end of our rounds, so go ahead and
take the time now to respond to each of those, if you could.
Mr. Volcker. I will take a first crack at some of them. And
Sir David I am sure can do those and others.
On separation, it is obviously an issue. I think there
should be some separation, somehow or another, within the firm,
or in some cases, prohibited for a firm. Where you draw that
line is going to occupy me in my work at Andersen and it may be
a matter of legislation or otherwise, too.
Senator Corzine. Do you think it is too early to call?
Mr. Volcker. Pardon me?
Senator Corzine. It is too early?
Mr. Volcker. It is too early for me. I know there is a
problem. Where you exactly draw the line--the whole tax area,
which has been a long-term business, quite legitimately, I
think, of auditing. But when has it not become auditing or
related to auditing and when does it become something else
which may conflict with auditing, is one of the many subtle
questions that arise here.
On this time-out question, I think that is something I
would be willing to look at in that context, too. What should
the rule be? I think, just as a matter of industry practice, or
auditing company practice, I do think there ought to be some
kind of limitation on it. What it is precisely is something we
are looking at.
When you look at rotation, an interesting structural
question which I would like to see debated. It is nothing for
Andersen to decide by itself. I think that is an industry
question and maybe a legislative question, and something you
might want to look at.
I know there are arguments on both sides. There is a very
clear argument, this is a way to deal with a lot of these
problems because you know you are going to have another auditor
looking over your shoulder pretty promptly, you are going to be
pretty careful about what you do.
There are arguments on the other side that in big,
complicated companies, it is very difficult to change auditors.
The auditors take a long time to learn the company. You will
have a lapse of knowledge and institutional knowledge if you do
that.
So there are arguments on both sides and I really think
that this is one that should be looked at on an industry-wide
basis.
Those are some of the things that I notice you asked for.
Senator Corzine. How about option accounting?
Mr. Volcker. Option----
Senator Corzine. Expense recognition of options. Do you
have a view on that?
Mr. Volcker. You have a favorite subject? This is a very
controversial area which my associates who I appointed felt
they had to deal with right away.
It is a problem. There is not any question about it. Sooner
or later, they are going to have to deal with it. I have made
some observations entirely apart from the accounting, but not
unrelated. I say entirely apart, but it is not unrelated to the
accounting issue.
I must say in the United States, I think the use of options
has gotten to the point where it is abused as much as used
correctly. I think we have seen examples of excesses in the
fashion of giving options and you see it in the Enron
situation.
I cannot quite understand how executives can make tens of
millions of dollars in options in the same year that the
company goes bankrupt. I mean there is something that seems to
be a kind of disconnect there.
Chairman Sarbanes. Well, it loads the whole system, doesn't
it, toward manipulating or affecting the stock price of the
company.
Those people have an incredible interest in getting that
stock price up, so it just drives them, it seems to me, to do
one and another thing in order to accomplish that because it
means very large amounts of money for key individuals in the
management structure of the company.
Mr. Volcker. I think there is a legitimate question in some
cases as to whether the slogan of aligning the interests of
management to the stockholder is not reversed and the interests
of the stockholder is being aligned with the interests of the
management, which is not the way it is supposed to be.
For instance, why do we pay so little dividends now on
stocks? Well, there is a tax reason. I know all the rationales
that investment bankers can give. There is no doubt in my mind
that if you have a choice between pushing up the price of the
stock and paying a dividend, you push up the price of the stock
if you have a lot of options.
Now, you have a great boom in the stock market, the good
managers benefit, the bad managers benefit. You get a down in
the stock market and nobody benefits from the options.
It is a very artificial, capricious kind of result in many
cases when they are used to excess. I think there is a
legitimate use for stock options, but I really raise the
question, whatever the accounting treatment is, whether they
haven't gone overboard.
Sir David Tweedie. Well, sir, if I could just add one or
two things to that.
I think the key issue right from the start is, who is the
auditor's client? Now, I probably made the mistake in my own
submission of doing what many of the firms do, thinking the
client is the company. Of course, it is the company's investors
and, if you like, the investing society at large. And that is
really what we have to get back to.
I think that there are various ways that we can do that. I
do not know what you do in the United States, but government
officials certainly are not allowed in the UK simply to walk
into other companies as soon as they finish. There is a
cooling-off period. They cannot go into a company in an
industry with which they have been dealing, so they have to
stay away for a certain period.
The questions that you pose have been around for many, many
years and there are no solutions on the table as yet. Rotation
has been asked, yes. There are dangers in the first year or two
as auditors learn the ways in which the new companies that they
are dealing with work.
But, ultimately, it comes down once more to who appoints
the auditors. If the auditors are protected, we have a better
chance to ensure that these sorts of situations do not occur.
If the auditors are frightened of management and feel they are
going to be fired if they stand against them, then we have a
real problem. And that may be happening in certain cases.
In that sense, the appointment of auditors has to be
removed from management, so you have a better way of appointing
them.
What that has to be is a matter for debate. There has been
lots of discussion about that in the UK, should there be some
form of commission or what have you? But it is something that
we do not have an answer for, but certainly, it is worth
looking at.
The other way, of course, is to hit them by discipline
procedures. We have European laws that ask whether or not an
auditor is a fit and proper person to do an audit.
Now if you fail in an audit and come before the discipline
committee, the chances are then that you can be thrown out of
the profession. So there is discipline the other way.
I do not know what the discipline rules are in the United
States. One of the problems we do have, though, and I think, as
Paul has said, is the aligning of management's interests and
shareholders'. Share options has, as the Chairman also said,
caused many problems. There are huge awards being made.
The numbers are big. The figures I have seen quoted from
American analysts is that if the figure that the FASB proposed
were to be charged in the income statements, then American
profits would fall by somewhere on average, 8 to 9 percent. But
in some industries, it is much, much bigger than that. So there
could be a misallocation of resources going on, too.
It is a big issue. And it was Congress that forced that
rule not coming through as a charge. That was one of the
problems of political influence. It is a difficulty.
The other problem, if I remember rightly, and Mr.
Leisenring will correct me if I am wrong, the performance
options perversely do lead to a charge in American accounts,
and therefore, you have very few of them.
The reward for good work does not come through because you
have a penalty in the accounting. And there is something wrong
with that and that is something we should just not have.
So it is perverse the way it works.
Senator Corzine. I would only say that the very first
statement that you made in response to the question: Who do the
auditors work for? I think is one of the very important key
points that needs to be understood as this debate gets away
from the headlines into how we structure this.
How do we get information into the hands of those that need
to analyze the information the best as possible, what is going
on in the company?
I think this whole question of what the options are about
how auditors are appointed, is a fundamental question that is
actually off the headlines, but real.
Mr. Volcker. In that connection, you may have noticed, the
idea was not spelled out, but the Secretary of the Treasury
made some comments at the World Economic Forum about an
approach toward this problem that got at the essence of it,
would be to hold the chief executive officer responsible for
what goes on in financial reporting or auditing, very clear. If
something goes wrong, it is his fault. And that will give a
certain incentive to make sure that the auditing is given
proper attention.
Senator Corzine. Mr. Chairman, I wonder if I could ask just
for some comment----
Chairman Sarbanes. Certainly. Then I know, Senator Enzi,
you probably have some follow-up as well, or I invite you to
enter into the discussion as we go, since there are only the
three of us here.
Go ahead, Jon.
Senator Corzine. The derivative accounting issue and
supervision issue is embedded in many of the repetitive nature
of problems that we have seen in the financial system, whether
it was Enron, which some would say was a financial institution
as opposed to an energy company, and similarly, long-term
credit. I do not need to go back into history, but it repeats
itself over and over again, the unregulated arenas where there
is financial engineering cause significant elements. Do you
have some initial thoughts to help frame us in how we should
look at that as we address some of these, both accounting and
regulatory issues?
Mr. Chairman.
Mr. Volcker. I do not have an answer. I am told that the
FASB rule on derivatives and its explanation runs to 650 pages,
of which no single human being understands.
[Laughter.]
I do not know whether that is true or not, but it sounds
like it may be because this, as you know, concerns me in its
complexity, and opportunities for a degree of financial
engineering boggles the mind and leads to sometimes unexpected
results.
If I understood correctly, it does not go to the
accounting, but this fashion of banks and other financial
institutions repackaging their loans, selling them in the
market, securitizing them, then they end up in the market
buying back some of them through a derivative, which they did
not even realize that they were buying back, and find out that
their exposure, in this case, to Enron, was twice as big as
they thought it was because they bought some of it back in a
derivative that they thought was protected, but it turns out to
be nonprotected.
I do not know all the facts, but that is what the newspaper
made it sound like. But it is illustrative, I think, of the
extreme complications of evaluating the value and the credit
standing of derivatives. I do not know. I wish them good luck.
[Laughter.]
I do not know the answer. We will let Sir David Tweedie
answer the question.
Sir David Tweedie. I think two of the questions that you
raise, sir, create serious problems because one of the key
issues facing us is when is something actually sold and when do
we get rid of it?
Now securitization, you start to ask questions if you
securitize 100 loans. But somehow, they can be put back to you
if you are not too good. It starts to make you think, well,
maybe they are not really sold in the first place.
There is a big argument going on now in accounting about
whether we should try and say, well, the fact that I have
guaranteed these loans means perhaps we should put a liability
for the guarantee on the balance sheet.
Now, we have questions how you measure that.
The way that we look to be going, which is incredibly hard
line and we will probably meet a lot of opposition, and where
we are still debating whether we are right or not, is simply to
say, if you have any continuing involvement, you haven't sold
it.
So if I have guaranteed the whole lot, none of them come
off.
Now that will cause probably bankers all over America to
have heart attacks when that gets out.
Chairman Sarbanes. It just got out. It just got out.
[Laughter.]
Sir David Tweedie. There is a question. That is going to be
one of our big discussion features, that we have to solve this
problem. It is not an easy one.
The derivatives, Paul mentioned that there are 600-odd
pages in the U.S. standard. I read over our revised one, which
is based on the American standard, yesterday, and it does read
like a pile of rules. It really does.
Now the reason for that is we actually divide the
derivatives into three different categories--those that you
hold to maturity, which you keep at cost--financial
instruments, I should say--those that you trade which you mark-
to-market and take through the income statement, and then
another category which is available for sale, but you mark-to-
market and do not take through the income statement. Why we do
that, I have not the foggiest idea, but that is what happens.
And that was the result of a compromise.
The alternative suggestion is, you can slash through all of
this, and this is where Paul will have a heart attack, if you
mark all financial instruments to market. Now, fortunately,
Paul is not allowed to say anything about technical matters,
but I certainly know what he thinks about this one.
Basically, it is simple, though we do have the subjectivity
of the values to look at now. That is the next question. But
these two issues that you have hit on are two of the biggest we
are going to face.
Senator Corzine. Well, there is an equally important one,
not only how we account for them, but also whether they fall
under some rubric of regulation because there are some places,
and apparently, that was the case with regard to some energy
derivatives and formats for this, where there is no oversight,
and whether there is any common oversight of financial
derivatives is a whole genre of other issues and it is for
another hearing, but it is one that I think is just as
important because it merges with the accounting issue.
So much of the financial dislocations that we have seen, if
one looks at the last 15 or 20 years, surrounds some element,
some derivative of derivatives in one form or another because
it is a way to get enormous leverage into the system. And
people with unchecked ability to do that, as you just described
it, you have brought all the securitized assets onto balance
sheets, we would have a whole different look at what the
leverage characteristics of some of our great financial
institutions would be.
Sir David Tweedie. I could not agree more.
Chairman Sarbanes. Senator Enzi.
Senator Enzi. Just briefly----
Senator Corzine. I know you were glazing over, Senator.
[Laughter.]
Senator Enzi. No, no, no. I am finding all of this
fascinating.
[Laughter.]
We are down to the hard-core right now.
[Laughter.]
Because, as all of the controversies go on, it is only
fascinating to the media and to the public as long as there is
some crime or fraud or ability to point fingers and figure out
who is at fault. As you get into the details like some of the
ones that Sir David has been talking about, there are few
people here that are really absorbing what he is saying. Many
of us will have to go back and look at the text of it to see.
Chairman Sarbanes. Those details are very important in
terms of what the system and structure is. This is serious
business.
Senator Enzi. Absolutely.
Chairman Sarbanes. Because if we can get a proper system
and structure in place, we can, I think, markedly diminish the
likelihood of such things occurring.
Senator Enzi. That is absolutely correct. But if we asked
the next hundred people that we saw what auditing is, which is
not detail, we would not get an answer that would be usable in
anything. And that is the level of education that we are at in
the whole process.
One of the things we are working on is auditor
independence, which is essential. But in looking at the Enron
situation, I was trying to figure out, if I were heading up an
auditing team--now I am beyond the Accounting 101 that we
talked about, and you even get some continuing education and
those sorts of things. But that is not enough.
When you are talking about a company that is as complex as
Enron, and the different kinds of businesses that they were in,
there is outside expertise that you have to have on that.
If an auditor, regardless of how many years he had spent on
it, did not hire somebody to help with the audit that had some
more of the economic principles of the kind of structures that
were involved there, they would be negligent in their job.
If we have auditor independence, now would that be hiring a
consultant? If we hire a consultant, is that crossing the line
of auditor independence?
I am trying to figure out how we can structure the rules so
that we can have this independence, but the expertise that
would result in a bona fide audit would still be available. Can
either of you give me any insight into how we do that?
Mr. Volcker. This is a question that I have begun to
struggle with myself because of what I have to look at. And the
argument is made that consulting helps maintain that kind of
expertise.
My sense of that is yes and no. A lot of consulting does
not and that there is no movement of personnel that is
significant. Other elements of consulting, it may.
But there is the consulting, what the firms have already
dealt with, at least in part, of installing very large computer
systems, information technology systems, the high-ticket items.
My impression is it is pretty independent from the auditing.
There may be a conflict because of the interest in getting the
business. There is that kind of conflict, but there is not much
movement of personnel or very much movement of expertise, at
least my initial impression.
But in other areas of so-called consulting, it may actually
overlap with an effective auditing function. And where that may
be true, for instance, is in some tax areas, tax preparation,
tax advice.
When does that overlap into a different kind of advice as
to how to evade or avoid taxes, which is not an ordinary role
of an auditor, who is supposed to be keeping you on the
straight and narrow. I am not sure I should do that with the
right hand and with the left hand, tell you how to skirt around
it.
It is that kind of problem.
Sir David Tweedie. I think, sir, one of the difficulties
you have with audit, if we look at the pure audit, the auditor
should be presented with management's representation of what a
fair presentation is and just simply check them. What he should
not be doing is auditing his own work, and that is obviously a
key role.
You raised the question of how do they go around valuing
these derivative instruments? And that is a problem because
these are very complicated, very technical issues.
One of the problems that auditing firms will face,
certainly if they cut away some of the activities that they
have at the moment, I suspect the consequence of that might be
the audit costs might have to rise because one of the things
that the firms have to be able to do is to attract the type of
graduate that can compete with some of these people in the
merchant banks who dream up these schemes.
You can certainly go outside for expert advice. In the
United Kingdom, we revalue fixed assets. But we have a
profession of valuers, surveyors, with their own rules, their
own discipline procedures, and we then, sort of in a way, hand
over to them, although, ultimately, the auditor has to stand
back and say, does that make sense to him as an auditor? Are
the numbers somewhere in the region he would expect?
But the valuer takes a great deal of the responsibility.
The auditor still has to see that it is reasonable.
Whether we get into areas where we ask these people, such
as pension liabilities, the actuaries could help and do up to a
certain point. But the firms tend to have these people, the
accounting firms tend to have these people within their ranks.
It is going to be an issue because, certainly, I think you
raise the same issue about how do you actually calculate some
of these numbers? They are very, very complicated. And it is an
issue for us as standard setters, how do we try and guide
people, how they might be doing it?
Senator Enzi. Well, the big firms may have that expertise.
But the closer you get to where I am from, the less likely you
are to have that level of expertise in a firm. And they are not
dealing with the major firms. They are not even dealing with
people that have to register with the Securities and Exchange
Commission. They might be just auditing a school.
What happens is that whatever we do at the national level
here seems to drift down as a requirement. That is why I am so
glad that you have that small business provision in there
because I am featuring one of my small businessmen having his
firm audited and then having the exit interview and saying to
him now, did we do anything wrong? He says, well, no, you did
not do anything wrong. And then he asks the next logical
question, is there anything that we should be doing better?
At that point, having the auditor say, oh, I am sorry. That
would be consulting and you will have to hire another firm to
do that. Otherwise, I am breaching ethics here.
That would be the small business paying twice for the same
service, and we do not want to get into that position. I do not
know at what level that gets to be a conflict.
I really appreciate both of you and your answers today.
Mr. Volcker. Let me say that this is a question that should
be always asked of auditors. What else should we be doing?
Senator Enzi. Yes.
Mr. Volcker. I think there is a question of whether to get
a good audit, people are ordinarily paying as much as a really
good audit costs. There is a human tendency to want to reduce
that cost. But if we are going to not get involved in other
services so heavily, it makes even more of a point, are we
paying adequately for the audit itself ?
I do not know how we deal with that. You have a system in
this country, I do not know what other system you could have,
where the person being audited pays for the audit and chooses
the auditor, which I suppose you could argue, in a most general
sense, is already a conflict. But it is important that the
audit fee not be squeezed to the point where you get an
inadequate audit.
Senator Enzi. One of the things I have always been proud of
the accounting profession for is that they do not work on a
contingency basis.
[Laughter.]
Mr. Volcker. That is I do not think an irrelevant comment.
[Laughter.]
Because that is one way that you deal with some of these
other services because I think they have an anxiety that, if it
is forbidden to have something called a contingency fee, they
find some way to have its equivalent. And that is the
temptation.
Chairman Sarbanes. I would note to my colleagues, there is
a vote underway and the second set of lights has gone on. I am
just going to try to draw this to a conclusion. I want to put a
couple of questions here.
Sir David, is the International Accounting Standards Board
setting the standards that the EU will adopt by 2005? Is that
correct?
Sir David Tweedie. It is, sir. The EU has the right to
reject one, although they say that they almost certainly won't,
because we are not inclined to write another one for them.
But, no, they are going to take--for listed companies, for
consolidated accounts, they are going to use the international
standards. That is 7,000 listed companies.
Chairman Sarbanes. And by when will they do that?
Sir David Tweedie. The year 2005 is the target. The law is
still going through in the European parliament, but they expect
it to go through in the next couple of months.
Chairman Sarbanes. The end of 2005?
Sir David Tweedie. The calendar year 2005. That is the
first of January when it starts.
Chairman Sarbanes. The first of January 2005?
Sir David Tweedie. Year beginning 2005, first of January.
Chairman Sarbanes. Well, of course, I would just note that
the EU--I was looking at a pamphlet here--its GDP now is almost
comparable to the United States' GDP. Of course, its population
is larger by about 100 million.
You are going to have this very significant economic
factor, which is, in effect, going to adopt this international
standard, which I think really raises a very important question
for the United States in terms of the importance of harmonizing
with the international standard because you are going to have a
significant economic block that has standards and a standard
setting procedure. The question is, how do you relate to that?
It is one thing for the United States, when it was a large
economy being compared with individual countries, to hold to
sort of a self-focused thing. But I think it is a very
different challenge here as we deal with the EU, we do not have
a lot of time on that front.
Presumably, your work harmonizes or correlates with the
work of national standard setting bodies, like FASB or others
that exist in other countries. And in fact, in a way, they need
to intensify their own activities. Would that be correct?
Sir David Tweedie. It is, sir. The standard setters in
Germany, France, and the United Kingdom are going to have to
accept our standards by 2005 because that will be the European
law.
Australia is trying to work toward them. The other
countries, Japan is nominally going to work toward them, though
it has its own problems. I think they are quite concerned with
some of the changes that we are proposing, which is bringing
Japan into line with international and American rules.
The United States and Canada are going to be the real key
to whether we have a single set of standards. They have said
that they are very enthusiastic about doing a harmonization
exercise. And, anyway, it is going to be tested in the next 2
or 3 years.
Chairman Sarbanes. Of course, to the extent that the United
States moves now in the near future to correct deficiencies in
its standards that Enron has reflected, which, in effect, would
be moving to a higher standard, that would enhance the chances
of harmonization, would it not, given the way you have
outlined, that your objective is to take things, as I
understand it, to the highest denominator, not to the lowest
denominator.
Sir David Tweedie. Indeed so, sir. And of course, we are
not sure whether it was accounting standards that were involved
in Enron yet. But whatever comes out of that, if we do find
that there are deficiencies, clearly, we must look at them,
too, and must make sure that, internationally, we cannot have
that mistake. And that is one of the advantages of
international standards because if we find a situation such as
the Burnett & Hallamshire that was mentioned, or Enron, we
could try to stop it from happening in other countries as well.
So it may be in the future that a disaster that might have
happened in America is averted because we have had signals from
another country that it is an issue there.
Chairman Sarbanes. Let me be very candid about it. I am
just trying to knock out of the box an argument that says, we
should not do something here in the United States right now
because we really ought to be trying to harmonize with the
international standards, and that is what we should focus on.
I am trying to establish the point that if we correct it
here, now, or in the near future, under our own national
standard setting, that this is not only not inconsistent with
the international harmonization, but also actually is conducive
to it, because we then move to a better standard. It should
make the harmonization easier, not more difficult. Would you
agree with that statement?
Sir David Tweedie. I would. And one of the reasons that it
will lead to harmonization, I would suspect is Mr. Leisenring's
job to make sure that we know that what is going on in the
FASB, the same way he has to take to FASB what we are doing.
And if, for example, the FASB are looking at special
purpose entities, we will be looking at them, too.
So the idea is, any ideas that we have that are an
advantage to FASB goes in there, and if they have ideas that
are of advantage to us, they come to us. Ideally, we end up
with the same rule.
That is the whole object.
Mr. Volcker. I think certainly in the case you cite, we
would be wanting to work together in the hope that you arrive
at a common conclusion.
Chairman Sarbanes. Gentlemen, thank you very much. You have
been a very helpful panel and we very much appreciate your
coming and the obvious work that went into the preparation of
your statements. Presumably, we will be back in touch with you
as we move ahead on this challenge.
Sir David Tweedie. Thanks, sir.
Chairman Sarbanes. The hearing is adjourned.
[Whereupon, at 12:30 p.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF SENATOR PHIL GRAMM
With us this morning is Mr. Paul Volcker, the former Chairman of
the Federal Reserve and current Chairman of the Trustees of the
International Accounting Standards Board and Arthur Andersen's
Independent Oversight Board. Thank you, Paul for your life-long service
to America. If I started making a list of who had made contributions to
this country, it would not be very long before your name was on it. We
are also very happy to have Sir David Tweedie here with us, who is
Chairman of the International Accounting Standards Board, and former
Chairman of the United Kingdom's Accounting Standards Board.
I have always believed that it was very important to achieve
homogeneous accounting standards, at least in the developed world and
then ultimately worldwide. The question I have is, how do we get from
where we are to there. I guess, Sir David, you won't be surprised to
hear me say, like most Americans, that I always thought the quickest
way to get there was to adopt American standards worldwide. In any
case, I applaud what you are doing.
A very important part of the Banking Committee's jurisdiction has
to do with accounting standards. In this era, some may say that
accountants are a big part of a troubled profession. But if I had to
choose among a preacher, a politician, or an accountant someone
selected at random in America to protect the sanctity and safety of my
family, I would choose an accountant to do the job.
Mr. Chairman, I am proud of your leadership as we try to deal with
this issue. There are many committees holding hearings on several
issues that brush with and around our jurisdiction, but at the end of
the day when Congress decides to do something about accounting
standards, it is going to be the Banking Committee that does it. Your
leadership and our ability to work together on a bipartisan basis give
me confidence that we are going to do more good then harm.
When I was an accounting student, a very long time ago, these
issues seemed very simple. But when I came to the U.S. Senate, and I
began hearing from constituents, talking to my colleagues and speaking
with FASB on how to deal with and account for these stock options, I
realized that these accounting issues were not simple. Should stock
options be charged against current income, or are they merely a
dilution of ownership? And how do you account for them? Then there are
the questions of accounting for derivatives. Are they closed end or
open ended, and how should the accounting treatment depend upon whether
the derivative is related to another liability you have. Then there is
the question of auditor independence.
These issues turn out to be a lot more complicated than they were
in the accounting class I took in 1961. One of the positions I have
taken consistently is that I have not always agreed with FASB, but I
have always believed that whatever FASB thought, I was more confident
in letting FASB set standards than in letting Congress set standards.
I have not always agreed with the SEC. I thought our dear friend
Arthur Levitt was too involved in accounting standards. He once told me
that he talked to the head of FASB all the time and had his home phone
number. To me, the fact that he had his home phone number is an
indication of a problem. But I always made it clear to Arthur Levitt
that if it came down to the Congress or to the SEC making decisions on
accounting standards, that I felt more comfortable with the SEC making
them.
Here is my question. As we begin to look at reforms, ultimately we
are going to look at how are we going to implement these accounting
reforms. Are we going to mandate new standards of accounting in
Congress? Are we going to try and give a directive to the SEC? Are they
going to set accounting standards or are we going to try and insulate
FASB so that they might be more independent in setting standards. These
are all questions that we are going to have to come to grips with.
Thank you.
----------
PREPARED STATEMENT OF SENATOR DEBBIE STABENOW
Mr. Chairman, I am glad to be back here for the second day in your
series of hearings examining accounting and investor protection issues.
The hearing that was held on Tuesday, I believe, was extremely
helpful as this Committee deliberates what reform measures it should
take up.
Having all of the former SEC Chairmen together was enormously
insightful, and I know that the witnesses today--well-respected for
their expertise --are also going to provide a wealth of insight as we
grapple with these important issues.
At the hearing on Tuesday, we heard a great deal from the Chairman
about what needed to be done in several areas including: Revisiting the
current system of self-regulation; establishing a financially
independent oversight board; ensuring that accounting firms sever
inappropriate mixing of accounting with certain consulting services;
and, expediting and depoliticizing the development of accounting
standards--just to name a few.
I know that the comments of the SEC Chairmen will be instrumental
in helping us to develop legislation to ensure that a debacle like
Enron never happens again.
Today's hearing will be another important piece of this careful
deliberative process. As we begin to review accounting standards, in
light of Enron and other failed companies, it is absolutely essential
that we do so with a global perspective.
As the Chairman and others have pointed out, the world's economy is
increasingly linked by corporations seeking both capital and business
in foreign companies. This raises important questions about which
accounting principles should be applied to those companies.
What makes this additionally challenging, however, is the fact
that, as several of the SEC Chairmen pointed out, the other day, it is
increasingly hard for the accounting industry to keep up with new
financial instruments, novel business arrangements, and special
accounting procedures.
This challenge is further confounded because too often basic
principles of accounting get lost in attempts to comply with, or in
some cases unfortunately, in attempts to evade the rules. We need to
put a stop to this rampant gamesmanship.
Mr. Chairman, I look forward to hearing from our witnesses today as
they testify on international accounting standards and I look forward
to continuing to work with all of my colleagues in examining these
important investor and consumer protection issues.
Thank you.
----------
PREPARED STATEMENT OF SENATOR DANIEL K. AKAKA
Expanded participation in the financial markets has provided
increased opportunities for individuals to build wealth. In my home
State of Hawaii, over half of all households own stock. Investing
decisions are already extremely complex. When information provided by
companies is false, investors are not given the opportunity to make
informed decisions. False information can lead to losses which destroy
the wealth of investors.
Protecting investors from misleading financial statements must be a
global effort as direct investment barriers have fallen and the
international markets provide additional opportunities for capital
appreciation and diversification. Special purpose entities, pro forma
profits, and opaque bookkeeping practices have the potential to confuse
and mislead United States and foreign investors.
We must all work together to improve the transparency of corporate
activities and ensure that investors are provided reliable information
to use in making their investment decisions.
I thank Chairman Paul Volcker and Sir David Tweedie for joining us,
and I look forward to their testimony and recommendations on what can
be done to restore the confidence of investors.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF SENATOR TIM JOHNSON
Mr. Chairman, thank you for holding today's hearing. We are honored
today with two distinguished witnesses, who will be helpful to our
Committee as we sort out what changes we should consider to our
accounting and financial reporting rules.
As we move forward in our investigation of issues related to the
recent collapse of Enron and accounting standards generally, we must
remain mindful that we live in a global economy. I am pleased that you,
Mr. Chairman, have had the foresight to include an international
component in our deliberations.
America deserves a full investigation of the recent events that
have shaken our markets, and further economic recovery depends on
maintaining the confidence of investors. Our economy has flourished
under the democratization of our capital markets, and we must take
every possible measure to ensure that Americans have the information
they need to continue investing in our Nation's businesses.
I look forward to today's testimony, and thank the witnesses for
their willingness to appear before our Committee. In particular, I
would like to thank Chairman Volcker for his many years of service to
America.
Our Nation's strength is due in no small part to the talent and the
determination of our citizens who are willing to serve in the public
sector. Mr. Volcker provided valuable leadership at the helm of the
Federal Reserve during the 1980's, and has continued his leadership
role in the area of accounting and finance.
Thank you, Mr. Chairman.
----------
PREPARED STATEMENT OF PAUL A. VOLCKER
Chairman, International Accounting Standards Committee Foundation
Chairman, Arthur Andersen's Independent Oversight Board
Former Chairman, Federal Reserve System
February 14, 2002
I appreciate this opportunity to meet with you this morning,
joining with Sir David Tweedie, the Chairman of the International
Accounting Standards Board (IASB).
When this session was arranged some weeks ago, the intention was to
concentrate mainly on the relevance of the work of the IASC and its
associated bodies to the evident problems besetting the accounting and
auditing professions.
Those problems, 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.
Those qualities are essential attributes of a capital market and
financial system in which investors can place confidence and which can
efficiently allocate capital. The implications extend far beyond the
shores of the United States.
We have long seen our markets, and our accounting systems, as
models for the world, a world in which capital should be able to move
freely to those places where it can be used most effectively and become
a driving force for economic growth and productivity. In fact, a large
portion of international capital now flows through our markets. We have
been critical of the relative weakness of accounting and auditing
standards in many other countries, arguing that those weaknesses have
contributed to the volatility, inefficiency, and breakdown of the
financial systems of so-called emerging economies.
How ironic that, at this point in economic history when the
performance of the American economy and financial markets has been so
seemingly successful, we are faced with such doubts and questions about
a system of accounting and auditing in which we have taken so much
pride, threatening the credibility and confidence essential to well-
functioning markets.
To my mind, we can extract some good news in all of this. Our eyes
have been opened to festering issues that have for too long been swept
aside or dealt with ineffectively. We now have the opportunity for
bringing our performance to a level that matches our words--to practice
what we preach.
For most of my professional life I have been a consumer (sometimes
a critical consumer) of accounting and auditing reports rather than a
participant in the process. That began to change when I agreed to Chair
the newly restructured International Accounting Standards Committee
some 18 months ago. The main responsibilities of that Committee --
modeled substantially on the Financial Accounting Foundation in the
United States--are to appoint the standard setting body Chaired by Sir
David, to obtain finance for its work, and to exercise broad oversight
over the effort.
The Committee I Chair does not engage in the technical work--we do
not set, or advise on, the standards themselves. I am not and never
have been an auditor. But as Yogi Berra once said, ``you can observe
quite a lot just by watching,'' and there has been a great deal to
watch.
I have attached to this statement excerpts from two earlier
statements of mine that reflect my growing concerns. The fact is the
accounting profession has been hard-pressed to keep up with the growing
complexity of business and finance, with its mind-bending complications
of abstruse derivatives, seemingly endless varieties of
securitizations, and multiplying off balance sheet entities. The new
profession of financial engineering is exercising enormous ingenuity in
finding ways around established accounting conventions or tax
regulations. In the rapidly globalizing world of finance, different
accounting standards and methods of enforcement in different
jurisdictions present increasing hazards.
Underneath it all, many have a sense that I share: In the midst of
the great prosperity and boom of the 1990's, there has been a certain
erosion of professional, managerial, and ethical standards and
safeguards. The pressure on management to meet market expectations, to
keep earnings rising quarter by quarter or year by year, to measure
success by one ``bottom line'' has led, consciously or not, to
compromises at the expense of the public interest in full, accurate,
and timely financial reporting.
The Three Pillars
I think of good financial reporting as resting on three pillars:
Accounting standards setting out with clarity logically
consistent and comprehensive ``rules of the game'' that reasonably
reflect underlying economic reality.
Accounting and auditing practices and policies able to
translate those standards into accurate, understandable, and timely
reports by individual public companies.
A legislative and regulatory framework capable of providing
and of maintaining needed discipline.
Standard Setting
It is the first of those pillars with which I have been directly
involved over the past 18 months.
The general case for international accounting standards has been
very clear for a long time. In a world of global finance, we have
strong interest in encouraging high-quality standards every place our
companies do business. We want to be sure foreign-based companies
desiring access to our well-developed market provide the kind of
information our investors want and need. We want to avoid distortions
in the international flow of capital because of misinformation or lack
of information. Not least, a single set of standards would minimize
compliance costs for companies and, I believe, assist enforcement.
Our American view has been that those objectives could be
substantially attained simply by insisting all companies approaching
our markets use U.S. GAAP--that is American accounting principles. But
that approach could, in my judgment, never be fully adequate. Other
countries will not easily agree ``Made in America'' is necessarily
best. Coverage will not be complete or uniform. For instance, Europe
will insist on international standards, and many countries will simply
be incapable of, or drag their feet on, good quality national
standards.
Recent events drive home another point. Taken as a whole, the U.S.
standards may, indeed, still be the most comprehensive and best quality
in the world. But plainly, the auditing processes and the standards
themselves need review.
Much has been made of the time that standard setters take adapting
their standards to current business developments and needs. Conversely,
there are claims of inadequate consultation, and those perceiving harm
to their interests threaten withdrawal of financial support or lobby
their legislators for preemptive action. In such a charged environment,
one can see that in the United States, as well as elsewhere, that
change is too slow and suspicions of political compromise damage
confidence in the process.
In this context, there is a real opportunity for a reinvigorated
international effort. A new highly professional organization is in
place. It has strong backing from industry and governments around the
world. Given its strong staffing and organizational safeguards, the
IASC framework should be able to maintain high credibility. In its key
components--the oversight committee I Chair, the standard setting board
Chaired by Sir David, its advisory council and interpretations
committee --it can command the best professional advice, international
representation, and appropriate independence.
Sir David will speak more directly to the substance and priority of
the work. However, I personally want to assure you that our intent is
to move beyond compromise among existing standards or convergence for
convergence's sake. Instead, we will work with the FASB and standard
setters in other countries to choose among, and to adapt the best of,
what exists. When necessary, we will innovate and develop new
approaches.
Time is a luxury that we cannot afford. We have known for some
time, the European Union will require publicly-traded EU companies to
report their consolidated financial statements according to
international accounting standards by 2005. In other countries, there
is an evident need for faster progress. And now American experience
underscores the urgent need for a fresh look in some crucial areas.
As Sir David will report, the IASB already is considering many of
the items in the headlines today-- consistency in defining operating
earnings and pro forma statements, special purpose entities, mark-to-
market or ``fair value'' accounting, and stock options.
You might ask where the FASB fits into the process I describe. I do
not believe that we face an ``either/or'' proposition between U.S. GAAP
and international standards. In fact, the FASB and IASB are working
together on many of these issues with the objective and expectation of
reaching the same conclusion. The result should be convergence and
significant improvement in both bodies of standards.
Restoring Confidence in the Auditing Profession
Broadly accepted, up-to-date international standards will help
discipline the auditing process and encourage effective and consistent
enforcement by national and international authorities.
Yet there is no escaping the fact, in the end, the accuracy and
reliance of financial reporting lies in the hands of the auditors
themselves. They are the ones who must interpret and apply the
standards and protect their integrity. They are the ones to which the
investing public must look to ask the tough questions, to demand the
answers and to faithfully certify that at the end of the day-- or the
quarter or year--the financial results of a company are fully and
clearly reported.
As you are aware, I have recently agreed with Andersen
International to Chair an Independent Oversight Board, with broad
responsibilities to work with the company in reviewing and reforming
its auditing practices and policies.
My hope is that, out of the current turmoil and questioning, Arthur
Andersen will again assume a position of leadership in the auditing
profession right around the world.
I do not minimize the challenge. The auditors individually and in
the auditing profession generally have been subject to strong and
conflicting pressures. Company management urgently wants to meet market
expectation to present results in the most favorable light and to
demonstrate a consistent pattern of earnings. Too often the emphasis is
on finding ways to meet the letter of the technical accounting
requirements at the risk of violating the spirit. Large and profitable
consulting assignments may, even subconsciously, affect auditor
judgment. Companies want to minimize accounting costs. Directors and
auditing committees may not be sufficiently knowledgeable or
attentive --that is, until it is too late.
All this raises questions of the internal management and policies
of auditing firms, matters with which I am only beginning to grapple.
How can the auditing functions and the ``technical'' accounting
decisions be protected from extraneous influence? Can strong safeguards
be put in place against other business interests intruding on the
auditing process? What are the appropriate limits on nonauditing
services performed by an auditing firm to avoid the perception or
reality of an unacceptable conflict?
The Enforcement Challenge
High-quality standards and improved audit practices should go a
long way toward enforcement. However, there are areas where it may be
difficult or impossible for any one firm to proceed alone. Hence, there
is a need for official regulation.
The United States has the framework for regulation and enforcement
in the SEC. Over the years, there have also been repeated efforts to
provide oversight by industry or industry/public member boards. By and
large, I think we have to conclude that those efforts at self-
regulation have been unsatisfactory. Thus, experience strongly suggests
that governmental oversight, with investigation and enforcement powers,
is necessary to assure discipline.
I can assure you in my roles both at the IASC and Andersen that I
will continue to work closely with Government officials here and abroad
in order to encourage more effective enforcement. One imperative is for
governments, including the United States, to provide adequate financial
resources to regulators. I also believe this Committee will want to
explore means for providing more ``backbone'' for industry oversight,
either through legislation or by encouraging exercise of SEC regulatory
authority. Better means of identifying professional misconduct, with
the possibility of meaningful fines and withdrawal of professional
licenses, appears essential.
A positive step in this direction is being taken by the European
Union in its effort to rationalize their securities laws and centralize
their enforcement. We should encourage other countries, through the
International Organization of Securities Commission (IOSCO) and
otherwise, to bolster enforcement mechanisms in other countries,
developed and emerging alike.
Concluding Comment
The crisis in the accounting and auditing professions is not a
matter of the failure of a single company or perceived problems in a
single audit. It demands attention to fundamental flaws basically
reflecting the growing complexities of capital markets and pressures on
individuals and their companies to improve financial results.
To fail to respond to that challenge would have serious
implications for maintaining confidence in markets, for the cost of
capital and for the global economy.
The United States has long had a leading role among world financial
markets, in financial reporting, and in the regulation and surveillance
for these markets. Constructive work of your Committee and the Congress
will be vital in maintaining that leadership. I also urge that you
recognize, in an open and interdependent world economy with
increasingly fluid capital markets, effective leadership, must
necessarily involve close cooperation with others interested in full,
accurate, and timely financial reporting.
The development of truly international accounting standards--
building on the best that now exists and responsive to new needs--can
be and should be a key element in the needed reforms.
The restructured IASC is in large part a result of initiatives
taken by the SEC and supported by the leadership of FASB.
I trust that support will not weaken. Rather, as you examine the
implications of the current crisis and the range of appropriate
remedies, I hope that you will help reinforce the effort to reach
international convergence, recognizing its potential for improving
accounting and auditing practices in the United States, as well as
abroad.
* * * * *
Excerpts from Notes for Remarks at
Financial Executives International Conference
on November 12, 2001
by Paul A. Volcker
Chairman, International Accounting Standards Committee Foundation
I come before you as a relative neophyte to the world of
professional accounting, but I am learning.
I am learning something that I could have sensed long before I
became directly involved--that obtaining a strong global consensus on a
single set of accounting standards will be very difficult. . . .
It is obvious I would not be here if I did not think that a
standard set of technically sound accounting standards is an important
ingredient for an efficient and effective global financial system. Good
and consistent information is essential if the allocation of financial
capital is to truly reflect comparative advantage, is to encourage
appropriately diversified investments, and is to minimize costs of
capital. Competition will be enhanced, not least by facilitating
foreign access to the highly developed American market and by better
assuring a ``level playing field.'' Not so incidentally, the potential
savings for many of your companies operating in different countries,
and required to conform to different national standards, can be
significant. That alone justifies your financial support.
As I have gotten more immersed in these issues, another fact has
impressed itself on me. Let me state my concern bluntly.
The profession of auditing and accounting is in crisis. The
challenges go far beyond the question of achieving international
convergence on standards. They arise in part from the nature of
business today--the simple fact that so much of the value of business
reflects intangibles and human capital that are not captured--at least
not accurately or consistently captured--by standard accounting models.
At the same time, the complexities arising from derivatives and the
extraordinary convolutions of ``financial engineering'' (engineering
the very raison d'etre of which often lies in circumventing tax or in
accounting conventions) challenge our collective understanding. Sadly,
we read almost daily here in the United States of failures in enforcing
accounting standards that we proudly cite as the best, the clearest,
and the most comprehensive in the world. If that is true in the United
States, what of other countries?
All of that raises large issues beyond the effort to reach global
standards. But neither are they unrelated. I hope and believe The
International Accounting Standards Board--the group charged with
working toward convergence on the international standards--will be
capable not just of achieving a compromise of varying national views
but of making an intellectual contribution to new standards. I also
trust that a clearer understanding and agreement on international
standards will lead to more effective and consistent enforcement within
auditing firms themselves and among national authorities.
* * * * *
Excerpts from Statement of Paul A. Volcker
Before The Securities and Exchange Commission
September 13, 2000
[There is] a special responsibility for American leadership in
auditing practices. We need to make sure we practice what we preach.
Yet, I must state clearly that my own experience suggests, and even
casual reading of the press reinforces the impression, that there are
weaknesses in our auditing practices and even serious lapses in the
objectivity and integrity of audits that need attention.
Surely, a number of factors can and do impair the quality of
auditing: The sheer complexity of international businesses and global
markets, lack of sufficient skill and diligence, inadequate training in
the face of changing technology, poorly defined or enforced standards,
and inadequate staffing among others. Good accounting and auditing
demands adequate resources.
But beyond the question of quality is the nagging issue of loss of
objectivity and independence. My sense is that, too often, auditors,
consciously or not, do not challenge management accounting, reporting,
and control practices as fully and as aggressively as required by their
public mandate. Too often we are surprised by business failures or
control breakdowns when the symptoms should have been detected and
reported. . . .
Conflicts of interest are inevitable in any professional practice
and certainly in large and complicated business organizations. Strong
legal and professional standards are necessary to help resolve those
conflicts. What is true generally is especially pertinent for the
auditing profession.
Its mandate, in law and public expectation, is clear and
unequivocal: The interests of investors (and other users of financial
statements) come first. Maintenance of that single principle has, in my
judgment, been increasingly placed in question by the extent to which
auditing firms have undertaken extensive and highly remunerative
consulting or other assignments for auditing clients. That is, the
essential justification, it seems to me, for action to limit
nonauditing activities by auditing firms and to more clearly determine
what is appropriate and what is not. . . .
The extent to which the conflict has in practice actually affected
a distorting auditing practice is contested. And surely, instances of
overt and flagrant violations of auditing standards in return for
contractual favors--an auditing capital offense so to speak--must be
rare. But more insidious, hard-to-pin down, not clearly articulated or
even consciously realized, influences on audit practices are another
thing.
It is clear that within large auditing firms there has been
considerable tension between ``auditing'' and ``consulting'' partners,
tension rooted in the division of revenues and the marketing of
services. An increasing number, voluntarily or by force of
circumstance, have taken action on their own to end that internal
conflict by separating lucrative consulting practices. . . .
Based on my experience as a regulator, I am certain that review of
these concerns is warranted.
----------
PREPARED STATEMENT OF SIR DAVID TWEEDIE
Chairman, International Accounting Standards Board
Former Chairman, United Kingdom's Accounting Standards Board
February 14, 2001
Mr. Chairman, Members of the Committee, I appreciate having this
opportunity to share my thoughts on some accounting matters that have
become the focus of much attention in recent weeks. I am the Chairman
of the International Accounting Standards Board (IASB). I ask that my
full submission, including an appendix that provides some background on
the International Accounting Standards Board and its procedures, be
entered into the record.
The Chairman of our Trustees, Paul Volcker, has already spoken
about the accounting profession, the need for reform, the rationale for
international standards, and how we can improve financial reporting. I
cannot overemphasise the importance of high-quality accounting rules
that give investors confidence that published financial statements show
a full and accurate picture of a company's performance and position.
The IASB's objective is to work toward a single set of high-quality
global financial reporting standards, produced in the private sector
under principles of transparency, open meetings, and full due process.
We have no intention to ``water down'' existing standards in any
jurisdiction. Instead, we plan to build a set of financial reporting
standards that are the ``gold standard.''
I do not plan to comment on specific accounting and auditing issues
surrounding Enron, although there are many. None of us knows enough
about the specifics of the transactions, the information available to
the auditors, and the judgements involved to form a solid professional
conclusion. As we learn more, we may find the U.S. accounting standards
should be improved.
If so, we plan to learn from this case and to make sure that
international accounting standards do not have similar problems.
I would, however, offer two observations. First, history is full of
examples of those who said ``it could not happen here'' and came to
regret it. I do not plan to repeat that mistake. Second, long
experience as a Chartered Accountant and as an accounting standard
setter tells me that business failures seldom have a single simple
cause. They are usually much more complex than they first seem and the
rush to a single easy answer is usually wrong.
Let me turn then to answer some questions that you may have about
the future of standard setting and the role of the IASB and
international financial reporting standards in assuring investor
confidence.
Why Have An International Accounting Standard Setter?
There are four answers to that question--points that Chairman Paul
Volcker has already touched on. My comments build on what he has
already said.
First, there is a recognised and growing need for international
accounting standards. A large number of sets of national standards,
each different from the others to some (often significant) degree,
imposes an unacceptable cost on the capital markets. Some of that cost
is direct and is borne by companies that must meet multiple standards
if they seek to raise capital in different markets. There is a more
important cost--a systematic increase in the cost of capital. Markets
demand a price for uncertainty, including uncertainty about the
accounting standards that govern reported information. The existence of
multiple, and sometimes unknown, sets of accounting standards increases
that uncertainty and drives up the cost of capital. We have seen
situations in which a lack of confidence in reported financial
information causes investors to leave markets and refuse to invest at
any price. Even if there was no systematic increase in the overall cost
of capital, the uncertainty created by multiple sets of national
financial reporting standards would be likely to lead to a
misallocation of capital among market participants.
Second, no individual standard setter has a monopoly on the best
solutions to accounting problems. Taken as a whole, U.S. Generally
Accepted Accounting Principles (GAAP) are the most detailed and
comprehensive in the world. However, that does not mean that every
individual U.S. standard is the best, or that the U.S. approach to
standards is the best. At the IASB, our goal is to identify the best in
standards around the world and build a body of accounting standards
that constitute the ``highest common denominator'' of financial
reporting. We call this goal convergence to the highest level.
Third, no national standard setter is in a position to set
accounting standards that can gain acceptance around the world. There
are several excellent national standard setters, including the United
States Financial Accounting Standards Board (FASB). Before accepting my
current post, I was Chairman of another, the United Kingdom Accounting
Standards Board, for 10 years. However, each of the national standard
setters operates in its own national setting. Leaders of the accounting
world have come to see that international standards must be set by a
group with an international makeup and an international outlook. I
should acknowledge the work of two Americans who recognised that point
and were instrumental in bringing the IASB to its present position--
Arthur Levitt, former Chairman of the U.S. Securities and Exchange
Commission,\1\ and Edmund Jenkins, Chairman of the FASB.\2\
---------------------------------------------------------------------------
\1\ For example, in a January 25, 2001 release, Chairman Levitt
said, ``Strong and resilient capital markets cannot function without
high-quality information. Efficient capital allocation depends on
accurate, timely and comparable financial reporting. The [IASB] Board
members who have been appointed today carry an enormous burden. It is
up to them, working in cooperation with our Financial Accounting
Standards Board and other accounting standards setters, to create
global accounting standards that will support effectively the
imperatives of a global marketplace.'' (www.sec.gov/news/press/2001-
17.txt)
\2\ For example, the FASB publication, International Accounting
Standard Setting: A Vision for the Future, includes this comment:
``However, the FASB believes that, for the long term, if the future
international accounting system is to succeed and, ultimately, result
in the use of a single set of high-quality accounting standards
worldwide for both domestic and cross-border financial reporting, the
establishment of a quality international accounting standard setter to
coordinate and direct the process is key.''
---------------------------------------------------------------------------
Last, there are many areas of financial reporting in which a
national standard setter finds it difficult to act alone. Constituents
often complain that a ``tough'' standard would put local companies at a
competitive disadvantage relative to companies outside of their
jurisdiction. Local political pressures and policies may work against
individual national standard setters. An international standard setter
can establish financial reporting standards that would (we hope) apply
to all companies in all jurisdictions, thus eliminating perceived
disadvantages.
Having explained the need for an international standard setter, I
should also explain that national standard setters are a critical part
of our activities. We look to the national standard setters for
research and counsel, for help in alerting us to particular local
problems, and for help in our due process. Most important, we look to
the national standard setters as partners in several of our projects,
enabling us to make use of their resources. Seven of our Board members
have direct responsibility for liaison with the national standard
setters in Australia, Canada, France, Germany, Japan, the United
Kingdom, and the United States. We expect that our liaison Board
members will spend as much as half their time in direct contact with
their assigned national standard setter, thus bringing the collective
wisdom of each country's financial community to our debates.
How Do International Financial Reporting Standards Differ from
U.S. Standards?
Many International Financial Reporting Standards (IFRS) are similar
to U.S. GAAP. Both international standards and U.S. GAAP strive to be
principles-based, in that they both look to a body of accounting
concepts. U.S. GAAP tends, on the whole, to be more specific in its
requirements and includes much more detailed implementation guidance.
In my view, the U.S. approach is a product of the environment in
which U.S. standards are set. Simply put, U.S. accounting standards are
detailed and specific because the FASB's constituents have asked for
detailed and specific standards. Companies want detailed guidance
because those details eliminate uncertainties about how transactions
should be structured. Auditors want specificity because those specific
requirements limit the number of difficult disputes with clients and
may provide a defence in litigation. Securities regulators want
detailed guidance because those details are thought to be easier to
enforce.
The IASB has concluded that a body of detailed guidance (sometimes
referred to as bright lines) encourages a rule-book mentality of
``Where does it say I cannot do this?'' We take the view that this is
counter-productive and helps those who are intent on finding ways
around standards more than it helps those seeking to apply standards in
a way that gives useful information. Put simply, adding the detailed
guidance may obscure, rather than highlight, the underlying principle.
The emphasis tends to be on compliance with the letter of the rule
rather than on the spirit of the accounting standard.
We favour an approach that requires the company and its auditor to
take a step back and consider whether the accounting suggested is
consistent with the underlying principle. This is not a soft option.
Our approach requires both companies and their auditors to exercise
professional judgement in the public interest. Our approach requires a
strong commitment from preparers to financial statements that provide a
faithful representation of all transactions and a strong commitment
from auditors to resist client pressures. It will not work without
those commitments. There will be more individual transactions and
structures that are not explicitly addressed. We hope that a clear
statement of the underlying principles will allow companies and
auditors to deal with those situations without resorting to detailed
rules.
What is the IASB's Work Plan?
The IASB is a small organisation. We must therefore set our
priorities with care. We have 12 full-time and 2 part-time Board
members, including 5 from the United States. We have a professional
staff of 17 that includes highly skilled people from Australia,
Bermuda, Canada, France, Japan, New Zealand, Russia, Sweden, the United
Kingdom, and the United States.
The Active Agenda
Our agenda includes nine active projects that we divide into three
groups.
Projects intended to provide leadership and promote convergence
include:
Accounting for insurance contracts.
Business combinations.
Performance reporting (joint project with the United Kingdom's
standard setter).
Accounting for share-based payments.
Projects intended to provide for easier application of
International Financial Reporting Standards include:
Guidance on first-time application of international financial
reporting standards (a joint project with the French national
standard setter).
Financial activities: Disclosure and presentation.
Projects intended to improve existing International Financial
Reporting Standards include:
Preface to International Financial Reporting Standards.
Improvements to existing International Financial Reporting
Standards.
Amendments to IAS 32, Financial Instruments: Disclosure and
Presentation, and IAS 39, Financial Instruments: Recognition and
Measurement.
Details of the projects on our agenda, including a summary of all
tentative decisions to date, can be found on the IASB's website at
www.iasb.org.uk.
The Research Agenda
In addition to the active agenda, there are 16 other issues that we
refer to as our research agenda. Each is being worked on by one or more
of our national standard setting partners. The IASB will be working
with these partners, or at least monitoring their efforts, in order to
ensure that any differences among national standard setters or with the
IASB are identified and resolved as quickly as possible. We expect to
move some of these issues to our active agenda as time and resources
permit.
The 16 issues on our research agenda are:
Consolidations
Of the 16 topics on our research agenda, one warrants special
discussion today. For several years, there has been an international
debate on the topic of consolidation policy. The failure to consolidate
some entities has been identified as a significant issue in the
restatement of Enron's financial statements.
Accountants use the term consolidation policy as shorthand for the
principles that govern the preparation of consolidated financial
statements that include the assets and liabilities of a parent company
and its subsidiaries. For an example of consolidation, consider the
simple example known to every accounting student. Company A operates a
branch office in Maryland. Company B also operates a branch office in
Maryland, but organises the branch as a corporation owned by Company B.
Every accounting student knows that the financial statements of each
company should report all of the assets and liabilities of their
respective Maryland operations, without regard to the legal form
surrounding those operations.
Of course, real life is seldom as straightforward as textbook
examples. Companies often own less than 100 percent of a company that
might be included in the consolidated group. Some special-purpose
entities (SPE's) may not be organised in traditional corporate form.
The challenge for accountants is to determine which entities should be
included in consolidated financial statements.
There is a broad consensus among accounting standard setters that
the decision to consolidate should be based on whether one entity
controls another. However, there is considerable disagreement over how
control should be defined and translated into accounting guidance. U.S.
accounting standards and practice seem to have gravitated toward a
legal or ownership notion of control, usually based on direct or
indirect ownership of over 50 percent of the outstanding voting shares.
In contrast, the IFRS and the standards in some national
jurisdictions are based on a broader notion of control that includes
ownership, but extends to control over the financial and operating
policies, power to appoint or remove a majority of the board of
directors, and power to cast a majority of votes at meetings of the
board of directors.
A number of commentators, including many in the United States, have
questioned whether the control principle described in IFRS is
consistently applied. The IASB and its partner standard setters are
committed to an ongoing review of the effectiveness of our standards.
If they do not work as well as they should, we want to find out why and
fix the problem. Last summer we asked the United Kingdom Accounting
Standards Board to help us by researching the various national
standards on consolidation and on identifying any inconsistencies or
implementation problems. It has completed the first stage of that
effort and is moving now to the more difficult questions.
The particular consolidation problems posed by SPE's were addressed
by the IASB's Standing Interpretations Committee in SIC-12. There are
some kinds of SPE that pose particular problems for both an ownership
approach and a control-based approaches to consolidations. It is not
uncommon for SPE's to have minimal capital, held by a third party, that
bears little if any of the risks and the rewards usually associated
with share ownership. The activities of some SPE's are precisely
prescribed in the documents that establish them, such that no active
exercise of day-to-day control is needed or allowed. These kinds of
SPE's are commonly referred to as running on ``auto-pilot.'' In these
cases, control is exercised in a passive way. To discover who has
control it is necessary to look at which party receives the benefits
and risks of the SPE.
SIC-12 sets out four particular circumstances that may indicate
that an SPE should be consolidated:
In substance, the activities of the SPE are being conducted on
behalf of the enterprise according to its specific business needs
so that the enterprise obtains benefits from the SPE's operation.
In substance, the enterprise has the decisionmaking powers to
obtain the majority of the benefits of the activities of the SPE
or, by setting up an ``auto-pilot'' mechanism, the enterprise has
delegated these decisionmaking powers.
In substance, the enterprise has rights to obtain the majority
of the benefits of the SPE and, therefore, may be exposed to risks
incident to the activities of the SPE.
In substance, the enterprise retains the majority of the
residual or ownership risks related to the SPE or its assets in
order to obtain benefits from its activities.
The IASB recognises that we may be able to improve our approach to
SPE's. With this in mind, we have already asked our interpretations
committee if there are any ways in which the rules need to be
strengthened or clarified.
Current Criticisms and Concerns About Financial Reporting
There are some common threads that pass through most of the topics
on our active and research agendas. Each represents a broad topic that
has occupied the best accounting minds for several years. It is time to
come to closure on many of these issues.
Off Balance Sheet Items
When a manufacturer sells a car or a dishwasher, the inventory is
removed from the balance sheet (a process that accountants refer to as
derecognition) because the manufacturer no longer owns the item.
Similarly, when a company repays a loan, it no longer reports that loan
as a liability. However, the last 20 years have seen a number of
attempts by companies to remove assets and liabilities from balance
sheets through transactions that may obscure the economic substance of
the company's financial position. There are four areas that warrant
mention here, each of which has the potential to obscure the extent of
a company's assets and liabilities.
Leasing Transactions
A company that owns an asset, say an aircraft, and finances that
asset with debt reports an asset (the aircraft) and a liability (the
debt). Under existing accounting standards in most jurisdictions
(including FASB and IASB standards), a company that operates the same
asset under a lease structured as an operating lease reports neither
the asset nor the liability. It is possible to operate a company, say
an airline, without reporting any of the company's principal assets
(aircraft) on the balance sheet. A balance sheet that presents an
airline without any aircraft is clearly not a faithful representation
of economic reality.
Our predecessor body, working in conjunction with our partners in
Australia, Canada, New Zealand, the United Kingdom, and the United
States, published a research paper that invited comments on accounting
for leases. The United Kingdom Accounting Standards Board is continuing
work on this topic and we are monitoring its work carefully. As noted
above, we expect to move accounting for leases to our active agenda at
some point in the future. There is a distinct possibility that such a
project would lead us to propose that companies recognise assets and
related lease obligations for all leases.
Securitisation Transactions
Under existing accounting standards in many jurisdictions, a
company that transfers assets (like loans or credit card balances)
through a securitisation transaction recognises the transaction as a
sale and removes the amounts from its balance sheet. Some
securitisations are appropriately accounted for as sales, but many
continue to expose the transferor to many of the significant risks and
rewards inherent in the transferred assets. In our project on
improvements to IAS 39 (page 6), we plan to propose an approach that
will clarify international standards governing a company's ability to
derecognise assets in a securitisation. Our approach, which will not
allow sale treatment when the ``seller'' has a continuing involvement
with the assets, will be significantly different from the one found in
U.S. GAAP.
Creation of Unconsolidated Entities
Under existing accounting standards in many jurisdictions, a
company that transfers assets and liabilities to a subsidiary company
must consolidate that subsidiary in the parent company's financial
statements (refer to page 7). However, in some cases (often involving
the use of an SPE), the transferor may be able (in some jurisdictions)
to escape the requirement to consolidate. IFRS governing consolidation
of SPE's are described earlier in my statement.
Pension Obligations
Under existing standards in many jurisdictions (including existing
international standards) a company's obligation to a defined benefit
pension plan is reported on the company's balance sheet. However, the
amount reported is not the current obligation, based on current
information and assumptions, but instead represents the result of a
series of devices designed to spread changes over several years.
Off Income Statement Items
Under existing accounting standards in some jurisdictions, a
company that pays for goods and services through the use of its own
stock, options on its stock, or instruments tied to the value of its
stock may not record any cost for those goods and services. The most
common form of this share-based transaction is the employee stock
option. In 1995, after what it called an ``extraordinarily
controversial'' debate, the FASB issued a standard that, in most cases
in the United States, requires disclosure of the effect of employee
stock options but does not require recognition in the financial
statements. In its Basis for Conclusions, the FASB observed:
The Board chose a disclosure-based solution for stock-based
employee compensation to bring closure to the divisive debate
on this issue--not because it believes that solution is the
best way to improve financial accounting and reporting.
Most jurisdictions do not have any standard on accounting for
share-based payments, and the use of this technique is growing outside
of the United States. The IASB has yet to reach conclusions on this
issue, but there is a clear need for international accounting guidance.
Accounting Measurement
Under existing accounting standards in most jurisdictions, assets
and liabilities are reported at amounts based on a mixture of
accounting measurements. Some of the measurements are based on
historical transaction prices, perhaps adjusted for depreciation,
amortisation, or impairment. Others are based on fair values, using
either amounts observed in the marketplace or estimates of fair value.
Accountants refer to this as the mixed-attribute model. It is
increasingly clear that a mixed-attribute system creates complexity and
opportunities for accounting arbitrage, especially for derivatives and
financial instruments. Some have suggested that financial reporting
should move to a system that measures all financial instruments at fair
value.
Our predecessor body participated with a group of 10 accounting
standard setters (the Joint Working Group or JWG) to study the problem
of accounting for financial instruments. The JWG proposal (which
recommended a change to measuring all financial assets and liabilities
at fair value) was published at the end of 2000. Last month, the
Canadian Accounting Standards Board presented an analysis of comments
on that proposal. The IASB has just begun to consider how this effort
should move forward.
Intangible Assets
Under existing accounting standards in most jurisdictions, the cost
of an intangible asset (a patent, a copyright, or the like) purchased
from a third party is capitalised as an asset. This is the same as the
accounting for acquired tangible assets (buildings and machines) and
financial assets (loans and accounts receivable). Existing accounting
standards extend this approach to self-constructed tangible assets, so
a company that builds its own building capitalises the costs incurred
and reports that as the cost of its self-constructed asset. However, a
company that develops its own patent for a new drug or process is
prohibited from capitalising much (sometimes all) of the costs of
creating that intangible asset. Many have criticised this
inconsistency, especially at a time when many consider intangible
assets to be significant drivers of company performance.
The accounting recognition and measurement of internally generated
intangibles challenges many long-cherished accounting conventions.
Applying the discipline of accounting concepts challenges many of the
popular conceptions of intangible assets and ``intellectual capital.''
We have this topic on our research agenda. We also note the significant
work that the FASB has done on this topic and its recent decision to
add a project to develop proposed disclosures about internally
generated intangible assets. We plan to monitor those efforts closely.
Conclusion
As I said at the outset, the IASB's objective is to work toward a
single set of high-quality international financial reporting standards,
produced in the private sector under principles of transparency, open
meetings, and full due process. The international financial markets
clearly want a single set of accounting standards that apply worldwide.
We have no intention to ``water down'' existing standards in any
jurisdiction. Instead, we plan to build a set of financial reporting
standards that are the ``gold standard.'' In pursuit of that goal, we
plan to pick the best of available standards produced by national
standard setters.
No single group has a monopoly on the best in accounting, and we
expect to learn from our colleagues. To the extent that the underlying
rationale in U.S. GAAP is the best available and of high quality, we
intend to incorporate that rationale into international standards. To
the extent that another standard has a superior approach, we intend to
adopt it. If no national standard adequately addresses the problem, as
may be the case in accounting for leases or share-based payments, then
we plan to work toward an international standard that does. We plan to
develop standards based on clear principles, rather than rules that
attempt to cover every eventuality. I hope that we can keep to that
plan, but its success will depend on the professionalism and judgement
of financial statement's preparers, auditors, and securities
regulators.
Our work will probably require tough decisions and unpopular
standards. Assets and liabilities that companies have moved ``off
balance sheet'' may move back ``on balance sheet.'' Expenses that today
go unrecognised may be recognised in companies' income statements.
Measurements may move from historical to more current information.
The United States, indeed the whole world, has been shocked by the
scale and speed of the Enron collapse. We who are on the outside learn
a little more every day, but it still remains to be seen whether the
financial reporting that preceded Enron's collapse was a result of
flawed accounting standards, incorrect application of existing
standards, auditing mistakes, or plain deceit. We owe an obligation to
the investors, employees, and others who have suffered to ensure, to
the best of our ability, that the lessons are learned. If there are
weaknesses in accounting standards, we should acknowledge that fact and
come forward with improvements.
In partnership with the FASB and others, we intend to change
financial reporting. In some cases, that change will be dramatic,
especially for countries without the advanced standards and financial
infrastructure found in the United States. Most of those changes will
be controversial. You and your colleagues may be asked to stop their
implementation in the United States. I hope that you resist those
requests. Global accounting standards do not create a national
disadvantage, and we have to work toward answers that investors can
trust.
Appendix One--Background Information on the IASB
Introduction
The International Accounting Standards Board (IASB), based in
London, began operations in 2001. It is funded by contributions from
the major accounting firms, private financial institutions, and
industrial companies throughout the world, central and development
banks, and other international and professional organisations. The 14
Board members (12 of whom are full-time) reside in nine countries and
have a variety of functional backgrounds. The Board is committed to
developing, in the public interest, a single set of high-quality,
global accounting standards that require transparent and comparable
information in general purpose financial statements. In pursuit of this
objective, the Board cooperates with national accounting standard
setters to achieve convergence in accounting standards around the
world.
Trustees
Board Members are appointed by the Trustees of the International
Accounting Standards Committee Foundation (IASC Foundation). Under the
IASC Foundation's Constitution, the Trustees also appoint the Standards
Advisory Council and Standing Interpretations Committee. The Trustees
also monitor IASB's effectiveness, raise funds for IASB, approve IASB's
budget and have responsibility for constitutional changes. The Trustees
are individuals of diverse geographic and functional backgrounds. Under
the Constitution, the Trustees were appointed so that initially there
were six from North America, six from Europe, four from Asia Pacific,
and three others from any area, as long as geographic balance was
maintained. Five of the nineteen Trustees represent the accounting
profession, and international organisations of preparers, users, and
academics are each represented by one Trustee. The remaining 11
Trustees were ``at-large'' appointments, in that they were not selected
through the constituency nomination process. The existing Trustees will
follow similar procedures in selecting subsequent Trustees to fill
vacancies.
Board
The Board consists of 14 individuals (12 full-time Members and two
part-time Members) and has sole responsibility for setting accounting
standards. The foremost qualification for Board membership is technical
expertise and the Trustees exercised their best judgement to ensure
that any particular constituency or regional interest does not dominate
the Board. The Constitution requires that at least five Board Members
have a background as practising auditors, at least three have a
background in the preparation of financial statements, at least three
have a background as users of financial statements, and at least one
has an academic background. Seven of the 14 Board Members have direct
responsibility for liaison with one or more national standard setters.
The publication of a Standard, Exposure Draft, or final IFRIC
Interpretation requires approval by eight of the Board's 14 Members. On
January 1, 2002, the Board Members were: Sir David Tweedie, Chairman;
Thomas E. Jones, Vice Chairman; Professor Mary E. Barth (part-time);
Hans-Georg Bruns (Liaison with the German standard setter); Anthony T.
Cope; Robert P. Garnett; Gilbert Gelard (Liaison with the French
standard setter); Robert H. Herz (part-time); James J. Leisenring
(Liaison with the United States standard setter); Warren McGregor
(Liaison with the Australian and New Zealand standard setters);
Patricia O'Malley (Liaison with the Canadian standard setter), Harry K.
Schmid; Geoffrey Whittington (Liaison with the UK standard setter); and
Tatsumi Yamada (Liaison with the Japanese standard setter).
Upon its inception the IASB adopted the body of the International
Accounting Standards (IAS's) issued by its predecessor, the
International Accounting Standards Committee. The accounting standards
developed by the Board will be styled International Financial Reporting
Standards (IFRS).
Standards Advisory Council
The Standards Advisory Council (SAC) provides a formal vehicle for
further groups and individuals having diverse geographic and functional
backgrounds to give advice to the IASB and, at times, to advise the
Trustees. The Trustees attach particular importance to the perspective
that the Council can bring to the IASB's role and mandate. The Council
comprises about 50 members, having diverse geographic and functional
backgrounds and the expertise required to contribute to the formulation
of accounting standards. It has the objective of (a) giving advice to
the IASB on priorities in the IASB's work, (b) informing the IASB of
the implications of proposed standards for users and preparers of
financial statements, and (c) giving other advice to the IASB or the
Trustees. The Council normally meets at least three times a year. It is
to be consulted by the IASB on all major projects and its meetings are
to be open to the public. The Trustees appointed the initial Members of
the Council in June 2001.
Standing Interpretations Committee
The Standing Interpretations Committee (SIC) was formed in 1997 and
was reconstituted in December 2001. The Trustees have proposed an
amendment to the Constitution in order to change the name of the
Committee to the International Financial Reporting Interpretations
Committee and to give it the following mandate:
Interpret the application of International Financial Reporting
Standards and provide timely guidance on financial reporting issues
not specifically addressed in IFRS, in the context of IASB's
Framework, and undertake other tasks at the request of the Board.
Publish Draft Interpretations for public comment and consider
comments made within a reasonable period before finalising an
Interpretation.
Report to the Board and obtain Board approval for final
Interpretations.
The IFRIC consults similar national interpretative bodies around
the world, in particular those in partner jurisdictions.
The Committee has 12 voting members, appointed by the Trustees for
a renewable term of 3 years. The International Organization of
Securities Commissions (IOSCO) and the European Commission are
nonvoting observers. In the changes to the Constitution, the Trustees
have also proposed that a member of the IASB, the Director of Technical
Activities or another senior member of the IASB staff, or another
appropriately qualified individual be appointed to Chair the Committee.
The Chair will have the right to speak to the technical issues being
considered but not to vote.
The IFRIC deals with issues of reasonably widespread importance:
Not issues of concern to only a small number of enterprises. The
interpretations cover both:
Mature issues (areas where there is unsatisfactory practice
within the scope of existing International Accounting Standards).
Emerging issues (new topics relating to an existing
International Accounting Standard but not considered when the
Standard was developed).
The IASB publishes a report on IFRIC decisions immediately after
each IFRIC meeting. This report is made available (in electronic
format) as soon as possible to subscribers and, subsequently, posted to
the IASB website.
IASB Staff
A staff based in London, headed by the Chairman of the IASB,
supports the Board. The technical staff and other project managers
currently include people from Australia, Bermuda, Canada, France,
Japan, New Zealand, the Russian Federation, Sweden, the United Kingdom,
and the United States.
Due Process
The IASB published its proposed due process in an Exposure Draft of
the Preface to International Financial Reporting Standards in November
2001. The following is that proposed due process, and may be changed as
a result of comments received on the Exposure Draft.
IASB Due Process
IFRS are developed through an international due process that
involves accountants, financial analysts, and other users of financial
statements, the business community, stock exchanges, regulatory and
legal authorities, academics and other interested individuals and
organisations from around the world. The Board consults with the SAC
about the projects it should add to its agenda and discusses technical
matters in meetings that are open to public observation. Due process
for projects normally, but not necessarily, involves the following
steps (the steps that are required under the terms of the Constitution
are indicated by an asterisk*):
Staff work to identify and review all the issues associated
with the topic and to consider the application of the IASB's
Framework to the issues.
Study of national accounting requirements and practice and an
exchange of views about the issues with national standard setters.
Consultation with the SAC about the advisability of adding the
topic to the Board's agenda.*
Formation of an advisory group to give advice to the Board on
the project.
Publishing for public comment a discussion document.
Publishing for public comment an Exposure Draft approved by at
least eight votes of the Board, including any dissenting opinions
held by Board Members and a basis for conclusions.*
Consideration of all comments received on discussion documents
and Exposure Drafts.*
Consideration of the desirability of holding a public hearing
and of the desirability of conducting field tests and, if
considered desirable, holding such hearings and conducting such
tests.
Approval of a Standard by at least eight votes of the Board
and inclusion in the published Standard of any dissenting opinions
and a basis for conclusions, explaining, among other things, how
the Board dealt with public comments on the Exposure Draft.*
IFRIC Due Process
Interpretations of IFRS are developed through an international due
process that involves accountants, financial analysts and other users
of financial statements, the business community, stock exchanges,
regulatory and legal authorities, academics and other interested
individuals and organisations from around the world. The IFRIC
discusses technical matters in meetings that are open to public
observation. The due process for each project normally, but not
necessarily, involves the following steps (the steps that are required
under the terms of the Constitution are indicated by an asterisk*):
Staff work to identify and review all the issues associated
with the topic and to consider the application of the IASB's
Framework to the issues.
Study of national accounting requirements and practice and an
exchange of views about the issues with national standard setters,
including national committees that have responsibility for
interpretations of national standards.
Publication of a Draft Interpretation for public comment if no
more than three of the IFRIC's members have voted against the
proposal.*
Consideration of all comments received on a Draft
Interpretation within a reasonable period of time.*
Approval by the IFRIC of an Interpretation if no more than
three of the IFRIC's members have voted against the Interpretation
after considering public comments on the Draft Interpretation.*
Approval of the Interpretation by at least eight votes of the
Board.*
Voting
Each Board Member has one vote on technical and other matters. The
publication of a Standard, Exposure Draft, or final IFRIC
Interpretation requires approval by eight (8) of the Board's fourteen
(14) Members. Other decisions, including the issuance of a Draft
Statement of Principles or a Discussion Paper and agenda decisions,
requires a simple majority of the Board Members present at a meeting
attended by 50 percent or more of the Board Members. The Board has full
control over its technical agenda.
Each Member of the IFRIC has one vote on an Interpretation. Eight
voting IFRIC Members represents a quorum. Approval of Interpretations
requires no more than three IFRIC Members present at the meeting vote
against the proposal.
Openness of Meetings
IASB and IFRIC meetings are open to public observation.
However, certain discussions (primarily selection of items for the
technical agenda and appointment and other personnel issues) are,
at the Board's and the IFRIC's discretion, held in private.
Portions of the Trustees' meetings are also open to the public, at
the discretion of the Trustees.
IASB continues to explore the use of recent technology (such
as the Internet and electronic observation of meetings), to
overcome geographical barriers and the logistical problems for
members of the public in attending open meetings.
IASB publishes in advance on its Internet site the agenda for
each meeting of the Trustees, IASB, SAC, and the IFRIC and
publishes promptly a summary of the technical decisions made at
IASB and IFRIC meetings and, where appropriate, decisions of the
Trustees.
When IASB publishes a Standard, it publishes a Basis for
Conclusions to explain publicly how it reached its conclusions and
to give background information that may help users of IASB
standards to apply them in practice. IASB also publishes dissenting
opinions.
Comment Periods
The Board issues each Exposure Draft of a Standard and discussion
documents for public comment, with a normal comment period of 120 days.
In certain circumstances, the Board may expose proposals for a much
shorter period. However, such limited periods would be used only in
extreme circumstances. Draft IFRIC Interpretations are exposed for a 60
day comment period.
Coordination with National Due Process
The Board meets with the Chairmen of its partner national standard
setters at least three times a year. Close coordination between the
IASB's due process and the due process of national standard setters is
important to the success of the IASB. As far as possible, the IASB
would integrate its due process with national due process. Such
integration may grow as the relationship between the IASB and the
national standard setters evolves. In addition, those Board Members
having liaison responsibilities with a national standard setter provide
a mechanism for more regular contact.
Opportunities for Input
The development of an International Accounting Standard involves an
open, public process of debating technical issues and evaluating input
sought through several mechanisms. Opportunities for interested parties
to participate in the development of International Accounting Standards
would include, depending on the nature of the project:
Participation in the development of views as a member of the
Standards Advisory Council.
Participation in advisory groups.
Submission of a comment letter in response to a discussion
document.
Submission of a comment letter in response to an Exposure
Draft.
Participation in public hearings.
Participation in field visits and field tests.
The IASB publishes an annual report on its activities during the
past year and priorities for the next year. This report provides a
basis and opportunity for comment by interested parties.
Preface to Statements of International Accounting Standards
The current Preface to Statements of International Accounting
Standards was approved in November 1982 and published in January 1983.
The Board issued a proposed Preface to International Financial
Reporting Standards in November of 2001. The Board expects to complete
its due process on the Preface in the second quarter 2002.
IASB Framework
The IASB Framework is a conceptual accounting framework (based on
pioneering work by the FASB) that sets out the concepts that underlie
the preparation and presentation of financial statements for external
users. It was approved in 1989. The IASB Framework assists the IASB:
In the development of future International Accounting
Standards and in its review of existing International Accounting
Standards.
In promoting the harmonisation of regulations, accounting
standards and procedures relating to the presentation of financial
statements by providing a basis for reducing the number of
alternative accounting treatments permitted by International
Accounting Standards.
In addition, the Framework may assist:
Preparers of financial statements in applying International
Accounting Standards and in dealing with topics that have yet to
form the subject of an International Accounting Standard.
Auditors in forming an opinion as to whether financial
statements conform with International Accounting Standards.
Users of financial statements in interpreting the information
contained in financial statements prepared in conformity with
International Accounting Standards.
Those who are interested in the work of the IASB, providing
them with information about its approach to the formulation of
accounting standards.
The Framework is not an International Accounting Standard and does
not define standards for any particular measurement or disclosure
issue.
In a limited number of cases there may be a conflict between the
Framework and a requirement within an International Accounting
Standard. In those cases where there is a conflict, the requirements of
the International Accounting Standard prevail over those of the
Framework.
* * *
This project contemplates a review of differences between existing
standards, rather than a comprehensive review of the topic.
ACCOUNTING REFORM AND
INVESTOR PROTECTION
----------
TUESDAY, FEBRUARY 26, 2002
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:25 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 Committee holds the third in a series of
hearings on accounting standards and practices and investor
protection. Our witnesses today have been asked to address the
preparation and audit of the financial reports of public
companies, auditor performance and independence, the
formulation of auditing standards and accounting principles,
and generally, the oversight of the accounting profession.
It probably needs to be said at the outset that accounting
abuses are not new under the securities law. The McKesson &
Robbins investigation as long ago as 1940, the collapse of Penn
Central and Equity Funding Corporation, the scandals leading to
the Foreign Corrupt Practices Act, and, of course, the S&L
crisis in the 1980's, all raised significant questions about
auditing and accounting for public companies under the
securities law.
Today's difficulties, unfortunately, appear to be more
widespread and the fears that they have generated are more
widely shared since more and more people are investing in our
stock market than ever before.
What is at stake is the all-important trust of our
citizens, and of the world's investors, in our capital markets.
Yesterday's Wall Street Journal reports, for example, that the
historical premium paid for U.S. stocks because of our:
``Supposedly stricter corporate governance standards'' and
accounting rules may be disappearing. Less money in our capital
markets directly reduces the ability of our economy to create
jobs, prosperity, and a secure retirement for working men and
women across America. This is an issue which must concern us
all.
The role of auditors in our free-market system was
summarized by the unanimous Supreme Court 30 years ago:
``In certifying the public reports that collectively depict
a corporation's financial status, the independent auditor
assumes a public responsibility. That auditor owes ultimate
allegiance to the corporation's creditors and stockholders, as
well as to the investing public. This `public watchdog'
function demands that the accountant maintain total
independence from the client at all times and requires complete
fidelity to the public trust.''
Since the early days of the securities law, we have chosen
to rely on private control of the audit process, private
auditing and accounting standard setting, and for the most part
private disciplinary measures, to maintain that public trust.
But the growing number of serious failures--not only Enron--
demands a response.
I will say more on each witness as I turn to them, but let
me say I feel that they are extremely well positioned to give
this Committee assistance. Walter Schuetze, Michael Sutton, and
Lynn Turner, in turn, occupied the position of SEC Chief
Accountant during most of the 1990's, under Chairman Breeden
and Chairman Levitt. And Mr. Schuetze returned to the SEC as
Chief Accountant for the Division of Enforcement from 1997 to
2001. Professor Beresford was Chairman of the Financial
Accounting Standards Board for a decade, from 1987 to 1997.
Before we turn to the witnesses, though, I want to note a
matter which I think is of current and of extreme importance.
And that is that the SEC be adequately funded and staffed to
carry out its dual responsibilities of protecting investors and
maintaining the integrity of the securities market. Especially
in view of the mounting numbers of financial restatements and
of the current apprehensions these have caused among investors,
the SEC needs to be in a position to act prudently,
efficiently, and decisively.
In my view, and this is a view that I have held for quite a
long period of time, it does not have the resources to do so.
Its current Chairman actually has gone as far as to describe
the situation as a staffing crisis.
A GAO report dated September of last year found the
following: More than 1,000, or about one third of the staff,
left the Commission in the 3 year period from 1998 to 2000. Of
those leaving, more than 500 were attorneys. SEC's turnover
rates for attorneys, accountants, and examiners averaged 15
percent in the year 2000. More than 280 positions, or nearly 10
percent, of all Commission positions were unfilled at the end
of 2001.
There is nothing mysterious about this crisis. In terms of
the compensation it can offer, the Commission is at a severe
disadvantage. Compared to their counterparts at the other
Federal financial regulatory agencies, SEC staff earn in the
range of 24 percent to 39 percent less.
Now, we worked hard in the last session to pass legislation
authorizing pay parity for the SEC and also cutting a number of
fees, because it was perceived that they were bringing in a lot
more revenue than the rationale for establishing them to begin
with, which was to be supportive of the SEC budget. The
President signed that into law, but the Administration's budget
request for the coming year does not make allowance for the
staffing problems or measures. It does not provide for the pay
parity, which I think we all assumed would be requested.
It in effect continues a current level of funding, which I
think is inadequate, and therefore, heightens the risk of
losing staff competence and professionalism at the SEC.
This is a matter that I think this Committee will return
to.
We are in the process now of trying to examine very
carefully and comprehensively what systemic and structural
changes need to be made and how the whole investor protection
system and structure operates. We are obviously seeking the
benefit of some very expert opinion in trying to arrive at our
recommendations. But it seems to me that there is one thing
that clearly could be done immediately that would help to
address this problem, and that is to address this shortfall or
shortage in the SEC budget.
Now, I have written to both the President and the Chairman
of the SEC, urging them to seek additional monies. We will try
in the Congress as best we can to provide them, even if they do
not seek them. It obviously would be helpful if the
Administration were behind that push as well. Otherwise, we are
going to continue to have this drain of the SEC staff because
of the failure to reach pay parity, and we are going to
continue to have the shortfall in terms of adequate staffing to
really address the current situation.
Senator Gramm.
STATEMENT OF SENATOR PHIL GRAMM
Senator Gramm. Mr. Chairman, first of all, let me just
begin by commenting on pay parity and fees.
This has been a truly bipartisan effort. It started when I
was Chairman, continued when you became Chairman. I think the
bill we passed is a very important first step. I think the
change in fees was needed. We provided pay parity. We can have
endless debates about how big Government ought to be, but I do
not think there is any debate about the fact that we want the
best people that we can find in Government.
I think it is foolish economics to hire people to do
important jobs and then not pay them enough to recruit and to
retain the best people.
We have had a problem at the SEC. I think we have taken a
major step in the direction of fixing the problem. I look
forward to working with you on the SEC budget and trying to see
that the fix is implemented.
Let me also thank you, Mr. Chairman, for the forward-
looking nature of these hearings. I do not know what the last
count was--18 or 20 committees are holding hearings on related
subjects. But the jurisdiction over the issue is this
Committee's jurisdiction.
So, in the end, it is not going to be enough for us to jump
up and down and shout and point fingers at people. It is going
to be our mission to figure out changes that need to be made.
I think the first hearing you had was an excellent hearing.
I look forward to hearing our witnesses today. I would say that
one of the things that we have to make a fundamental decision
on is who is going to set accounting standards?
I would have to say that, all things considered, I still
support an independent body setting accounting standards. It
scares me to death having Government or politicians set
accounting standards.
As I once said to our previous Chairman of the SEC, that
while I differed with him on breaking up accounting firms,
there was no circumstance under which I at the time as Chairman
was going to allow Congress to intervene, no matter what
decision he made, that in the end, the only thing worse than
the SEC setting standards is to have Congress get in the
business of setting standards.
I think, having said that, the question then becomes how do
we fund FASB? How do we guarantee its independence, including
independence from the Government, one of the most corrosive
influences that I can imagine?
So this is a tough assignment. It is one thing to talk
about there is a need for change. But when you start talking
about changing something as fundamental as accounting standards
and accounting procedures, this is a very tough issue and it is
one that we are going to have to be very deliberative about. It
is one that we are going to have to be sure that we know what
we are talking about.
I think your hearings have thus far been excellent in terms
of preparing us for that decision.
Mr. Chairman, I look forward to working with you on this.
This is something that can and should be done on a bipartisan
basis. I think it is the only way it is going to be done right.
This Committee has an opportunity to make a great contribution
to the financial security of the country, to the well-being of
workers and investors. We benefit every day by having the
greatest capital market in the world. And we have it within our
power to make it better, I believe.
Chairman Sarbanes. Thank you very much.
Senator Miller.
COMMENTS OF SENATOR ZELL MILLER
Senator Miller. Thank you, Mr. Chairman.
I do not have an opening statement, but I would like to
echo the comments of Senator Gramm about the quality of these
hearings. I would also like to thank all of our witnesses for
being here, particularly Professor Beresford, who is at the
University of Georgia, and we are so pleased that he is there.
Thank you.
Chairman Sarbanes. Senator Enzi.
STATEMENT OF SENATOR MICHAEL B. ENZI
Senator Enzi. Thank you, Mr. Chairman.
I want to thank you for your willingness to continue the
dialogue on the accounting standards. This is a real red-letter
day for me because we have had people who have been in here
talking about a number of the problems that exist, some of
which deal with accounting. And it is so exciting to finally
have the accountants to be able to talk about accounting.
[Laughter.]
Chairman Sarbanes. Said in a heartfelt way by an
accountant.
Senator Enzi. Yes.
[Laughter.]
During the break, I traveled about 2,000 miles across
Wyoming. And one of the exciting things was to find the renewed
interest in accounting. Not in a negative way, but in a very
positive way. There are people who just did not realize that
this was such an exciting profession and that we controlled so
much.
[Laughter.]
I know when I was going to college, I thought about the
business courses or the more specified accounting courses. I
picked accounting because it does not change as rapidly as some
of the other
principles and it is a way that you can find out how an entity
is operating. Since I have gotten here, I have done some audits
on agencies to see how what they say they are doing compares to
what they really are doing. It is probably a good thing that a
lot of our agencies aren't listed on the stock market.
Today's witnesses will further educate us. After 2 weeks of
hearings focused on protecting investors and our witnesses all
have different ideas how best to combat these problems and it
is important for us to learn from them before acting on
legislation.
I do appreciate the testimony they have provided. I know
that it is longer than what they can present during the time
that is allotted, but I do hope my colleagues will take a look
at the extensive knowledge that they have shared with us in the
testimony.
The recent collapses of Enron and Global Crossing, and
before that, Sunbeam, Waste Management, and MicroStrategy, as
well as others, have affected the confidence of America's
investors in our capital markets. While we in Washington
encourage Americans to save and invest in the markets, we have
not taken the needed time to ensure that the financial
accounting system is providing the transparency needed for
investors to invest their money wisely. However, I believe we
should not rush to over-react.
As we have seen, the marketplace has taken care of a lot of
the problems created by Enron. Credit-rating agencies are
examining the books more closely. Analysts are asking tougher
and more pointed questions. These are very positive
developments.
Unfortunately, as new businesses have emerged, the
accounting system has not kept pace. A simple example is Rule
133, dealing with the financial derivatives. Eight hundred
pages were required to outline and explain this rule. The
accounting rules seem to be able to match the complexity of the
Internal Revenue Code.
When this many pages are required to explain a rule, it
breeds an environment where loopholes are found to circumvent
the rule instead of adhering to the spirit of the rule.
Another example is FASB's consolidation policy. I look
forward to hearing from our witnesses as to what they see are
the hurdles to making substantial change. I also want to learn
from them why we did not catch this type of problem sooner.
It seems to me that any time you have a rule proposal that
is not finalized for 15 years, a systemic problem exists,
especially with the accounting industry where technology and
standards are changing at an extremely rapid pace.
Any action that is taken either through regulation or
legislation must be sensitive to business size. And I say that
because I know that a small business in Wyoming should not have
the same restrictions or burdens placed on a large,
multinational corporation.
In many of the communities in Wyoming, we only have two or
three accounting firms. If we fail to recognize the predicament
of these small businesses, we will end up hurting more than
helping.
However, investors must also begin to scrutinize companies
in which they invest more closely. A farmer wouldn't buy land
without knowing what he could plant on the land or what kind of
return it offers, whether it is close to a flood plain or what
is grown on the land historically.
In contrast, investors seem to be content to invest their
money in the markets with little or no knowledge of what the
company does, how it makes money, or with what it is affiliated
or if it even has a product. This situation must change, and
that is why I am glad that the Chairman has focused some of the
Committee's attention on education, the financial education,
the financial literacy.
We had a great hearing on that here, and I do appreciate
it. However, this is not meant to indicate that some form of
legislation might not be needed. As we have seen, executive
compensation needs to be reported more expeditiously and
accurately. Off balance sheet debt must be accurately reflected
in the balance sheets. And more oversight and accountability is
needed by the boards of directors of these large corporations.
Again, Mr. Chairman, I do appreciate your holding this
hearing today. I look forward to working with you and Members
of the Committee on this issue. I thank the witnesses and I
look forward to hearing their testimony.
Thank you.
Chairman Sarbanes. Thank you very much, Senator Enzi.
Senator Stabenow.
COMMENTS OF SENATOR DEBBIE STABENOW
Senator Stabenow. Well, thank you, Mr. Chairman. Thank you
very much to the witnesses today. I also, Mr. Chairman, would
echo what my colleagues have said about the thoughtfulness of
the hearings and your willingness to be thorough.
As we have listened to witnesses that have provided
excellent information, I am sure the same will be true today.
We have seen a number of common themes that I hope we will
explore more today. One is the current process of establishing
accounting standards and the problems, and I would welcome the
comments from our witnesses today.
I am certainly concerned about finding a better way to
insulate the establishment of accounting standards from
politics and pressures, both from the industry and, frankly,
from Congress.
We need to make sure that we are providing the right kind
of standards in the right kind of way.
I am also concerned that, as others have pointed out, we
need to think about how the domestic as well as the
International Accounting Standards Boards can create a system
to finance themselves without relying on funding from
corporations who would ultimately comply with the Board's
standards. And whether there is wrong-doing or not, it
certainly leaves an unfortunate impression.
I would welcome thoughts from our panelists today as well.
And certainly, I would also welcome comments regarding changes
that need to occur, if any, at the SEC. I am continually
concerned about our small investors, the employees that have
been caught in systems where they are highly invested in their
own companies, and I think they deserve a better system. And
frankly, I do not think it is too much to ask for an accounting
system that ensures that publicly released information is
accurate, easily understandable, and comprehensive.
I hope that as we proceed with the hearings, that we will
be able to do everything within our power to ensure that
investors can count on a system that has integrity, that is
transparent, and ultimately, will allow them to protect their
own interests.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Stabenow.
Senator Allard.
COMMENTS OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, I would like to join my other
colleagues on the Committee in thanking you for holding this
hearing. You have moved forward quickly to examine recent
corporate failures and I appreciate your swift action.
I think that transparency needs to be resolved. I think it
is key to bringing confidence to the stock market. We have all
heard a great deal about the recent meltdowns at Enron and
Global Crossing and other companies. A great deal of the
controversy seems to center around the reliability of the
financial statements from these companies.
Our financial markets depend on timely, accurate, and
reliable information. I believe that it is important to examine
the public policy implications of these collapses so that we
can help to restore investors' confidence.
Particularly, I am concerned with the use of off balance
sheet arrangements, which can be used to obscure the actual
condition of a company. I am hopeful that the Financial
Accounting Standards Board will ensure that such transactions
are appropriately reflected in the financial statements and
disclosures.
I would like to take this opportunity, Mr. Chairman, to
welcome one of my constituents, Lynn Turner, to the Banking
Committee. Lynn was the Chief Accountant for the SEC from 1998
to 2001, and he currently serves as the Director of the Center
for Quality Financial Reporting at my alma mater, Colorado
State University.
I would also like to welcome our other witnesses and thank
them for being here today. I understand that you are all very
busy, but your expertise will be helpful as the Banking
Committee grapples with the many accounting issues that have
been brought to light during recent weeks. I again thank you
for being here and I look forward to your testimony.
Thank you, Mr. Chairman.
Chairman Sarbanes. Senator Shelby.
COMMENTS OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman. I will try to be
brief.
Through the course of the hearings that the Committee has
conducted in the last several weeks, we have heard a great deal
about the importance of accurate information for properly
functioning capital markets. One of the most essential tools
for providing such information is the independent financial
audit.
Certified public accountants are supposed to provide
objective analysis to ensure that the investing public is
presented with an accurate picture of a company's financial
condition. Unfortunately, recent events provide clear examples
of where firms have acted more like lapdogs instead of
watchdogs. We have seen that too often the ``public''
responsibilities associated with the title ``certified public
accountant,'' have been ignored.
Mr. Chairman, the Enron case and many others like it
requires that this Committee address a very basic question--can
the accounting industry be relied upon to meets its
responsibilities to the public? As I have noted in some of my
previous remarks, addressing this question is extremely
important. Fraud in the capital markets causes damage that go
far beyond the losses of a particular group of investors. Fraud
diminishes investor confidence and ultimately stifles economic
growth.
Because of the seriousness of the damage that it causes, I
believe that we must not only severely punish fraud in our
markets, we must also find ways to tear it in the first place.
In the end, I do not think that we can legislate honesty or
integrity in accounting or any profession. But I do believe
that we must try to establish that those with responsibilities
meet them or face consequences for their failure to do so.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Shelby.
Senator Corzine.
COMMENTS OF SENATOR JON S. CORZINE
Senator Corzine. Yes, Mr. Chairman. Thank you for holding
this hearing. I will have a more complete statement that I
would like to be put in the record. But I continue to say what
was said at the previous hearings, that it is our
responsibility to look at the underlying factors that I think
have been highlighted by the Enron situation, but not unique
with them with regard to financial disclosure, transparency of
the financial information that companies present, particularly
in the public forum. And that it is a broad-based issue that
needs overall review.
I would rather see us focused on the principles at play, as
opposed to some of the more dramatic elements of it.
I think this is truly one of the areas, the discussion
today that the witnesses will bring to us, that can bring
enhanced strength to our financial markets and security to
investors. And I think as long as we keep it focused on that,
we will do ourselves a big favor.
Thank you very much for having these hearings and I
appreciate the public service that the gentlemen at the table
have provided to the Nation and I know that their testimony
will be very helpful in addressing this issue.
Thank you.
Chairman Sarbanes. Thank you very much, Senator Corzine.
Your full statement will be included in the record.
We will now turn to our panel. I want to echo the
appreciation which has been expressed by other Members of the
Committee for your being willing to come today, and the time
and effort that has obviously gone into the prepared
statements, which will be included in full in the record, and
given our time constraints, I know you understand the need to
summarize.
We will first hear from Walter Schuetze, who was the Chief
Accountant at the SEC from January 1992 through March 1995, and
actually came back to the SEC as Chief Accountant of the
Commission's Division of Enforcement in November 1997 and
served until February 2000.
Mr. Schuetze was one of the initial members of FASB, from
April 1973 through 1976. He was also a member of the Accounting
Standards Executive Committee of the American Institute of
Certified Public Accountants, a member of the Steering
Committee of the International Accounting Standards Committee,
and was a partner with the public accounting firm of KPMG from
1965 to 1973 and from 1976 until 1992.
Mr. Schuetze, we would be very happy to hear from you.
STATEMENT OF WALTER P. SCHUETZE
CHIEF ACCOUNTANT
U.S. SECURITIES AND EXCHANGE COMMISSION
1992 TO 1995
Mr. Schuetze. Thank you, Mr. Chairman, Senator Gramm, and
Members of the Committee. My name is Walter Schuetze. My brief
resume is attached.
I need to mention that although I am retired, I am a
consultant to the Securities and Exchange Commission and
several other entities under consulting contracts. I will be
pleased to discuss those privately with the Senators or their
staff. In addition, I have one remaining tie with my former
firm, KPMG, in that I am an insured under a group life
insurance contract obtained and administered by that firm. I
pay the premium attributable to me.
You have my prepared remarks to which you may refer. In the
interest of time, I will abbreviate those remarks.
As has been noted by the Senators, the public's confidence
in financial reports of and by Corporate America, and in the
audit of those financial reports by the public accounting
profession, has been shaken badly by the recent surprise
collapse of Enron, by recent restatements of financial
statements by the likes of Enron, Waste Management, Sunbeam,
Cendant, Livent and MicroStrategy, and by the SEC's assertion
of fraud by Arthur Andersen in connection with its audits of
Waste Management's financial statements in the 1990's, which
Andersen did not admit or deny in a settled SEC action last
summer.
As has been noted by the Senators, the financial statements
and the financial reports are extremely important. I refer to
them as the oxygen of our capital markets.
You will hear or have heard many suggestions for
improvement to our system of financial reporting and audits of
those financial reports. Some will say that auditor
independence rules need to be strengthened. That external
auditors should not be allowed to do consulting work and other
nonaudit work for their audit clients. That external audit
firms should be rotated every 5 years or so. That oversight of
auditors needs to be strengthened. That punishment of wayward
auditors needs to be more certain and swift, and so on and on.
In my opinion, those suggestions, even if legislated by
Congress and signed by the President, will not fix the
underlying problem.
The underlying problem is a technical accounting problem.
The problem is rooted in our rules for financial reporting.
Those financial reporting rules need deep and fundamental
reform. Unless we change those rules, nothing will change.
Today's crisis as portrayed by the surprise collapse of Enron
is the same kind of crisis that arose in the 1970's when Penn
Central surprisingly collapsed and in the 1980's when hundreds
of savings and loan associations collapsed, which precipitated
the S&L bailout by the Federal Government. There will be more
of these crisis unless the underlying rules are changed.
Under our current financial reporting rules promulgated by
the Financial Accounting Standards Board, management of the
reporting corporation controls and determines the amounts
reported in the financial statements for most assets.
Except for inventories and marketable securities, none of
these amounts in the financial statements is subjected to the
test of what the cash market price of the asset is. Yet, we
know that most individual investors, and, in my experience,
even many sophisticated institutional investors, believe that
the reported amounts in the financial statements, in the
corporate balance sheet, represent the current market prices of
those assets. Nothing could be further from the truth.
And under the FASB's definition of an asset, corporations
report as assets things that have no market price whatsoever.
Examples are goodwill, direct response advertising costs,
deferred income taxes, future tax benefits of operating loss
carry forward, costs of raising debt capital, and interest
costs for debt said to relate to the acquisition of fixed
assets. I call these nonreal assets. Today's corporate balance
sheets are laden with these nonreal assets. This is the kind of
stuff that allows stock prices to soar when in fact the
corporate balance sheet is bloated with hot air. When it comes
time to pay bills or make contributions to employees' pension
plans, this stuff is worthless.
The same goes for liabilities. Corporate management
determines the reported amount of liabilities for such things
as warranties, guarantees, commitments, environmental
remediations, and restructurings. Again, this is as per the
FASB's accounting rules.
The upshot is that earnings management abounds. Earnings
management is like dirt--it is everywhere. SEC Commissioners
have made speeches decrying earnings management. Business Week,
Forbes, Barron's, The New York Times, The Wall Street Journal,
and the Harvard Business Review carry hand-wringing articles
about earnings management. Earnings management is talked about
matter-of-factly on Wall Street Week and on Bloomberg TV, CNBC,
CNNfn, and MSNBC. Earnings management is a scourge in this
country. Earnings management is common in other countries as
well because their accounting rules, and the accounting rules
promulgated by the International Accounting Standards Board,
are much the same as ours.
We need to put a stop to earnings management. But until we
take control of the reported numbers out of the hands of
corporate management, we will not stop earnings management and
there will be more Enrons, more Waste Managements, Livents,
Cendants, MicroStrategys, and Sunbeams, to mention only a few.
Now how do we take control of the reported numbers out of
the hands of corporate management? We do it by requiring that
the reported numbers for assets and liabilities, including
guarantees and commitments, be based on estimated current
market prices--current cash selling prices for assets and for
current cash settlement prices for liabilities.
Let me just give you an example of what I am talking about.
Pre-September 11, 2001, the major airlines, to the extent that
they own aircraft instead of leasing them, had on their balance
sheets aircraft at the cost of acquiring those aircraft from
Airbus and Boeing. Let's say that that cost was $100 million
per aircraft. The prices of those aircraft fell into the
basement post-September 11 to about $50 million per aircraft
and they remain there today although prices have recovered
somewhat. Yet under the FASB's rules, those airlines continue
to report those aircraft on their balance sheets at $100
million and are not even required to disclose that the aircraft
are worth only $50 million. Under mark-to-market accounting,
the aircraft would be reported at $50 million on the airlines'
balance sheets, not $100 million.
I could give you many more examples, but I will add just
one more. In the late 1970's, this country was experiencing
great inflation. The Federal Reserve Board raised short-term
interest rates dramatically. Long-term rates shot up. As a
consequence, the market value of previously acquired
residential mortgage loans and Government bonds held by savings
and loan associations declined drastically. But the regulations
of the Federal Home Loan Bank Board and the FASB's accounting
rules said that it was okay for the mortgage loans and bonds to
be reported at their historical cost. Consequently, the S&L's
appeared solvent but really were not. This mirage allowed the
S&L's to keep their doors open and in so doing they incurred
huge operating losses because their cost of funds far exceeded
their interest income on loans and bonds in their portfolios.
Some of the S&L's decided to double-down by investing in risky
real estate projects, also accounted for at historical cost,
and proceeded to lose still greater amounts, which losses were
hidden on the balance sheet under the historical cost label.
Of course, when the Federal Government had to bail out the
insolvent S&L's in the 1980's, the Federal Government paid for
the losses that were hidden in the balance sheet under the
historical cost label and the operating losses that had been
incurred while the S&L's kept their doors open because of
faulty accounting. Had mark-to-market accounting been in place,
and had the Federal Home Loan Bank Board computed regulatory
capital based on the market value of the S&Ls' mortgage loans,
Government bonds, and real estate projects, the S&L hole would
not have gotten nearly as deep as it ultimately did.
Various Members of Congress have said in recent hearings
about Enron, and I think it was echoed here this morning, that
a corporation's balance sheet must present the corporation's
true economic financial condition. A corporation's true
economic financial condition cannot be seen when assets are
reported at historical cost amounts. The only objective way
that the true economic financial condition of a corporation can
be portrayed is to mark-to-market all of the corporation's
assets and liabilities.
Recall my earlier example about the cost of aircraft being
$100 million and the current market value being $50 million.
Mr. Chairman and Members of the Committee, is there any
question that the $50 million presents the true economic
financial condition and the $100 million does not? Moreover,
following today's FASB's accounting rules produces financial
statements that are understandable only to the very few
accountants who have memorized the FASB's mountain of rules.
Indecipherable is the word Chairman Pitt has used in recent
speeches. On the other hand, marking to market will produce
financial statements that investors, the Members of Congress,
and my sister, who also happens to be an investor, can
understand.
The various proposals that have been made to cure Enronitis
will not cure the problem. The only cure, in my opinion, is
mark-to-market. Now, you may ask, how much will it cost to
mark-to-market? Can we afford to mark-to-market?
My response is that we cannot afford not to mark-to-market.
How much of the cost of the S&L bailout was attributable to
faulty accounting? The amount is unknowable, but undoubtedly,
was huge. How much does an Enron or Cendant or Waste Management
or MicroStrategy or Sunbeam cost? The answer for investors is
billions, and that does not count the human anguish when
working employees lose their jobs, their 401(k) assets, and
their medical insurance, and retired employees lose their cash
retirement benefits and medical insurance.
By some estimates, Enron alone cost $60 to $70 billion in
terms of market value that disappeared in just a few months.
Waste Management, Sunbeam, and all of the others also cost
billions in terms of market capitalization that disappeared
when their earnings management games were exposed. And these
costs do not include the immeasurable cost--which has been
referred to here this morning--of lost confidence by investors
in financial reports and the consequent negative effect on the
cost of capital and market efficiency.
By my estimate, annual external audit fees in the United
States for our 16,000 public companies, 7,000 mutual funds,
7,000 broker-dealers total about $12 billion. Let's say that of
that $12 billion, $4 billion is attributable to mutual funds
and broker-dealers. Incidentally, mutual funds and broker-
dealers already mark-to-market their assets every day at the
close of business, and we have very few problems with
fraudulent financial statements being issued by those entities.
Mark-to-market works and is effective. That leaves $8 billion
attributable to the 16,000 public companies. Assume that the $8
billion would be doubled or even tripled if the 16,000 public
companies had to get competent, outside valuation experts to
determine the estimated cash market prices of their assets and
liabilities. We are then looking at an additional annual cost
of $16 to $24 billion. If we prevented just one Enron per year
by requiring mark-to-market accounting, we easily would pay for
that additional cost. And when considered in relation to the
total market capitalization of U.S. corporate stock and bond
markets of more than $20 trillion, $16 to $24 billion is,
indeed, a small price to pay.
So the question arises--who should mandate mark-to-market
accounting? I respectfully disagree with Senator Gramm. And I
recommend that there be a sense of Congress resolution that
corporate balance sheets must present the reporting
corporation's true financial condition through mark-to-market
accounting for the corporation's assets and liabilities. Then I
recommend that Congress leave the implementation to the SEC,
much the way it is done by the SEC today for broker-dealers and
mutual funds. There will be many implementation issues, so the
SEC will need more staff and more money.
I will be pleased to answer the Committee's questions.
Thank you very much.
Chairman Sarbanes. Thank you, sir, for a very interesting
statement. We very much appreciate it.
We will next hear from Michael Sutton, who is currently an
independent consultant on accounting and auditing regulations
related to professional issues. Mr. Sutton was the Chief
Accountant of the SEC from 1995 to 1998. He has also been a
special consultant to FASB. From 1987 to 1995, he was a member
of FASB's Emerging Issues Task Force, and from 1983 to 1986, he
served on FASB's Financial Accounting Standards Advisory
Council. Mr. Sutton was National Director of Accounting and
Auditing Professional Practice of Deloitte & Touche and a
Senior Partner in that firm, earlier in his professional life.
Mr. Sutton, we are very pleased to have you here.
STATEMENT OF MICHAEL H. SUTTON
CHIEF ACCOUNTANT
U.S. SECURITIES AND EXCHANGE COMMISSION
1995 TO 1998
Mr. Sutton. Chairman Sarbanes, Senator Gramm, and Members
of the Committee, thank you for inviting me to appear today.
First, I will comment briefly on my background and
experience. I was Chief Accountant of the Securities and
Exchange Commission from June 1995 to January 1998. Prior to
holding that office, I was a Senior Partner in the firm of
Deloitte & Touche, responsible for developing and implementing
firm policy relating to accounting and auditing and practice
before the SEC. My career with Deloitte & Touche spanned from
1963 to 1995. As a retired partner, I receive a fixed
retirement benefit from that firm. Presently, I undertake from
time to time independent consulting and other assignments in
the field of accounting and auditing regulation and related
professional issues and I would be pleased to discuss those
with you or the Committee staff. Currently, I am serving on an
arbitration panel of the American Arbitration Association
hearing a dispute not involving a public company.
As we gather today, we find ourselves at a crossroads. We
are searching for a way forward that will restore badly shaken
investor confidence. To help put that into perspective, I would
like to offer some essential views that I think we all can
agree on.
I think we all will agree that our capital market system is
a national treasure. It is vital to the success of the economy.
Indeed, our exceptional standard of living depends on its
vitality. Accordingly, we all share a compelling common
interest in assuring the strength and liquidity of those
markets. This compelling common interest must shape our policy
goals and guide our thinking as we search for solutions.
Finally, the most critical, yet intangible, ingredient of a
successful capital market system is the confidence of investors
that the markets are fair--confidence that the information they
depend on is trustworthy, confidence that they can make
informed decisions and will not be misled.
In our search for solutions, I believe we need to consider
a wide range of possible reforms. Every idea has to be put on
the table and examined closely. I have offered a number of
those thoughts in my written statement and I will comment
briefly today on just some of the key points.
For independent auditors, I believe that the future begins
with full acknowledgement of the reality that seems so clear
today. Failures in our financial reporting system are more than
aberrations--they seriously undermine investor's confidence in
the institutions they are supposed to protect. They ``poison
the well.'' Pleas that the vast majority of financial reports
are sound, that most audits are effective, and that failures
are few, miss the point. In capital markets, a single financial
reporting failure can be a disaster, in which losses can wipe
out decades of hard work, planning, and saving. In that
context, debates about how many failures can be tolerated are
not only nonproductive, they are also nonsense. To restore and
maintain confidence in the independent audit, I believe that
the auditing profession will need to do three things.
First, it will have to embrace a role that is fully
consistent with high public expectations. In public capital
markets, insiders have an advantage over public investors. And
in that arena, independent auditors are expected to balance the
scales by ensuring investors that the financial reporting gives
them a fair presentation of the economic realities of the
business.
Second, the auditing profession will have to tackle
fraudulent financial reporting as a distinct issue with a
distinct goal--zero tolerance. We understand that, in life,
``zero defects'' are almost never realized. Nevertheless, the
public expects that the profession will pursue that end.
Third, it will have to accept and support necessary
regulatory processes that give comfort to the public that the
profession is doing all that it can do to prevent future
episodes.
Regulatory processes that will build confidence in the
auditing profession will be truly independent; they will be
open; they will actively engage, inform, and involve the
public; they will be adequately resourced and empowered to
accomplish their mission; and they will be adaptable to change.
I believe that the critical ingredients of those processes
include timely and thorough investigations of circumstances
that may involve fraudulent financial reporting; objective and
fair assessments of the role and performance of the independent
auditor; timely and meaningful discipline of those who violate
accepted norms of conduct; regular oversight and periodic
examinations of the policies and performance of independent
auditors; and, timely and responsive changes in professional
standards and guidance when a need for improvement is
identified.
In my view, those goals can be best accomplished through an
independent statutory regulatory organization operating in the
private sector under the oversight of the Securities and
Exchange Commission. That organization should be empowered to
require registration of independent auditors of public
companies, establish quality control, independence, and
auditing standards applicable to registered independent
auditors, conduct continuing investigations of the accounting
and the auditing practices of registered firms, undertake
investigations of possible financial reporting failures, and
conduct proceedings to determine whether disciplinary or
remedial actions are warranted.
To carry out those responsibilities, the Statutory
Regulatory Organization, SRO, will need appropriate subpoena
and disciplinary powers. As a starting point, we might consider
reconstituting the existing Public Oversight Board as an SRO,
expanding its mandate and powers to include the elements that I
have outlined.
With respect to accounting standards, we simply cannot
tolerate financial reporting that hides the ball, and we cannot
tolerate processes that are not responsive to critical
financial reporting needs. Current rules for accounting for
SPE's, for example, are nonsensical. They can only be explained
by accountants to accountants. We have a right to insist that
accounting standards clearly reflect the underlying economics
of transactions and events. And it is not acceptable to sit by
while market innovations outstrip the development of needed
guidance.
Criticism of U.S. standards is beginning to focus on the
fact that they have become increasingly detailed, and arguments
have been made that they should be broader statements of
principle, applied with good judgment and respect for economic
substance. I have sympathy for the desire to break the cycle of
the mind-numbingly complex accounting rules that have become
the norm, but to do that I think we have to confront
realistically the reasons why our standards have evolved the
way they have. Here are some of the underlying pressures at
work.
Business managers want standards that provide the greatest
flexibility and room for judgment. They want to be able to
manage reported results, but yet be able to point to an
accounting standard that assures the public that they are
following the rules.
Dealmakers and financial intermediaries want standards that
permit structuring transactions to achieve desired accounting
results--results that could obscure the underlying economics.
In that world, creative transaction structures are a valuable
commodity.
Auditors are pressured to support standards that their
clients will not take issue with, and they often are restrained
in their expected support for reporting that is in the best
interests of their investors and the public.
Others, including some of the legislators, too often lose
sight of the fundamental importance of an independent and
neutral standard setting process. Without independence and
neutrality, standards setters cannot effectively withstand the
myriad of constituent pressures that it inevitably will face to
make the tough decisions that it inevitably will need to make.
And then, standards setters too often seem to pull their
punches, perhaps because of a perceived threat to the viability
of private-sector standards setting, perhaps because of the
sometimes withering strain of managing controversial change,
perhaps because of a loss of focus on mission and concepts that
should guide their actions.
As we reexamine our processes, the debate shouldn't be
whether accounting standards should be broad or detailed.
Rather, about what formulation of standards and standards
setting processes best accomplish the goal of providing capital
markets with reliable and decision useful financial
information.
We need to reenergize our standards setting processes and
the commitment of capital market participants to support a
fully effective independent standards setting.
Of critical importance is the urgent need for those who
have the greatest stake in transparent financial reporting,
buy-side analysts, those who invest for retirees and manage
their funds, and other institutional investors, to take a more
active role in the processes.
We should provide independent funding for the FASB, funding
that does not depend on contributions from constituents that
have a stake in the outcome of the process. We also need a more
independent governance process to replace the current
foundation board. The leadership for these changes should come
from visionaries of unquestioned objectivity and demonstrated
commitment to the goals of financial reporting and the public
interest. Perhaps the needed change could be best considered
and carried out under the auspices of an independent commission
made up of leading lights within the corporate governance
movement, heads of investment funds and retirement systems,
academic leaders who are grounded in business and economics,
and former leaders of institutions responsible for capital
market regulation.
In closing, I would suggest that some very practical and
effective first steps in reforming the system could come from
improvements in corporate governance. I understand that you
will be conducting hearings on that subject later this week,
and I have included some thoughts in my written statement that
you may wish to consider at that time.
Thank you again for inviting me. I would be pleased to
respond to your questions.
Chairman Sarbanes. Thank you very much, Mr. Sutton.
We will now hear from Mr. Lynn Turner, who is currently, as
Senator Allard indicated, the Director of the Center for
Quality Financial Reporting at Colorado State University. Mr.
Turner was Chief Accountant of the SEC from 1998 to 2001. In
the early 1990's, he was a partner at Coopers & Lybrand, was
designated as the SEC consulting partner. From 1989 to 1991, he
was a professional accounting fellow at the SEC. And prior to
that, he held various positions at Coopers & Lybrand.
Mr. Turner, we are very pleased to have you here today.
STATEMENT OF LYNN E. TURNER
CHIEF ACCOUNTANT
U.S. SECURITIES AND EXCHANGE COMMISSION
1998 TO 2001
Mr. Turner. Thank you, Senator Sarbanes, Senator Gramm, and
Members of the Committee.
I had the good fortune of joining this proud profession
straight out of the University of Nebraska and Colorado State
University as well, in 1976, and I served until 1999 with
Coopers & Lybrand, as you mentioned, as a partner and as leader
of their National High Technology Practice and as an SEC
consulting partner for them.
Then in the summer of 1996, I joined the larger
international semiconductor firm, Symbios, Inc., which is
located in Colorado, and served as their Vice President and
CFO. So, my remarks are made from both sides of the table in
that regard.
I would also note that Symbios had been one of my clients
at Coopers & Lybrand. Then Chairman Levitt gave me a call and I
did have the good fortune of serving as the Chief Accountant at
the Securities and Exchange Commission from 1998 to 2001.
Now, I have the privilege of shaping the minds of students
who are the future of the accounting profession, as an
accounting professor at Colorado State University. I also
provide training and education to Bloomberg, and most recently
served as an expert witness for one of the Big 5 accounting
firms.
I commend the Chairman and this Committee for scheduling a
series of hearings on finding effective solutions to the issues
that confront the capital markets today; that have caused
investors to lose trust; that have unfortunately painted both
the unscrupulous and the honest with the same brush. It is
important that the current systemic failures be corrected.
While I was at the Commission, we began work on a staff
report that identified concerns and issues surrounding the
financial reporting and accounting profession. Due only to time
constraints, we were unable to complete the report.
I know there have been some implications that perhaps
Chairman Pitt had tried to stop that and that is absolutely
incorrect. It was only the time constraints.
Yet the recommendations for improving the deficiencies in
the quality of our financial reporting system are even more
relevant today than when I left the Commission. These
recommendations essentially are about one vitally important
principle--independence. Independent governance and oversight
of the accounting profession, independence of the accounting
and auditing standard setting process, independent auditors and
audit committees, and independent analysts.
My written testimony provides the Committee with an in-
depth discussion of the specific recommendations we would have
made in the report if we had had time to do so. Let me
summarize some of my written comments for you today.
Independent audits provide investors with confidence that
the numbers are accurate and reliable. Yet, today, the
multitude of organizations often referred to in the press as
``alphabet soup,'' do not yield an efficient or effective
quality control process for the audits. I have prepared a
diagram of the current confusing and ineffective structure. It
probably best could be described--take the top one off--okay.
That is fine. Thank you very much. It is almost like a
spaghetti picture.
In light of these recent events that have called into
question the independence and integrity of the accounting
profession, and as Chairman Pitt has stated, we need to
establish an independent public accounting regulatory oversight
body for the accounting profession under the supervision of the
SEC.
It is important that this body have these critical
elements: That it be conducted by an adequately funded
independent organization; that members are full-time and are
drawn from the public rather than the profession; that it has
timely and effective disciplinary actions against those who
fail to follow the rules, regardless of whether they are small
or large firms; that it has the authority to issue auditing and
quality control standards that establish a benchmark for the
performance of quality audits and its disciplinary process; and
that it inspects the work of auditors on an ongoing basis.
Audit quality will be enhanced through effective
independent inspections by the oversight board. The current
system of firm-on-firm reviews by the large firms reminds one
of grade school where the rule was--``I won't tell on you so
long as you do not tell on me.''
As a result, further recommendations continue to need to be
implemented to improve audit quality. They include: The 200
plus recommendations the panel on audit effectiveness made to
the profession and accounting standards setters in August 2000
need to be adopted as proposed, without being watered down; and
auditing standards need to be established by an independent
standard setting body.
Auditors' independence has long been a hotly contested
issue to the profession and the SEC. But after cases such as
Waste Management and Enron, no longer are people asking,
``where is the smoking gun.'' Disclosures of consulting fees
that run into tens of millions of dollars and multiples of the
audit fees are generating an outcry for action.
Once and for all, we need to adopt rules that will truly
protect the independence and the integrity of the audit, and
gain the public's confidence that the auditors are working for
them, not for management.
To accomplish that we need to: Close the revolving door
between audit firms, its partners and its employees, and the
company being audited. Require that in order for the auditor to
be considered independent, the firm must be hired, evaluated
and, if necessary, fired by the audit committee. Adopt a rule
that allows the auditors to provide only audit services to an
audit client, unless the audit committee makes a determination
and discloses that the services provided by the audit firm are,
one, in the best interests of the shareholders and, two, will
improve the quality of the company's financial reporting.
Prohibit an independent auditor from assisting a company design
and structure transactions, as we have seen on Enron, then
provide their accounting or tax opinion on what the appropriate
accounting is for the transaction, and then audit the
accounting for that transaction. Finally, require mandatory
rotation of the audit firm every 7 years.
Remember that investors have suffered their largest losses
on audits of companies that did not involve an initial audit,
but rather an ongoing relationship. And I do understand that
Senator Durbin from Illinois will be introducing legislation
later on today that will incorporate many of these features.
It was in 1940, after the discovery of a large fraud at
McKesson & Robbins that the Commission first encouraged the
establishment of independent audit committees.
In light of Enron and questions surrounding the oversight
of its audit committee, recommendations that can further
enhance the vital role and quality of audit committees include:
The audit committee should, as I mentioned previously, directly
hire, evaluate and, if necessary, fire the auditor. The
exceptions provided for in the rules of the stock exchanges,
which still permit an audit committee member who is not
independent, should be eliminated. The definition of an
independent director should be modified to prohibit the company
from engaging the director for any services other than those
provided as a director, and ban financial payments on behalf of
the director, such as contributions to charitable organizations
or similar types of payments.
The audit committee should require the CEO and CFO to
provide to the audit committee and investors a report by
management that clearly states management's responsibility for
establishing, maintaining and ensuring an effective system of
internal control actually exists and is operating. If the
executives are nervous about signing such a report, I suggest
investors should be nervous about the numbers. The CEO and CFO
should be required to sign and certify to the audit committee
and investors, as is done in some foreign jurisdictions, that
the financial statements comply with the applicable rules and
include disclosure of all material information. There should be
civil penalties for negligence and criminal and civil penalties
for intentional misrepresentations to the public or to the
auditors.
Let me shift gears to the topic of U.S. accounting
standards that was mentioned earlier.
I would like to thank the Chairman and his staff for their
unyielding support of our efforts during recent years as the
SEC tried to improve the quality of financial reporting
standards with our initiatives on earnings management and
auditor independence.
Senator Sarbanes, some days you were like an old oak tree
out there I could grab hold of, and I thank you for that.
I would also say Senator Dodd and some of his staff were
very helpful at times, too.
But the job of improving accounting standards is not
complete. Our rules and standard setting process here in the
United States requires significant improvements to provide
investors and regulators with greater transparency.
Improvements that need to be made include:
Revising the structure of the Board of Trustees of the FASB
to bring it in line with the Trustees of the International
Accounting Standards Board currently chaired by former Federal
Reserve Chairman Paul Volcker.
Create an independent, no strings attached, funding
mechanism for the FASB.
The FASB needs to develop accounting standards in a timely
fashion that reflect the reality of the actual economics of the
underlying transaction.
As Senator Allard from my own State of Colorado mentioned,
he has recently highlighted the need for timely issuance of
such standards and I, as I am sure other investors do, commend
you, Senator, for that position.
The Emerging Issues Task Force at the FASB should be
restructured to require public representation and should not be
able to pass a new rule without the explicit approval of the
FASB, as they do internationally.
The SEC should require that companies disclose greater key
performance indicators that give investors greater predictive
capability with respect to trends in the business.
The SEC proposed new rules to increase the transparency of
reserves and large writedowns in the value of assets such as
plant and equipment. As the Association for Investment
Management and Research has recently requested, the SEC should
quickly issue final rules similar to those proposed. And I
could not agree more with Chairman Pitt on the issue of we do
need to get the plain English financial statements through the
SEC's review process.
Touching on the SEC, let me talk about the resources.
People down there have responsibility for about 12,000
actively-traded public companies who file 12,000 annual
reports, 36,000 quarterly financial statements, thousands of
additional initial public offerings, registration statements,
proxies, and tender offers. There is another 4,000 or 5,000 of
inactive companies that they have to oversee.
Senators, it is physically impossible within their current
budgetary handcuffs for the SEC to carry out their mandate to
ensure full disclosure and timely enforcement of the laws and
regulations. The words pay parity in an unfunded bill is a
broken promise to thousands of dedicated public servants at the
Commission. The Panel on Audit Effectiveness recommended the
SEC provide additional resources to combating financial fraud.
I hope Congress will respond to the Panel report and provide
the necessary funding for the SEC staff.
The statutory authority of the SEC also needs to be
examined and beefed up as it relates to Rule 102(e)
proceedings. Gaining timely access to the work papers of
auditors in foreign jurisdictions, modifying Section 10(a) of
the Security Acts to more narrowly redefine how the auditors
view their responsibility for reporting an illegal act. And I
also believe that the SEC should make changes to its rules for
Form 8-K disclosures whereby if there is a termination of a CFO
who quite often these days will lose their job if there is a
miss on earnings management numbers, if they do not manage the
numbers. We need to get disclosure out there as to whether or
not those CFO's will be terminated over a disagreement
regarding a financial accounting or disclosure matter.
Now, I have discussed recommendations for standards
setters, regulators, and preparers. Let me shift the focus for
just a moment to education.
Great people who are talented, well educated, and motivated
make for great organizations, while weak people are nothing
less than, as the television show aptly calls it, the weakest
link.
To assure the public accounting profession is able to
attract and retain the best and brightest minds, we need to
correct the lack of investment that the public accounting firms
have made when hiring new personnel. And educators need to take
concrete steps to integrate into the classroom a broad-based
business and accounting curriculum.
Hopefully, the recommendations I have made today have given
you an understanding of what the SEC staff was striving for in
their report to the Commission. As you can see, it provides a
benchmark for measuring the progress, or the lack thereof, by
the profession in making substantive, meaningful change. As you
can also see from the attached chart, these recommendations can
no doubt create a new system of simpler, less complex
regulation in a reliable and effective system.
Thank you.
Chairman Sarbanes. Thank you very much, Mr. Turner.
Our concluding panelist this morning will be Dennis
Beresford. Mr. Beresford was the former Chairman of the
Financial Accounting Standards Board from 1987 to 1997, and he
is now Professor of Accounting at the University of Georgia's
Terry College of Business. Before becoming FASB's Chairman in
1987, Mr. Beresford was National Director of Accounting
Standards for Ernst & Young.
We are very pleased to have you here, sir. We would be
happy to hear from you.
STATEMENT OF DENNIS R. BERESFORD
FORMER CHAIRMAN
FINANCIAL ACCOUNTING STANDARDS BOARD
1987 TO 1997
Mr. Beresford. Thank you very much.
Good morning, Chairman Sarbanes, Senator Gramm, and other
Committee Members. I am Denny Beresford, from the University of
Georgia. Thanks to former Governor, now Senator, Zell Miller, I
am proud to say that Georgia is one of the great public
universities in this country.
Senator Gramm is also a proud graduate, I understand.
I am also a retired partner of Ernst & Young. I am
presently a Board Member of National Service Industries, a New
York Stock Exchange listed company, and Chairman of the Audit
Committee.
I have provided expert witness services to several
corporations and accounting firms. And perhaps of relevance, I
was a short-term investor in Enron from November 5 to November
14, and lost $7,000, due to my own stupidity and no one else's
fault.
[Laughter.]
Like former SEC Chairman Arthur Levitt and certain other
recent testifiers, I believe that Congress should not get
involved in specific technical accounting issues. A case from
my personal experience where Congress allowed itself to do so
was the debate over accounting for employee stock options.
Certain Members of Congress were sufficiently influenced by
the appeals from corporate executives that they were persuaded
to introduce legislation to counter the FASB's proposal. Most
importantly, the legislation would have required that the SEC
repeat the FASB's process on any new accounting proposals, thus
effectively eviscerating the FASB. Faced with the strong
possibility that its purpose would have been eliminated by this
legislation, the FASB made a strategic decision to require
companies to disclose the effect of stock options in a footnote
to the financial statements but not record the expense in the
income statement. Thus, the FASB compromised only under
Congressional pressure that would have effectively legislated
it out of business.
The FASB holds a public trust and Congress is entitled to
examine how the Board is carrying out that duty, particularly
in trying times like those at present. However, my view is that
Congress' primary role in this area should be to see that the
FASB is fulfilling its public obligations appropriately.
Congress ought not to interfere with individual technical
decisions.
While the SEC has enforcement powers to correct reporting
that is identified as being inappropriate, it does not have the
resources to review all companies' reports and determine their
propriety, as has been indicated already. It must rely on the
private sector, including corporate executives and independent
auditors, to do the right thing. There must be a high degree of
trust among regulators, reporting companies, and auditors for
the reporting system to work best. Therefore, I commend
Chairman Pitt and Chief Accountant Herdman for their recent
efforts to create a more positive environment in which all
interested parties can work together to improve both individual
companies' reporting and the overall system.
At the same time, I am confident that the SEC will continue
to act decisively when individual companies or their auditors
have not performed in a satisfactory manner.
Many of the commentators about the current state of
financial reporting say that it takes way too long to develop
accounting standards. I agree 100 percent. I believe that the
FASB could reach earlier resolution on many projects by
streamlining its internal processes in at least three ways.
First would be to limit the content of FASB's standards to
the most significant matters related to the issues in question.
Dealing with great detail not only takes more time, it also
leads to lengthy and complicated accounting standards that
actually may result in less desirable outcomes.
Second would be for the individual board members to not
strive for what they personally believe are conceptually pure
answers when doing so would significantly delay finalizing
guidance for practitioners. A timely answer is better than an
arguably more theoretically pure one delivered at a much later
date.
Third would be to increase the size of the FASB staff by 10
to 15 people. This would almost certainly allow projects to be
considered more rapidly. Additional funding and candidate
identification are tough challenges, but the trustees of the
Financial Accounting Foundation should consider these to be
critical objectives in order to allow more timely attention to
important accounting issues.
Notwithstanding the complexities of today's business world,
one of my major concerns is that accounting rules and
regulations have become far too complicated. That has added to
the burden of those who are reasonably informed and are
reasonably diligent about studying corporate reports. It is
time to step back to see if more general standards can work as
well or better.
Accounting standards are necessary in order to cause
reports by various companies to be reasonably comparable.
Similar to the rules of football, without some standardized
approaches to accounting, sorting out the winners and losers in
the business world would be much more difficult. However, like
the compromise over Instant Replay for NFL games, often the
parties involved in the process are willing to accept fewer or
less specific rules so that the game flows more smoothly but
still within some appropriate boundaries.
The overemphasis on detail will not be reversed overnight.
However, over time, this is something that I believe the FASB
must strive for.
In spite of the fact that the real issues in the Enron
matter had to do with a lack of substance in certain
transactions, attention has centered on the accounting for
SPE's, largely because they were the vehicles used to obscure
the transactions' substance. SPE's are included in the scope of
a FASB project on consolidation. A few months ago, the Board
agreed that it would concentrate its near-term efforts related
to the consolidation project on SPE matters.
I am sure all of you have wondered why it has taken so long
to resolve the general consolidation matter.
Control is a very hard notion to define in a way that can
be applied consistently in practice. With each iteration of
definition and supporting implementation guidance, the FASB has
ultimately concluded that consistent application in practice
was unlikely.
Beyond these operational challenges, there is the matter of
what reporting actually best serves users of financial
statements in this area. For example, should a real estate
operator have to consolidate all of the limited partnerships in
which it serves as a general partner and arguably has control,
even when its interest in each partnership is only 1 percent?
Consolidation is only one matter relating to the overall
topic of so-called off balance sheet financing that was
mentioned earlier. At the extreme, this could include very
simple executory contracts such as the University of Georgia's
agreement to employ me for the next school year. Should Georgia
record an asset for the value of my future services and a
liability for the amount the University has agreed to pay me?
I hope there is a match between those two things, by the
way.
[Laughter.]
Most accountants probably would say, no, because this
contract involves both future services and future payments. But
that is also the case for most of the off balance sheet
financing arrangements that have been criticized recently.
A key reason why many of these arrangements are allowed to
be kept out of balance sheets at present is that the company
does not own the asset in question. A third party has legal
title to the asset and often, but not always, has agreed to
make it available over time to the company. If you have signed
a lease for an apartment in Washington for the next year, do
you consider that to be an asset? I suspect that most of you do
not, and corporations often feel the same way about their
future obligations.
These have been tough accounting issues for some time. It
is very appropriate for the FASB to seek quick improvements for
SPE's, but broader topics like off balance sheet financing
require careful study.
As stated earlier, I am in favor of less complicated and
less detailed accounting principles, which is the approach
being pursued by the International Accounting Standards Board
that you heard from 2 weeks ago.
That said, it is important to note that, on balance, our
U.S. financial reporting system remains the best in the world
because of the combination of comprehensive accounting
principles, required audits by independent accountants, and
vigorous regulation and enforcement by the SEC.
The IASB activity should be commended and supported by U.S.
parties. However, no action should be taken in the near-term
that would have the effect of watering down Generally Accepted
Accounting Principles in our country simply for international
convergence.
My full statement also includes comments on funding of the
FASB and composition of audit committees. However, in the
interest of time, let me summarize by saying that this is a
critical time for financial reporting and the auditing
profession. It is important that the issues raised by the Enron
matter and other recent business, accounting, and auditing
failures be studied and be used to evaluate what changes can be
made to improve the system.
However, it is equally important that the baby not be
thrown out with the bath water. The current system is not
foolproof, but it works well in the vast majority of cases.
Consideration of changes should call attention to and build on
the strengths of the current system.
Thank you.
Chairman Sarbanes. Thank you, Mr. Beresford.
I would like to ask the panelists if this is do-able, to
outline very briefly what you think the structure should be in
terms of how we monitor the accounting profession, both in
terms of how the standards are set and how we survey or monitor
the practice of the profession. What should the structure be,
if you could just set that out for us briefly? I will just go
right across the panel.
Mr. Schuetze. Well, Mr. Chairman, we have had some 60 years
of experience with private-sector standard setting in both
accounting and auditing. When I look back over the some,
approximately 40 years that I have been involved in the process
since 1957, it is clear to me that private-sector standard
setting has not worked. I am sorry to say that, but I think it
has not worked.
So as I recommended in my testimony, I think that there is
a sense of the Congress to require mark-to-market accounting. I
keep coming back to mark-to-market.
Mark-to-market is extremely simple. Now it is not that easy
to do in some cases, but it is extremely simple. And if we had
a sense of the Congress that there should be mark-to-market in
order to portray the true economic financial condition of
corporations, and then leave the details and the implementation
to the SEC, I think that solves a large part of the problem, 70
to 75, 80 percent of the problem.
Now, admittedly, there will be the continuing problems with
the auditors, and I would recommend that that also be left to
the SEC to deal with as the SEC sees fit, and then have the
SEC, as it already does, report periodically to the Congress as
to what----
Chairman Sarbanes. I take it that your structure would in
effect have a significant expansion within the SEC in terms of
how it interacts with the profession. Is that correct?
Mr. Schuetze. Well, mark-to-market is so simple. It is so
simple, that you really do not need much more once you have
that broad principle laid out. You do not need much
implementation guidance. You do not need much regulation beyond
that, I do not think.
Now maybe in practical terms, the SEC would find that, day
to day, there would need to be some guidance from the SEC. But
I would leave it to the SEC to do.
Chairman Sarbanes. Would your system have a FASB or a
Public Oversight Board or anything like that?
Mr. Schuetze. I don't think so.
Chairman Sarbanes. Okay.
Mr. Sutton.
Mr. Sutton. With respect to the auditing profession, the
profession has had decades--it has been on notice for decades--
that its self-regulatory processes are not working and they
have not improved, they have gotten worse.
So my suggestion for the auditing profession is to
establish an independent statutory regulatory organization--
independent from the AICPA and the practicing profession and
that has the requisite authority and powers to do that job
effectively.
With respect to the accounting standards, I said that what
we need to do is reenergize and strengthen the process that we
have by making it as independent as well as capable as it can
be, in the process. And to foster that independence I suggested
two things. One is funding, take control of the money away from
those who want to manipulate the system. And two, have a truly
independent governance process. If you do that, I think we
would have a chance of getting better and more timely answers
from the FASB.
Chairman Sarbanes. Would the statutory board for the
auditing standards also be the entity that monitored the
application of those standards by the auditors?
Mr. Sutton. I think that would be done indirectly through
the oversight of the auditing profession. The auditing of the
application of accounting standards, I think, would be as it is
today--under the oversight of the SEC. So the registrants would
be overseen by the SEC in their applications. But indirectly,
through the oversight of the auditing profession, there would
be some oversight there.
Chairman Sarbanes. Mr. Turner.
Mr. Turner. First, let me start off by saying that I harken
back to some of the words that Senator Gramm said at the
beginning of the hearing. He expressed the view that Congress
should not be involved with accounting standard setting, and on
that point, we could not agree more, Senator. I think Congress
getting involved, explicitly or implicitly, is bad.
I know at the Commission, even though we had an oversight
responsibility, I remember a couple of times we were asked by
the business community to overrule their standards explicitly.
I think some of that was at your urging as well. We did not do
that. I think keeping the politics out of the standard setting
process is absolutely right. And you stood tall on that and
certainly Chairman Levitt and I appreciated that.
As far as the actual oversight body of the accounting
profession, what I think I would do is take this spaghetti
chart and if you create a single oversight board with auditing
standards, quality control and the right to do inspection in
it, then you can turn around and--if you would put up the next
chart. You can take that spaghetti chart and turn it into
something like this.
I think there is just one question with respect to this
chart, and that is, on the Financial Accounting Standards
Board, do you leave it out still underneath an independent set
of trustees?
Right now, we really do not have an independent set of
trustees like we have for Chairman Volcker in the International
Accounting Standards Board, and I think we need to get that.
So it is just a matter of do you use the Independent Public
Oversight Board as independent trustees for the Financial
Accounting Standards Board, or set up a separate set of
trustees just to advise the current trustees and leave that
structure in place?
But aside from that, this is pretty much the structure that
you would get, and it is much simpler, much more effective. I
think it is going to be able to act much more timely and
without a lot of the bureaucracy that we currently have.
Chairman Sarbanes. So, you would establish that structure
by statute?
Mr. Turner. Yes.
Chairman Sarbanes. And establish the funding of that
structure by statute?
Mr. Turner. Yes. Both of those would take statutory moves.
Chairman Sarbanes. Mr. Beresford.
Mr. Beresford. I will speak mainly in the accounting area.
I feel obligated to offer a competing point of view from Walter
Schuetze's, my good friend. Market value accounting is not
simple.
Chairman Sarbanes. That is why we have these panels.
[Laughter.]
Mr. Beresford. The FASB has been working on the definition
of market value for 8 to 10 years. Now some could say that just
shows that the FASB is too slow, but it is a very complicated
issue and it works well when you can look it up in The Wall
Street Journal. But beyond that, as Enron and some other
situations have shown, it is much more problematic.
I think that it is an overstatement to say that the
International Accounting Standards Board has an independent set
of trustees and that the FASB financial accounting foundation
organization does not.
Those things are always a question of degree. During my
term at the FASB, through some pressures, frankly, that Arthur
Levitt applied to the trustees, there was a reorganization. We
appointed several new trustees that were more public in nature
in that they did not represent a particular constituency like
the auditing profession or reporting corporations and so forth.
I think it is a fine group of individuals. I think there is
a need to balance those who are interested and directly
involved in the activity, as is the case in the international
group right now, with those who are trying to serve the public
interest and do not have quite as much of a vested interest in
the outcome of the thing.
So, I think that this is the kind of thing that I am
reasonably happy with the way it is right now, as long as we do
not digress or do not go back to a situation where there was
too much special interest type representation on the FAF.
I would be happy to talk more about funding, but I think
that is a different subject that you might want to get to
later.
Chairman Sarbanes. Thank you very much. My time has run
over, but the panel is being very helpful.
Senator Gramm.
Senator Gramm. Thank you, Mr. Chairman.
Let me say, Mr. Beresford, that I agree with you that Zell
Miller is the reason that Georgia now has two great public
universities.
All over America, States instituted lotteries and then took
the money from the lottery and put it into the general budget
where all money is fungible, and the money ended up being spent
on everything except education. Only in Georgia did the money
go to the student. As a result, my guess is that in the next
rating, Georgia Tech will be one of the top 10 public
universities in America, an extraordinary change.
I wanted to concur with your assessment of Senator Zell
Miller's leadership.
Rules make a difference. They make a profound difference.
Your example is one of them. What we are talking about here is
another.
Chairman Sarbanes. Actually, this is a classic example of
how the elevation of an institution which Governor Miller
helped to accomplish, accrues to the benefit of even the
previous graduates of the institution.
[Laughter.]
Senator Gramm. That is right. You have two University of
Georgia graduates on this Committee.
[Laughter.]
In fact, I took two courses in accounting. And other than
lack of personality to be an accountant, the practice set in
that second course convinced me that I did not want to do
accounting.
[Laughter.]
But I benefited from those two courses.
Mr. Beresford. That is why we have cut that requirement
out.
Senator Gramm. Oh, have you? Good.
[Laughter.]
I want to touch on a couple of things. Lynn, I want to
thank you for your kind comment. I guess we are all affected by
the lives we have lived.
We have had several dozen bills introduced since I have
been in the Senate that were aimed at mandating accounting
standards and overriding FASB. I think that is potentially very
dangerous. And in each and every case, as Chairman and as a
Member of this Committee, while I, for example, never
understood FASB's decision about stock options, I thought
whatever they decided was far preferable to Congress voting on
it.
I would say that when we looked at the whole acquisition
and mergers, that one of the things that we tried to do was to
move toward mark-to-market. In terms of a general valuation of
the assets required, I am not sure exactly how you would do
that. But as a concept, I think it is a powerful concept.
I want to ask my first question on the whole idea of
funding. Let's just say for a second that we decided to have an
independent board that set accounting standards that oversaw
the implementation of those accounting standards, that had some
real power in terms of power to subpoena. How would you fund
it?
I guess I would say in posing the question, that I am
fearful about taxpayer funding because--you know, each of you
felt the necessity to tell us where you were earning income. I
would not want to hear from people who somebody was not paying
them for their opinion.
But Government funding carries its own problems in terms of
political influence. And I would like to ask each of you, if
you had made the decision, whether you are for it or not, to
have the independent board, how would you fund it? Do you share
concerns about public funding?
Mr. Schuetze.
Mr. Schuetze. Well, I wouldn't have this board.
Senator Gramm. Okay. But if you had it, how would you fund
it?
Mr. Schuetze. I think you run into a Hobson's Choice there.
You have the SEC. Commissioners are paid, what? $135,000.
Senior staff are paid $130,000. If you are going to have this
board, the current FASB is paid $430,000. How can you pay a
board $400,000 when you have the SEC being paid $130,000? What
kind of people are you going to get at the SEC?
Senator Gramm. That is a question about funding at the SEC.
I was the original----
Mr. Schuetze. Well, wait a minute. If you limit the SEC
salaries to the salaries that you personally get of--what is
it, $145,000, $150,000, $175,000? And this board is being paid
$400,000. What does that say about your salary?
Senator Gramm. Look. I want good people on this board. In
fact, $400,000 sounds perfectly reasonable to me. Maybe too
little. I am in favor of giving the SEC more power to pay
higher salaries. I think we get a very false economy by not
hiring the best people.
Mr. Schuetze. Then give the SEC pay parity, increase their
budgets so that they can do more and better jobs. But do not
create another body that is going to compete with them.
Chairman Sarbanes. Do you regard this as a competition?
Mr. Schuetze. I did not see that chart until just this
morning. My eyesight is not good enough for me to see it.
Chairman Sarbanes. Okay. You could have the SEC and then
have beneath it these sort of----
Mr. Schuetze. My experience tells me that private-sector
standard setting doesn't work, and I recommend that you all not
do it.
Senator Gramm. Okay.
Mr. Sutton.
Mr. Sutton. With respect to the oversight of the auditing
profession, let me separate them briefly. Whether they go under
one organization or two organizations, I think is another
discussion.
But with respect to the oversight of the auditing
profession, the auditing profession has been given a valuable
franchise. I think it is reasonable to expect them to pay a fee
to be a registered auditor of public companies. That would
adequately fund that oversight.
And with respect to the accounting standard setting
process, the benefits are more broad than that. I would like to
see some enlightened people figure out how to endow it--it is
not that big of an expenditure on an annual basis when you
compare it certainly to the damage that is done from bad
accounting or other Government spending. But I would suggest
that we look first at ways to endow it so that it doesn't have
to have the fund-raising activity.
Mr. Turner. Senator Gramm, I agree with you on the public
funding issue. When you tie some of this into public funding,
you again get Congress and politics involved, and that could
have some very negative implications. So, I agree with you on
the funding.
On the oversight board itself, currently, the accounting
profession funds that on their own. The accounting profession
pays fees into the AICPA and it provides them to the various
groups that is on the spaghetti chart and that funds it.
I see no reason if you require the firms to register with
this SRO, and part of the registration is that they have to by
statute pay their fees. We just turn around and have those
fees, instead of going to the AICPA, have those fees come into
here.
I think actually in a private-sector body, you will be able
to attract some very good talent and I think that is very good.
As a CFO, I found that the private-sector standard setters
did a very good job and even as the CFO, wrote to my Members of
Congress urging them to let it work.
Nothing's perfect. As Denny said, we do have, though, the
best system that there is in the world, bar none.
I have seen both as a CFO and as an audit partner the
quality of the systems in the other part of the world. I have
gone through the Asian crisis up close and personal, very
close, and I know we are much better. So, I would have to say
that history has shown that we are much better, and I would do
it.
As far as funding the FASB and providing it the resources
that it needs, I think you can tag on a fee that is either
assessed to the members of the stock exchanges and/or issuers,
and that would turn around and provide it the resources it
needs, because one of the problems it has is they only have 40
or so people up there.
It is all resource-constrained. And in light of the crown
jewel that our markets are to us today in providing capital and
providing jobs and opportunities for people, I think that is a
reasonable source of funding.
Mr. Beresford. Again, speaking of the FASB specifically, we
were not really resource-constrained in the sense we would have
done X-more things if we had had Y-more dollars. That was not
really an issue, although I think we could have moved some of
the projects along more quickly, as I indicated, with more
staff.
The process right now involves about two-thirds of the
funding being raised by selling our own publications, largely
to accounting firms, but to corporations and libraries and
other people like that. So it is a commercial operation of
sorts. And about one-third from voluntary contributions. Those
are spread over about a thousand public corporations and
hundreds of accounting firms and practitioners and so forth.
Frankly, that seems to me to be kind of a nice balance
because it provides some amount of independence in the sense
that the Board has a commercial operation, but it also provides
a bit of a market test that if the Board was getting so far out
of touch with its constituents--the business community, the
accounting firms, the users of financial statements and so
forth, that people were simply unwilling to provide any
financing in the future, then I think that would be a strong
signal.
I think that it is important that the Board be reasonably
independent and also be subject to oversight by the SEC, which
has always been excellent as far as I was concerned. But also
participate in the process and such in a way that can be open-
minded and not arrogant, not be so isolated that the rulings
come down from on high and are not received with some degree of
acceptability by the business community.
We have a term called Generally Accepted Accounting
Principles, which really means, generally required accounting
principles. Companies have to follow them. They have no real
choice in the matter. But by calling them generally accepted,
that indicates at least some degree of participation, which
there is plenty of, but also at least some degree if they
really agree with the final outcome.
Senator Gramm. Thank you.
Mr. Chairman, my time is up.
Chairman Sarbanes. Thank you.
Senator Miller.
Let me just say, since we have had this extensive promotion
here for the University of Georgia, that the University of
Maryland is also a very fine academic institution.
[Laughter.]
Senator Miller. Thank you, Mr. Chairman, and I thank
Senator Gramm for his very generous remarks.
I guess I will have to wait until later in the day to see
how I pay for that.
[Laughter.]
But I appreciate it very much. I appreciate all of your
testimony. It has been very, very informative.
Mr. Schuetze, I want to explore this a little bit more
because I am intrigued, but I am not yet convinced. Tell me
how, in your opinion, if we had had mark-to-market accounting,
if we had had that in effect, how would that have affected the
Enron situation? In particular, the SPE's?
Mr. Schuetze. I have not looked at Enron, so I cannot
comment on that. But let me just deal with the SPE situation
conceptually.
The Financial Accounting Standards Board a couple of weeks
ago tentatively decided that it is going to change the 3
percent minimum investment to 10 percent. And if that 10
percent minimum investment is not met by an outside party, then
the assets and the debt have to be consolidated. I will tell
you what that is going to do. It is going to corrupt and
contaminate the asset side of the balance sheet by putting on
there an asset that the enterprise doesn't own and cannot sell.
Now why would you want to do that?
Well, the FASB is going to do it because everybody up here
is saying that we have to get the debt on the balance sheet.
That is not correct. You cannot put on the balance sheet an
asset that you do not own and cannot sell. That corrupts and
contaminates the assets of the corporation.
The trick, under mark-to-market accounting, is to find the
market price of the guarantees that the enterprise has made to
pay the debt of the SPE. What would Goldman Sachs charge to
stand in the shoes of the enterprise to pay off that guarantee?
That is where mark-to-market accounting is so simple and it
works. You do not put on the balance sheet an asset you do not
own and cannot sell. You put on the balance sheet the market
value of your guarantee. That is what SPE's are all about. That
is how it works. It is deceptively simple and it is so
effective. And it works. I hope that answers your question.
Senator Miller. Does any panelist have any comment on that?
Mr. Schuetze. What the FASB is going to do is corrupt the
balance sheet by putting on assets that you do not own and
cannot sell. You cannot do that.
Senator Miller. Mr. Turner, and then I want to hear from
Mr. Beresford.
Mr. Turner. After I got my accounting class out of the way,
I went and took some series of six economic classes. I did not
stop at two, but made it all the way through six. And one thing
that you learned is that relevant information for people is
what is the current value of something today.
If I had something that I paid $1,000 for 5 years ago and
it is worth $5,000 today, people are probably going to want to
know what it is worth today and what I can realize out of it.
And so, the concept of fair value accounting and the concept of
putting these things on your financial statements at fair value
I think is very good and I do not think that I would have had
any problem with that as a CFO. I think it probably would have
put better information out there for me to manage my business
with, which is what is most important. That is what you get out
of that.
But I do know, on the other hand, that trying to come up
with the values for some of the derivatives that we would enter
into and trade in, and some of the other financial instruments
that are dealt with in the market today, if they are publicly-
traded, it is very easy to get those market values. If they are
not the type of derivatives that you see traded on Wall Street,
there is a portion of those that are not. Those are not simple
to value. It is not real easy and it is not real easy, quite
frankly, for the auditors to verify that.
So one, I think moving in that direction is very positive.
It is really good. It really reflects economics in underlying
transactions and I think that is what we ought to get to.
On the other hand, until we get some real good guidance on
how we are going to mark some of these to model and make sure
that those are reliable numbers, if we can get that, then I
would agree with Walter, let's go. But we need to make sure
that we have good, reliable numbers before we go.
Mr. Schuetze. But you go ask Senator Corzine the amount of
money that he would pay for it when he was Co-Chair of Goldman
Sachs, he can give you the number.
Senator Gramm. Well, unfortunately, he left.
[Laughter.]
Mr. Schuetze. Senator Corzine dealt in over-the-counter
instruments every day, hour-by-hour. He knows how to price
those instruments.
Mr. Sutton. What is being manifested here right now is the
fact that there are different notions of what assets and
liabilities are.
Now, my response to your question would be, we need
accounting that can be understood, not just by accountants, but
by economists and business people and investors. And I cannot
explain to anyone except an accountant why the debt of an SPE
is not on the balance sheet. I think that is the bottom line.
Senator Miller. Mr. Beresford.
Mr. Beresford. Senator Miller, I think your question was,
would mark-to-market accounting have somehow disclosed Enron's
problems sooner? My answer is no.
Senator Miller. My time is up. Mr. Chairman, thank you.
Chairman Sarbanes. Thank you, Senator Miller.
Senator Enzi.
Senator Enzi. Thank you, Mr. Chairman.
While we are getting in plugs for universities, I have to
mention George Washington University, which is where I went to
college. My advisor was a Professor E.J.B. Lewis, who was the
Editor for the Governmental Accountant magazine.
I thought that I received too much governmental accounting
because I was going into business and would never need that
sort of thing. Then I came here and found out that that was
mostly what I needed. It is kind of good to be getting back to
some business accounting again.
When I came today, I expected to have a delicious, four-
course dinner of accounting information. And it exceeded my
expectations. It turned out to be four delicious desserts.
[Laughter.]
It was a bit of an overload, though. I do appreciate you
having written testimony in the longer, more extensive form.
Mr. Schuetze, I appreciate the two additional, very learned
documents that you included. We do not get to talk about
something that sounds as simple as what are assets and
liabilities. And I am sure that today, we have given some
people some insight into how complicated all of these things
are, even though they sound very simple at first.
A difference that I noticed with this panel today from any
other that I have heard since I came to Washington, is all of
you gave some disclosures before you started testifying.
[Laughter.]
I do not know if that is just an accounting thing or what.
[Laughter.]
I do appreciate that. Mr. Beresford, your example of an SPE
using your teaching contract, extremely helpful, showing the
future value offset by the amount that the university has to
pay you. And just from what I have read from your testimony and
heard today, I expect that the university comes out very well
on that.
Mr. Beresford. Thank you.
Senator Enzi. I would love to take a course from you
sometime.
With your involvement in FASB, though, can you give me some
insight into why it has taken so long to finalize the FASB
consolidation policy?
Mr. Beresford. I tried to mention that briefly. It was a
combination of disagreement over what represents control.
I think in my longer statement I mentioned that we met with
David Ruder, who was then Chairman of the SEC, early in the
project. And he said, good luck. The SEC has been working on
that definition since 1932 or so, and still has not come up
with something completely satisfactory.
And then, second, what information was of most usefulness
to users of financial statements?
You have already heard within our panel disagreements on
whether more or less consolidation of some of these entities
would provide more useful information. Beyond that, frankly,
the process is one where the board members listen very
carefully to a wide range of views from preparers, auditors,
users of financial statements, regulators and so forth, and
develop their own personal views. We simply had an impasse on
the question of what represented control for a long period of
time.
During the time that I was Chairman, the voting
requirements were changed by the trustees of the Financial
Accounting Foundation. There are those who feel that that
wasn't necessarily a change for the better.
We previously had a requirement that only four out of seven
board members had to approve something and it was changed to
five out of seven, a super-majority requirement. That certainly
slowed things down on some of the projects. I am not saying
that it was the thing that finally caused us not to resolve
that more timely, but we simply could never get five board
members who agreed that we had a sufficiently operational
answer with respect to what does control represent and whether
the resulting information would really be an improvement versus
a bright line test that we have right now that you have to have
more than 51 percent ownership.
I recall having a brief conversation with Lynn Turner on
this and his sharing with me at the time that the SEC was very
concerned about lots and lots and lots of disagreements with
auditors and corporations if the board had gone with at least
one of the various iterations in that project.
So notwithstanding all of what I have said, I tend to be a
pragmatist and I think the Board needs to figure out a way to
resolve issues and come up with the best possible answer, even
if it is not going to satisfy everyone on a more timely basis.
Senator Enzi. A major point that other panels we have had
on FASB has been changing so that it stated a principle and
then gave examples and guidelines. As a final part of the
process of auditing, the audit report would include a statement
that the principles were met, not all of the detailed rules--
getting way from the 830 page rule and getting to a goal that
would be attested to by the accountant. I would be interested,
since the nonaccountants all suggested that, in what the
accountants would say about it. I appreciate all your help.
Chairman Sarbanes. Thank you very much, Senator Enzi.
Actually, it would be extremely helpful to the Committee if
the panelists could make themselves available to us for a
further interchange. We have to obviously digest these
statements very carefully. But there is a tremendous amount of
knowledge and wisdom at the table, and we would hope to be able
to draw on it.
We appreciate that very much.
Senator Stabenow.
Senator Stabenow. Thank you, Mr. Chairman.
I too have numerous questions and will just speak to a
couple of them at this point.
Clearly, we are all very interested in looking for the best
way to make sure that there is integrity in the system. There
is transparency, there is confidence in the system for
investors, for employees. And all of the pieces that you have
talked about today raise important issues regarding the best
way to make that happen.
When we look at an independent oversight board, I wonder if
each of you could speak to the question of who should sit on
that board? Some people have said that there should not be any
members of the accounting profession on the board. Others have
said there should be.
I noticed, Mr. Turner, you embraced the British model that
has no members of the accounting profession on the board.
I wondered if others on the panel would like to
specifically address whether or not you believe that an
independent oversight board should include members of the
accounting profession.
Mr. Schuetze. Well, as I said, I wouldn't support such a
board. But if we had to have one, I would opt for having a
preponderance of public members as opposed to professional
accountants on it.
Senator Stabenow. Yes.
Mr. Sutton. The model I would support would have these
board members separating their ties to their former positions,
whatever they might be. In other words, truly, someone who
comes out of the private sector business and goes into the
private sector regulatory process and is compensated for doing
that.
Having done that, which is the model for the SEC, I would
say that we need to get the best people for those positions
that you can find. Background might be important to consider.
And like Mr. Schuetze, I would be a little uncomfortable if the
preponderance of the members came from the accounting
profession. But assuming that the board is established as an
independent board, separated from the profession, then I would
say get the best people you can.
Senator Stabenow. Mr. Turner, would you want to respond any
more to the British model that you spoke of ?
Mr. Turner. In the British model, which was set up as a
result of some business accounting audit issues over their
failures, the accounting profession actually took the lead over
there and come up with the model that they took to the
government.
Their oversight board--it is called the foundation--is
entirely members from the public, very prestigious some of
those members from the public are. The notion is you really
want public oversight because that is who the ultimate client
is here, the public.
I think that is a very good approach. I think it is very
similar to what the Congress established with the SEC. You make
them all full time.
This is a big job to do, all the discipline, auditing
standard setting, the inspections. This is not a part-time job.
So, I think that is important. I do agree with Mike that it
needs to have the very best people that you can get.
I would provide for some nonpracticing accountants that
have severed their ties for some period of time from the
accounting profession. We have some wonderful people out there
that meet that criteria--Chuck Bowsher, former Comptroller of
the GAO in the United States, the gentlemen here at this table
before me. These are all wonderful people. And as long as they
have cut that tie and there has not been a conflict there for
some period of time, 2, 3, 4, whatever number of years, then I
think you can bring some accounting experience to the board as
well. But I would not bring practicing accountants.
We had a mixed board at the Independent Standards Board
which had practicing accountants on it, and members of the
public. It was a 50/50 board. And that experience tells me that
that does not work.
Senator Stabenow. Thank you.
Mr. Beresford.
Mr. Beresford. It really depends on what the particulars
are going to be, I suppose. It is hard for me to right now
envision what a group like this would do on a full-time basis.
Now having said that, obviously, the FASB did work on this
on a full-time basis. But thinking about what the Public
Oversight Board has done up until recently, maybe they did too
little. But it was very definitely a part-time type of
organization.
It is a little hard to answer the question until I hear
more about what the structure might be.
I do think, though, that it is very important to have a
mixture between the two. I think that having had some people,
as Lynn said, there are plenty of excellent people that have
done good things in the profession and have finished their
career or moved into a different area and might be excellent
candidates for something like this.
I think it would be a mistake to have a group that is
totally devoid of any knowledge and experience with the area in
question.
It is just a question of the right balance.
Senator Stabenow. If I might ask one other question, Mr.
Chairman, regarding separating consulting and accounting
services.
In light of Enron, we have heard a lot of discussion, the
industry seems to be moving away from allowing both of those to
happen with the same accounting firm.
My concern is, once the fervor dies down, whether or not
the separation will remain. Mr. Turner, it appears that you
would support a clear separation between those two functions.
And I am wondering if other members on the panel would also
support a clear separation and possibly a legal ban on mixing
those consulting services and auditing services.
Mr. Schuetze. I did not deal with this in my testimony, but
I would support a complete separation and allow the audit firm
to provide only audit services to the audit client. No other
services whatsoever, and that includes tax. No tax work.
Senator Stabenow. Okay. Thank you.
Mr. Sutton. I would support a complete separation, with two
provisos. One is that this new board that might be set up would
have the authority to examine whether or not, for some specific
service, the auditor should be permitted to do that. But absent
some affirmative undertaking by that board, have a complete
separation. Whatever nonaudit services might be permitted, I
think they should be permitted only with the approval of the
audit committee board of directors.
Mr. Turner. In my written statement, I did say that I think
there should be a ban on anything other than auditing services
being provided to the audit client.
I do not think we can possibly foresee when we might see
something where there is a service that actually will enhance
the quality of the audit. Or you might run into situations
where you have a small accountant in Gillette or Sheridan,
Wyoming. You have to give this some flexibility where there
might be some situation where, because of that, especially with
some of the small towns and small firms, you may want to allow
some flexibility.
So, I would build into it, as Mike said, this override
protection on behalf of the audit committee.
If the audit committee can conclude that, in fact, it will
enhance the quality of the auditor, it will turn around and
improve the quality of financial reporting, the audit committee
should be the ones closest to it and have that ability to deal
with that issue and give that by-pass, provided they disclose
it to investors.
I think that is also one of the ways to deal with some of
the issues that might come up on a small business perspective,
which you have to be cognizant of.
The one thing to keep in mind is this does not require
separation of the audit and accounting practice. It just means
they can still do consulting if they want. They cannot do that
consulting for that audit client, which is what I think the
real concern is on behalf of the investors.
Mr. Beresford. This is a tough issue and I chose not to
discuss it in my comments because I do not feel that I am as
expert as the gentlemen to my right who had to deal with these
kinds of things in their work at the SEC. Nevertheless, I have
a personal view.
It is a tough call. I think it is hard to determine what is
a consulting service, for one thing. Certainly, the auditing
profession now refers to attestation, which involves a lot of
things besides just the basic auditing.
Lynn mentioned whether a service enhances the quality of
the audit. It is hard for me to know that there would be too
many things that would do that.
Perhaps the other question is, does it detract from the
quality of the audit? And there are many things that probably
would meet, if that is considered to be a lesser test.
I think that this is definitely the type of issue that
should be considered by a group like the Independent Public
Oversight Board. The Independence Standards Board was dealing
with this before it went out of business, and I guess to a
certain extent, the POB in its prior life was doing it as well.
I think that those are issues that should be left to very
careful consideration by groups like that. And if they are
properly constituted and sufficiently independent, I would
trust their judgment.
Senator Stabenow. Thank you.
Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you, Senator Stabenow.
Senator Allard.
Senator Allard. I will have to admit, Mr. Turner, that your
chart seems to streamline a process that looks kind of tortuous
to somebody that is not an accountant. And from a management
standpoint, it looks like it has had some advantages. I also
notice that the auditing standards board that you had on the
chart had oversight from the Securities and Exchange Commission
and then from the accounting standards executive committee. And
when I look at your chart, there is nothing there about the
auditing board.
Don't the problems that we are having today concern audits
and how you handle debt in a financial statement? I would like
to have you share with me how it is you are treating the
auditing function in your chart?
Mr. Turner. That is a very good question, Senator.
The auditing standards board who sets the standards that
govern what steps we have to do during the course of an audit
today, is comprised of about 16 members of the American
Institute of CPA's. Most of those I think actually are
accountants and probably 13, 14 of those are actually
practicing accountants with an accounting firm. They actually
draft the standards.
One of the problems with that part of the system today is,
when they go through that drafting process, since it is all
being done by the firms themselves, in fact, their legal
counsels get involved in editing those very standards
themselves, those standards tend to be written to protect the
accounting firms in case they get in trouble on an audit,
sometimes probably which is deserved and, quite frankly,
sometimes which is not deserved. But they write it to protect
themselves and you cannot fault them for that. If I was
drafting, I would probably be doing the same thing.
It is not drafted with the public interest in mind. And
back in 1978, probably the greatest predecessor to the three of
us is Chief Accountant Sandy Burton, who testified before
Congress and said, ``As long as you leave that standard setting
process in the hands of the firms and the firm's legal counsel,
you are going to get standards written to protect them in
court, as opposed to standards written to ensure that they do
audits that will protect the public.''
As a result, what you see in the revised chart is that the
auditing standards board goes away. We create an independent
board with adequate staff, knowledgeable staff, who then will
start drafting and issuing auditing standards that will be
driven by the public interest.
Let me give you a good example.
Recently, the board adopted a standard on documentation,
what has to be documented and included in the work papers on
the work that they have performed. We tried to push that
auditing standards board to say, you have to document enough
and leave enough in the work papers so that if someone else
from the outside comes in and looks at it, they can determine
that you have really done a good audit. Yet, in the final
conclusion, when they finally issued that standard last month,
they chose to leave that requirement out of it. So even today,
the auditors could do an audit and if you want a third party,
the SEC or someone to come in and overlook and see if it was
done, you cannot tell.
It may help them in court, but it certainly is not going to
protect the public. And I think that is a good example of what
is going on and why we need to pull it out of the profession.
As Sandy Burton said 20, 25 years ago, put it in the hands
of the public, or at least have the public oversee it.
Senator Allard. I am not a serious investor in the stock
market, but I look at the financial statement. The financial
statement includes debt, or should. At least when I took one to
the banker when I was trying to get a loan, he did not want me
to leave out debt. Would you explain to me a little bit, Mr.
Schuetze, how you leave debt out of here? You have lost me on
your comment there.
Mr. Schuetze. Well, I wouldn't leave the debt out. There
would be disclosure of the amount of debt of the special
purpose entity that had been guaranteed by the reporting
enterprise.
Let's say that that total debt was $100. But the fair value
of the guarantee--and there are companies that write guarantees
every day. Chase Bank, CitiBank. Everybody in the financial
world is writing guarantees every day for money. Guarantees are
being priced in the marketplace.
So what you need to do is get on the balance sheet of the
reporting entity the market price of the guarantee that it has
written. It is a put. It is a written put. And then there needs
to be disclosure of the $100.
Let's say the guarantee is worth $16. You put the $16 on
the balance sheet as a liability. That is the fair value of the
written put.
Now this is technical, but if you guarantee my debt, how
much would you charge to guarantee my debt of $100? In the
scenario that I just posed, you would charge $16. Well, that is
the fair value of the guaranteed liability. That is what needs
to go on the balance sheet. But do not put on the balance sheet
all of the assets that are not owned and cannot be sold.
Senator Allard. Now let me just bring in an everyday
situation that myself would look at as a small businessman.
If you signed a lease, a 10 year lease, that you are going
to pay so much per month for 10 years. And if you do not meet
that, that is an obligation that you still owe because you
signed the lease. You have an obligation for 10 years out. So
isn't that in a way a debt to you as a businessman because you
signed the lease? But whoever owns the building, is that
carried out as an asset, then, on his side?
Mr. Schuetze. Generally speaking, in leases that are
written in the United States, and there are many types of
leases, but leases what I call a drop-dead liability. Instead
of the total rents for the next 10 years, if I, the lessee, can
get out of the lease by paying the exit price. Let's assume
that the annual lease payments are $100, $100, $100, for the
next 10 years. That is $1,000.
Senator Allard. Yes.
Mr. Schuetze. But most leases are written such that the
lessee can exit the lease for a payment of, let's say, $250.
The $250 is the drop-dead liability. Not the $1,000. The $250
is the drop-dead termination liability. That is what needs to
go on the balance sheet.
Senator Allard. And do accountants generally agree with
what you are saying?
Mr. Schuetze. Lease accounting is a veritable hash. It is
hash with ketchup on it.
[Laughter.]
It is a book this thick. You cannot make heads or tails of
it.
Senator Allard. So there is a lot of individual
interpretation from the accountant or the auditor as you move
forward. Doesn't that speak to why we need to have more
transparency in these statements?
Mr. Schuetze. That speaks to why we need mark-to-market
accounting, because mark-to-market accounting is simple and it
is by its nature transparent.
Mr. Turner. Senator, I could not agree with you more about
the lease. That is a prime example of why we need to have more
transparency in the financial statements.
Back in 1964, the standards setter then turned around and
wrote a general standard that says that these are installment
purchase of an asset. You ought to have them on your balance
sheet and you ought to have them in our liability.
Unfortunately, we as a profession did not do a very good
job of following that. And if we had, we probably wouldn't have
had some of these problems we have today. But that is a prime
example of the need for greater transparency.
Senator Allard. I see that my time is expired, Mr.
Chairman.
Chairman Sarbanes. Thank you very much, Senator Allard.
Senator Schumer.
STATEMENT OF SENATOR CHARLES E. SCHUMER
Senator Schumer. Mr. Chairman, thank you for holding
today's hearing.
I want to thank all four of our witnesses for a great deal
of erudition and lots of different ideas. We are hearing a
whole lot of them.
I would like ask every one of the panelists three ideas and
their opinion of them. All of them relate to the fundamental
problem I think we have here--I do not know the history, you
know it better than me--but you are basically paying your own
watchdog. The company pays their accountant and they are paying
their own watchdog. And that is the fundamental issue here.
Mr. Turner, for instance, proposed a solution of forced
rotation of accountants which gets at that to some extent. I
would be very interested in the other three people's view of
that issue.
Now, I have heard the other side. The other side is that
the first few years that the new accountant comes on board,
they do not know the company well and if you have a company
that is out to fool the accountant, then it is much easier to
do without that knowledge.
So for the three of you, what do you think of the forced
rotation? And for Mr. Turner, what is the answer to that
problem? It is an idea that intrigues me. I ask all three and
then ask the panel to respond seriatim.
I have been very intrigued by the idea of what we call here
an uber-auditor, that in troubled companies or potential
troubled companies, that the SEC has the ability itself to do
an audit. Obviously, they could not do this for very many
companies. But when they begin to smell a rat, that they might
be able to go in and do an audit themselves. The idea is that
the companies should have the same reaction to an SEC audit
being possibly done as a taxpayer would have to an IRS audit
being done.
It also, again, gets to the fundamental problem that at
least you wouldn't be paying your SEC auditor and could relate
to some independence.
Now, you would all know much better than I how difficult
that would be to do, how cumbersome it would be to do, how
expensive it would be to do. But it is an idea that intrigues
me because I think you would get some bang for the buck. Just
the idea that it would be out there would be somewhat
prophylactic.
Then, I had breakfast with one of our leading economic
thinkers in the Government. I won't say who because I am not
sure it was public. And I asked that person, what is the number
one thing you would do to prevent all the problems we have been
seeing? He answered unequivocally. He said, expense stock
options. He said the idea that stock options are given so much
out there and willy-nilly, has fundamentally created a problem
where, not just the CEO, but the leadership of the company all
having these options puts an undue emphasis on the stock price.
The stock price drifts away from the real value of the
company--what they are producing, what their earnings are, et
cetera. And everyone's just focused on making the price as high
as possible.
Again that seems to make some sense and deals not only with
the recent problems--we have had Enron, Global Crossing, Tyco--
but also with the whole idea that the dot coms, which did a lot
of these stock options. And that is how they paid a lot of
their employees--ended up having stock values that seemed
totally remote from the actual sales, revenues, or anything
else.
So those are the three issues that I would ask each of you
to comment on--forced rotation of auditors, 5 to 7 years,
something like that. This uber-auditor idea that the SEC could
come in and occasionally do its own audit. And the expensing of
stock options, which does seem to have some merit as the root
cause of everything we are talking about, because you are going
to find six different ways that each problem comes about. That
is because of all of the complexity that you gentlemen have
been expostulating on, far more knowledge than I have. But the
fundamental thrust--let's get that stock price up as quickly as
possible.
Mr. Schuetze, let me start with you and just work my way to
the other side of the panel.
Mr. Schuetze. On the first question that you posed, paying
your own watchdog, Congress considered that when the 1933 and
the 1934 Acts were enacted and recognized the problem that
exists when the client pays the auditor, that there is the
problem of, at least the appearance of lack of independence, if
nothing else. But nonetheless, decided back in 1933, 1934 to
leave that be.
I think it would be a good idea to have forced rotation of
auditors every 5 years or so. Then at least the retiring
auditor would take his or her Brillo pad and scrub the balance
sheet in the third or fourth year and hand over a balance sheet
that looked like a new copper penny to the new auditor. And I
think that would be a very good idea.
Senator Schumer. Do you want to comment on the other two,
uber-auditor and stock options?
Mr. Schuetze. The uber-auditor? As a practical matter, I do
not think that would work.
You mentioned IRS examinations. Those are done in
retrospect. They aren't done beforehand. It would be very
difficult for the SEC to, ``smell something or to see something
rotten in Denmark'' and do something before something happens.
The enforcement division right now does that on a
retroactive basis. When something breaks down, the enforcement
division looks back to see what happened. I think it would be
very difficult to do looking forward.
The expensing stock options, I know that that has a great
currency. I personally disagree with it for very, very
technical reasons. I will spend just a couple of minutes
describing those technical reasons. Expensing stock options
implies that the stock of the corporation is an asset of the
corporation. The stock of the corporation is not an asset of
the corporation.
Enron used its own stock to backstop its SPE's. I think
that clearly implied that the stock of Enron was an asset of
the corporation. That is wrong.
Stock options to me are divisions of the ownership interest
between owners and they represent a division of ownership
interest--they do not affect the corporation. The corporation
does not get any assets as a result of stock options except the
exercise price. The corporation does not pay out any assets.
The total market capitalization of the corporation does not
decrease as a result of issuance of stock options.
I think all of the proposals that have been made regarding
accounting for stock options as an expense of the corporation
amount of proforma, as-if accounting. And I do not agree with
it, but it is extremely technical.
Now if the Congress wants to do it and if the accounting
profession wants to expense stock options, I think that is
probably okay because it is proforma, as-if, and it does not
affect the assets of the corporation. But I personally think it
is wrong because I think the underlying thesis for it is wrong
because stock is not an asset of the corporation and you cannot
use stock to create an expense.
Now it is highly, highly technical and I will send you an
article that I have written about it. But I would not do it,
personally.
Senator Schumer. My guess is I wouldn't understand----
Mr. Schuetze. Yes, you will. It is written in English.
[Laughter.]
Senator Schumer. Thank you.
Mr. Schuetze. It is written in English.
[Laughter.]
Senator Schumer. Well, I have some rudimentary knowledge of
English of the Brooklynese variety, so----
[Laughter.]
Mr. Sutton.
Mr. Schuetze. South Texas and Brooklyn are compatible.
[Laughter.]
Mr. Sutton. With respect to the rotation watchdog issue, I
agree with Walter's recollection of 1933, 1934. But my
recollection also is that Congress arrived at that decision
because of the reality that there was not a workforce in place
that could do the work that needed to be done. And the auditing
profession stepped forward and volunteered to do that, and
Congress agreed with that.
With respect to rotation, I would say rotation is one of
the issues that I would present more generally. And that is,
how do you break the bond between management and auditors?
I would support the rotation of auditors. It would mean
that the profession, the practicing accountants would have to
change their business model. But I am convinced that they could
adapt to that and rotation could be an effective way of
breaking the bond.
Uber-auditor--I think I agree with Walter that my sense of
the SEC mandate is that that would be difficult to do. In my
view, the issue that you are talking about there would be, we
would get at that through this new independent oversight board.
It would be that body that would be looking over the auditor's
shoulder, if you would.
Expensing stock options, I could not disagree with Walter
more. Again, I accept his explanation that it is a very
technical issue. He has a model of accounting and a definition
of assets and liabilities that I respect. But they are his and
not mine and probably not the rest of the profession.
Of course, stock options are an expense, is my answer to
that. The FASB concluded that and was prepared to issue a
statement to that effect. But I will leave it to Mr. Beresford
to explain further why that did not happen.
Senator Schumer. Do you think it is important to do? I
mean, is it as high up as this gentleman mentioned to me?
Mr. Sutton. I do. I think Lou Lowenstein wrote a brilliant
article and the theme of it was, you manage what you measure.
And if you do not measure real economic things----
Senator Schumer. You do not manage them.
Mr. Sutton. --you do not manage them.
Senator Schumer. Okay.
Mr. Turner.
Mr. Turner. Senator Schumer, let me start with the last one
first, the stock options.
I love going to New York and I would love it a lot more if
you could figure out how to get those stock options expensed.
I think the real economics are that there is tremendous
value in there. In fact, I will tell you as a CFO of a major
high-tech company, we go through valuation. We had independent
outside valuation, very good experts come in and just tell us
how much value there really was there. There was phenomenal
value.
In fact, I participated in a survey periodically with many
of the best-known companies out of the Silicon Valley. We all
did compensation surveys of what one another was paying.
There are three pieces to those charts every time--cash
compensation, perks, including 401(k)-type benefits, and then
the third chart, every single time, was how much value we were
giving our stockholders in terms of compensation in stock
options.
There is unequivocally a piece when you manage a business
that you have to look at as far as what is the cost to the
stockholders of those stock options. And to play Grimm's Fairy
Tales that these things have no value is crazy.
We need transparency, as Senator Allard mentioned.
Transparency means, as Senator Gramm said, getting the real
economics of the transactions in the financial statements. And
in this case, it has been too long and it is well past due to
start recording those stock options as expense.
Senator Schumer. Do you agree with the fundamental analysis
that it separates the value of the company from the value--or
puts a premium on the leadership of the company trying to get
the value of the stock up, whether the value of the company is
increased or not. The actual things we know companies are
supposed to do, which is make profits.
Mr. Turner. There is no question, having sat in that seat,
that those stock options have an impact on the management, have
an impact on the employees, absolutely.
Senator Schumer. Uber-auditor?
Mr. Turner. On the uber-auditor, I think just personal
behavior would be that if you know you have an IRS auditor
coming in, you are going to act differently.
A couple of comments on it. Obviously, the SEC does not
have the resources or the talent right now to do it.
Senator Schumer. We would have to give them the resources.
Mr. Turner. Right. You would have to give them the
resources. But more importantly, American investors over the
last half-dozen years, give or take a number, have seen about
$200 billion in value come out of the markets when these
balloons have been burst on these companies that have had
problems.
My concern with the uber-auditor thing is we need to make
sure that the problems get fixed before a bad event happens.
Chairman Pitt, and I very much commend him for this, has
said, we have too many problems popping up and we are dealing
with them through enforcement afterwards.
I hope our system, with what changes we make to it, will
prevent that type of damage to American lives and their savings
rather than dealing with a situation like Enron where, even
though you go in there afterwards, it won't matter. There is
not enough money to recoup the $60, $70, $80 billion that these
people have lost. They are not going to see it again.
So even in an Enron case, a uber-auditor does not do us any
good. It does not help those tens of thousands of American
lives that, quite frankly, have been destroyed.
And I hope we turn from being reactive to being proactive.
Senator Schumer. The uber-auditor could go in at any time.
It would not have to wait until the bubble bursts.
Chairman Sarbanes. Chuck, we are 10 minutes over and
Senator Shelby is waiting.
Mr. Turner. Actually, that is exactly what the Public
Oversight Board, if you look at it, that is exactly what it
does. It turns it into an uber-auditor.
Senator Schumer. I would just ask Mr. Beresford to submit
the answers in writing.
Chairman Sarbanes. No, go ahead, Mr. Beresford. We will
give you a minute or two here.
Mr. Beresford. I will talk about stock options because that
is where I might have a comparative advantage, I guess you
might say, with the others.
Clearly, the FASB would have adopted a final rule on
accounting for stock options, except that Congress threatened
to put us out of business. We were convinced that was a real
threat. It would happen. The SEC said they would not support us
on the issue because it was not important enough for them--or
for us, frankly, to lose the franchise.
The question I think you started with, though, was is this
the most important issue of the day? I am not convinced it is,
frankly, but it is one that is such a sensitive issue to both
corporations and fortunately now, to investors, that it might
be a symbol, if the FASB and/or the international groups were
able to deal with this issue right now.
There are great difficulties in determining what the value
of options would be. There are complex accounting questions
about whether you determine the value at grant date or vesting
date or exercise date, things like that, that those can be
dealt with. And even if it is a minimum measure of the
compensation amount, it ought to be recorded in financial
statements. How much that would actually change behavior, is
really almost impossible for me to predict. But it is a pretty
glaring omission from the accounting model today.
Senator Schumer. Thank you, Mr. Chairman. I thank the
panel.
Chairman Sarbanes. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
If the basic purpose of an audit, as I understand it, that
is, is to provide information to the marketplace, or to meet
legal requirements by providing technical or financial
information, how would you rate the quality of the information
that is available in the average financial statement of the
average publicly-traded company?
Mr. Schuetze.
Mr. Schuetze. The financial statements today are
impenetrable.
Senator Shelby. That is right.
Mr. Schuetze. They are indecipherable, to use Chairman
Pitt's words. If you go to the Internet and pull down the
financial statements of relatively simple companies, the
management discussion and analysis, the financial statements
and the notes to the financial statements run 40, 50, 60, 70
pages of simple companies, never mind complex companies. So, I
think the usefulness of the information is pretty close to a D.
It has to be C-minus.
Senator Shelby. Mr. Sutton.
Mr. Sutton. I might give it a slightly higher grade, but I
would agree that the financial reporting has become
increasingly impenetrable, to use Walter's word. And it is time
that we reexamine----
Senator Shelby. Past time, isn't it?
Mr. Sutton. Past time--how we go about establishing
standards and what those standards should present and what
financial reporting should present.
Senator Shelby. Mr. Turner, how would you rate it?
Mr. Turner. Actually, I think there is a lot of good people
out in America preparing these financial statements that do a
good job.
Senator Shelby. We know that. There are a few bad ones,
too.
Mr. Turner. Yes, there are. If you look at the surveys,
there are probably about 10 percent of them, 15 percent, that
clearly, unequivocally, have gone over the cliff and are off
the map, so to speak. I would guess that you probably have an
equal amount that are doing an outstanding job and I would give
them an A for their transparency.
Senator Shelby. What do you do with these people? In the
legal profession, which some of us are familiar with, you get
suspended, you get disbarred, you do all these things. But the
CPA's, what happens to these guys that continue to do bad work
or continue to be compromised, continue to have to restate
their audits, so to speak?
Mr. Turner. Very good question, Senator Shelby.
There are in the existing disciplinary system, the
profession itself essentially does not do any real discipline.
We actually saw some cases at the Commission where we had even
censured the professionals. And the profession itself actually
voted not even to investigate the matter. It would have been
one thing if they investigated and had taken action. But they
actually voted not even to investigate the matter where the SEC
itself had chosen to censure these people.
Senator Shelby. That is a sad state of affairs.
Mr. Turner. It is a very sad state of affairs. The State
boards are so resource-constrained, that the State boards
themselves basically can very seldom take action. They are very
difficult. And the State boards, keep in mind, basically are
representatives. They are people out of accounting firms, a
growing percentage of them coming from the Big 5 accounting
firms.
So the State boards themselves have inherent conflicts. I
do not know that you can always look to the States. Some do a
very good job and try, but they are very budget-constrained.
The SEC--this is back where we get into the discussion of
pay parity and resources. They have 20 to 25 accountants in the
Division of Enforcement in Washington, DC, down the street from
here. Two hundred to 250 cases. Maybe 30 to 40 accounts around
the rest of the country.
I have been an expert witness, as I admitted. Three to four
of us would have to work on every single case to get it ready.
And on an Enron case, maybe you would need 10 accountants. If
you think that they have 20 to 25 accountants, 200 to 250
cases--there is not a prayer. Many of those cases will go
unprosecuted, not because the dedicated staff do not want to go
after them, but because the staff just do not have the bodies,
do not have the resources and, quite frankly, are getting paid
cents on the dollar compared to what they can do if they go
elsewhere.
Senator Shelby. I do not know what the term would be. Since
you are not admitted to the bar, you are admitted to the
accounting profession. Do they disbar, using the term loosely,
accountants? In other words, do you have just hundreds of them
kicked out of the profession each year?
Mr. Turner. No, you do not. In fact, the State boards----
Senator Shelby. Why not? For the reasons you told me?
Mr. Turner. For the reasons I told you. They do not have
the resources. The States grant the license. The States take
away the license. They do not have the ability to prosecute.
Probably, quite frankly, one of our faults at the SEC was
we did not interact enough with the States on that. We were
trying to do that and met with the States a number of times, as
Chairman Levitt and I were in the latter years. But it is a
system that needs to be fixed. The discipline does not exist.
Senator Shelby. Mr. Beresford.
Mr. Beresford. Senator Shelby, as you know, those of us in
the university community have been accused of grade inflation.
Nevertheless, I think that financial reporting deserves a
much higher grade than my fellow panelists do. However, I would
also say that it requires, as the FASB concepts state, that you
have to be reasonably educated in accounting-type issues and
you have to be reasonably diligent in being able to look
through reports.
There have been lots of reports that Enron's financial
statements, were basically incomprehensible, at least the
footnotes and so forth. I have tried hard to look through them.
And I find them challenging, to say the least. But that does
not mean that every other corporation in America is beyond
comprehension.
The average person, the average man or woman on the street
is not going to be able to look at a complete set of financial
statements of the typical publicly-held company and have much
hope of understanding exactly what is going on.
Now, we do have lots of financial intermediaries, as I
would call them in our system, financial analysts, lending
officers, other people who make decisions based on the
financial information.
I absolutely agree with the statements that have been made
otherwise that our financial reporting system is the best in
the world. Can it be better? Absolutely, yes. Can it be simple?
No.
Senator Shelby. What are your views as to the causes behind
the increases in the number of restatements and audit failures?
In other words, why? They do a financial statement for various
companies. We showed how many in the chart here a week or so
ago that the Chairman had a hearing on. It has just moved up so
fast.
Obviously, you look back and you say, gosh, we were wrong.
And these are accountants doing this. Why can't they get it
right the first time? Because, to me, it goes to the very truth
of a situation. What is the true state of this company's
financial condition at this given time? And it is either false
or it is not, or it is misleading or it is not.
Mr. Schuetze. Well, when I was Chief Accountant of the
Division of Enforcement at the SEC, we prosecuted a number of
cases where the auditors had seen the problems. It was
documented in the auditor's working papers that they had seen
the problem, knew what it was, and they decided, simply decided
to sign unqualified opinions, notwithstanding that they had
seen it.
Now, I cannot explain to you why that is happening. I just
know that it is. The number of restatements that we are seeing
has grown immensely. And in the number of cases in which I was
involved when I was in the Division of Enforcement, we saw that
the auditors saw the problems.
Senator Shelby. But they did not solve the problems, did
they?
Mr. Schuetze. They did not solve the problems. They did not
go to their clients and say, Mr. or Mrs. Client, you need to
adjust these financial statements. They simply did not do it.
Senator Shelby. This was mentioned earlier. And Mr.
Chairman, you have been lenient with me on the time. But if you
do audits and if you have to do them, the big accounting firms
have to do them, in the future, why can't you rotate these
firms? In other words, one cannot do the audit next year and
the management cannot choose. They can maybe choose from
somebody else, or the SEC sends the dogs in to look at the
situation. Dogs meaning the accountants.
Mr. Schuetze. Well, as I stated previously, I think that
auditor rotation is a good idea.
Senator Shelby. Mr. Sutton, what do you think?
Mr. Sutton. It is one of the ways where you can go about
getting at a broader issue, and that is, breaking the bond
between management and the auditor. And as you look at
corporate governance, there would be some other ideas there
like wresting control from management and putting more control
in the audit committee and some other ideas. But rotation would
work.
Senator Shelby. Mr. Turner.
Mr. Turner. I agree totally with you, Senator Shelby. I
would rotate just as was mentioned. And probably when the new
auditor came in, have some type of public reporting of any
problems that they saw as they came in because, as Walter
mentioned, during my term, we also saw a number of instances
where the auditors actually identified the problem,
notwithstanding that, in fact, meetings where there were many
auditors in the room and they documented the fact that they
found the problem, but then still let the report go out. It is
not just the auditors. It is also the management team.
Keep in mind that the primary responsibility for these
financials are the management team. We have to get to where not
only do we have good discipline and timely, effective
discipline as the auditors as you proposed, and I commend you
for that, but we also have to get timely and effective
discipline of the people who cook the books and are in the
kitchen stirring the kettle. And that is the CEO and the CFO.
Senator Shelby. Maybe we do not have enough criminal
statutes out there to prosecute these guys yet.
Mr. Turner. I think we need to get some things to put the
heat under their feet because as long as they are cooking the
books, you are having situations where people, quite frankly,
are also probably lying to the auditors as well as the
investors, and that is a serious concern.
Senator Shelby. You steal something at the grocery store
and you are caught, you should be prosecuted. No telling what.
Or you steal a car and you are prosecuted, and you should be.
But people in corporate America, a lot of them have stolen and
cheated people out of millions, hundreds of millions, if not
billions of dollars.
Look at the enormous difference there. Not that there is
any difference in--if you break the law, you ought to be
punished. But these people, for the most part, are getting by
with that.
I think it is sad and I think the American people, the
average person, investor or noninvestor, they realize that
there is a deep problem in the capital markets. And the people
aren't going to trust the accounting profession. They are not
going to trust these statements. That is not good for America.
Mr. Turner. No, it is not. You are right. We do need to
step up the enforcement. And if there is one criticism I would
probably have of us, even while we were at the SEC, we probably
needed to take stiffer actions as well. When you turn around
and slap someone on the hands, it sends a message after a while
that that is all that is going to happen.
The greatest fine we ever fined an accounting firm was
while we were there and we fined them only $7 million, where
the investors lost billions. We probably have an obligation
that the Commission get tougher.
Senator Shelby. But if we do not go back to what is true
value, as Mr. Schuetze said earlier, if we do not get back to
what is really valued in a company's financial statement, it is
a fraud in a way. And if you cannot sell something--I know you
can trade options. We understand all that. Some things might be
valuable from an accounting standpoint, but it has no value in
the marketplace. That is a problem. It looks to me like it
makes the statements more bloated to fool the investor in the
long run.
Mr. Turner. I agree. After those six economic classes, I
tell you, our financial statements have to reflect the actual
underlying economics and not sham transactions like we have
seen with the SPE's or without real good values being reported
in the financials, as Walter has mentioned. And until we get
there, we have still a lot of work to do and we are not being
honest with the public and with investors.
Senator Shelby. Mr. Beresford.
Mr. Beresford. Just one comment. You started with the
question of why have there been so many restatements in recent
years?
Senator Shelby. Absolutely.
Mr. Beresford. Why has there been such an increase? A big
reason for that is that the accounting rules were changed after
the fact in many situations. These are complicated areas that
companies dealt with. Whether they were dealing with the best
professional advice or judgment in all cases, that is
questionable.
But, to be clear, there were a number of situations with
respect to revenue recognition and some other specialized
situations where they were told after they had reported
something, that there was a new rule that had to be applied and
they had to go back and correct earlier financial statements.
Senator Shelby. A lot of these rules are going to have to
be revisited, aren't they? Accounting rules that brought about
the situation that we are in today. Not just Enron. Perhaps not
just Global Crossing. But no telling what else is out there.
Mr. Turner. I would actually disagree with Denny on his
remarks. I think in most of the cases, the people actually just
flat out cooked the books. There is a study that has been done
by the financial executives that found that in 85 percent of
the cases, there were errors that were found after the fact by
either the auditors or the companies themselves, companies like
Sunbeam, that have found it out after the company went under.
About 15 percent of the cases were actually found by the SEC
where they went in and looked at it.
So, I think, quite frankly, most of the restatements have
come out when there has been a problem develop at the business,
and unfortunately, the problem was not reported in a timely
fashion to investors. Like cases like Sunbeam and W.R. Grace.
And then, eventually, as the business got into trouble and it
came to light, yes, they did have to restate.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Sarbanes. Thank you very much, Senator Shelby.
This has been an enormously helpful panel. I just want to
ask a couple of questions in closing.
If the standard being set by the institutions established
to set accounting standards are wrong or inadequate, in the
judgment of the SEC, with respect to public companies
currently, does the SEC have the authority to set a different
standard?
Mr. Schuetze. Yes.
Mr. Sutton. Yes.
Chairman Sarbanes. Does the SEC currently have the
authority to discipline the auditors or accountants that it
thinks are not measuring up to required performance, again with
respect to public companies?
Mr. Schuetze. The SEC has a rule called Rule 102(e), which
is in the rules of practice before the Commission. The SEC sued
two auditors back about 20 years ago under a predecessor to the
rule that is now in place. The name of that case is Checcosky
and Aldridge. It took that case about 15 years to work its way
through the courts. And after that case worked its way through
the courts, the SEC changed its Rule 102(e) to where now it
does not require recklessness in order to charge auditors with
malfeasance.
It requires heightened concern in certain areas. But even
that standard I think is very, very difficult to police. I
would go back to a standard that is based upon negligence
alone. I think we ought to have a standard for corporate
officers based on negligence alone, not recklessness or gross
negligence. I would move the standard over to negligence for
both auditors and corporate officers and the directors.
Chairman Sarbanes. Yes?
Mr. Beresford. The answer to your question is yes.
Chairman Sarbanes. What?
Mr. Beresford. The answer to your question is yes, clearly.
Chairman Sarbanes. Obviously, I understand the pressures
that the SEC was placed under in a governmental context. But it
goes to the question of what structure we are going to
establish to monitor the situation, and what resources you give
to the SEC and so forth. We are thinking about all these
different boards and everything. But a very enforcement-
oriented SEC could make a really big difference.
Now the question is, well, that is true in today's
environment since everyone's running around now concerned about
Enron and all the rest of it. Some people have completely
flipped positions and so forth. But the fact remains what
structure do you get that gives us the greatest assurance that
these things can be policed and prevented from happening?
That is one of the things that we need to search through in
order to figure out in terms of what needs to be put in place.
So any further thoughts you have on that, we very much
appreciate it. Did you want to add anything?
Mr. Sutton. I was just going to say that one thing to keep
in mind is that if we wanted to do the disciplinary part of
this through the SEC, I suspect the SEC would still need more
than just resources. It probably would need some more finely
tuned enforcement tools.
Today, the SEC is principally a law enforcement agency. The
club it carries is a real big one. And so, if we are going to
try to do discipline through the SEC, I think you ought to
consider--and I am not a lawyer--what additional tools you
might need for the SEC to do that, not just resources.
Senator Shelby. Chairman Sarbanes, can I ask a question?
Chairman Sarbanes. Sure.
Senator Shelby. Does the SEC currently have the power, if
you saw fit, to suspend from practicing in the United States an
accounting firm that consistently made gross mistakes or was
complicit in something that was deemed fraud or close to it?
Mr. Schuetze. Maybe not a firm, but individual auditors,
yes.
Senator Shelby. Why not the firm? I have seen accounting
firms that have paid out hundreds of millions of dollars, in
the billions, probably. I am going to have a chart on it, Mr.
Chairman, when we have another hearing sometime.
It looks to me like it is so rampant. In other words,
nobody has been disciplined, as we talked about earlier. There
is a fear factor. Fear is a heck of a thing, positive and
negative.
But in this case, if you are going to oversee accounting
firms--and FASB obviously is not going to oversee them. They
just haven't done it. And I do not think they are capable of
doing it in the way that they are set up today.
If you suspended one of these firms, I think the message
would go out, oh, there would be political fallout, but it
wouldn't last long because the American people would be behind
you.
Mr. Schuetze. If you go back to 1975, and the settlement
reached between Peat Marwick Mitchell & Coe and the SEC in the
Penn Central matter, the Penn Central matter and National
Student Marketing and some others that existed at that time,
the SEC and Peat Marwick did agree that Peat Marwick would not
take on a new publicly-held client for 6 months. And that put a
significant crimp in Peat Marwick's practice.
Now that is the most severe penalty that I am aware of in
terms of a suspension of practice. In the Arthur Andersen
matter that was settled last summer between the SEC and Arthur
Andersen, Arthur Andersen did agree to an injunction.
So starting in the summer of 2001, there was an injunction
in place against the firm and the individuals within Arthur
Andersen regarding further fraudulent activity by that firm and
its partners and staff.
I am not a lawyer. I would need help from a lawyer to
explain the significance of that. But as I understand it from
the lawyers at the SEC, that was a powerful settlement that the
SEC extracted from Arthur Andersen. It has been given very
little note. Everyone in the press has focused on the $7
million fine that was assessed against Arthur Andersen, but has
not focused on the fact that the SEC has an injunction that
prohibits further fraudulent activity by the firm.
Senator Shelby. So, Mr. Chairman, maybe this is not the
same analogy, but it is an analogy of sorts.
You say a college football team or a university
participates in the NCAA athletic program. They could be
suspended. They could be punished in various ways for violating
the rules. Or their program could be terminated. It was. I
think it was SMU, a great school in the southwest a number of
years ago.
But that puts the fear factor out there that accountants
would know, we are not only going to be suspended, but also we
might lose this client. We are going to lose our whole
livelihood.
Mr. Schuetze. That is an idea worthy of consideration.
Senator Shelby. I did not say do it. I am saying it would
work.
Mr. Schuetze. It would work. But you then have to consider
the impact of that. Each of the Big 5 firms has approximately
2,000 publicly-held clients. And if you say to one of the Big 5
firms that as of, let's say, March 31, you are precluded from
practicing before the SEC, the firm, then you have 2,000
companies who cannot get an audit report. That may effectively
preclude them going to market until they are able to get
replacement auditors. That is a huge economic burden that is
placed now on 2,000 registrants and all of their shareholders.
Senator Shelby. I understand that. But the other is worse,
not to do anything. In other words, to let the situation fester
as it is today, where more and more people in America have
little, if any, confidence in the financial statements in our
capital markets, in the accounting profession, and so forth.
Mr. Schuetze. I was simply pointing out the ramifications.
Senator Shelby. Yes, sir, I understand. But, still,
somebody would supply that. It might take a little while.
Mr. Schuetze. Oh, sure.
Senator Shelby. Yes, sir, Mr. Sutton.
Mr. Sutton. Senator Shelby, I think that hits on my comment
that if we pursue more disciplinary activities through the SEC,
it may be necessary to more fine-tune the tools so that this
does not happen.
Senator Shelby. Yes, sir.
Mr. Turner. I would agree with that, Senator Shelby. I do
think that the SEC does need to fine-tune some additional tools
and fine-tune some of the rules that are there. You need to
give that to them if you are going to look for more.
Mr. Schuetze. I would encourage you all to move the
standard from recklessness over to negligence. If you do that,
you will get fine-tuned audits.
Senator Shelby. You will get better audits, won't you?
Mr. Schuetze. You will get fine-tuned audits.
Senator Shelby. You will get more independent accountants
and you will have more honesty in the financial statement,
would you not, Mr. Turner?
Mr. Turner. You would have created that uber-auditor in the
back of their mind, anyway, if you bring it down to negligence.
I would agree with you, Senator.
Senator Shelby. Mr. Chairman, I hope you will consider
that. You are our leader.
Chairman Sarbanes. We are going to consider a range of
things. I am pondering how we alter the structure of the
balance so that the auditors and the accountants have a more
independent position to resist the pressures that are put on
them by the companies.
Senator Shelby. That is right.
Chairman Sarbanes. The companies, after all, are the ones
who are paying them. The companies want to achieve a certain
result. My perception is they push the auditors to approve
those results.
Now, I guess a very upright auditor resists all of that,
but a lot of them fall prey to it. And the people who are
pushing them to do it, in effect, can presumably fire them.
We are going to do corporate governance tomorrow, so we
will examine the role of the audit committee and how that
relates to management and the directors and so forth.
But the whole thing is structured now, it seems to me, in a
way that constantly has the pressure working to go to the
lowest common denominator rather than the highest common
denominator. Part of that is, of course, you have a stick or
enforcement. Volcker talked about this at some length when he
was here. How do you change this frame of mind, this attitude?
Actually, it is very interesting. I read a little bit about
Arthur Andersen himself, the individual who founded this firm
and who came with a highly responsible set of values to the
role of the accountants. But, obviously, we have not always
been able to carry through on that.
Senator Shelby. Mr. Chairman, one last comment, if I could.
I know we are missing our conferences, but this is more
important, is it not.
Our banking system--and this is the Banking Committee--we
have auditors from the Federal Deposit Insurance Corporation,
the Comptroller of the Currency, the Federal Reserve, different
ones. They go into X-bank, not as a friendly auditor,
necessarily. Perhaps maybe not as an adversary. They are not
owned by anybody. They are not influenced by anybody. And I
think that is healthy.
I am not proposing that the SEC set up something to audit
everybody yet. The Chairman sort of alluded to it. Maybe not
the same thing that I am getting ready to say. There is some
fear there with the auditor, that when the FDIC auditor comes
into the bank, they had better have those things in order.
I am not sure there is any fear in corporate America to
speak of when the auditors come in and they are so close to
them, they are sweethearts, as opposed to off-hands auditor,
maybe not adversary.
There is a difference there. How do we stop that? I think
that will go to the independence of the auditor and the
independence of the people preparing the tax return, without
being compromised by who is paying them.
It is difficult, but it is not impossible to handle. I
think what is at stake is something much bigger, the integrity
and the perception of integrity in our capital markets. Isn't
this true?
Chairman Sarbanes. Does anyone on the panel have any
closing remarks?
Mr. Turner. I would agree with you, Senator.
Senator Shelby. Do you disagree with that?
Mr. Turner. No, I agree with you, wholeheartedly.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Sarbanes. Gentlemen, thank you very much. You have
been an extremely helpful panel and we appreciate it.
This hearing is adjourned.
[Whereupon, at 1:25 p.m., the hearing was adjourned.]
[Prepared statements, response to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR WAYNE ALLARD
I would like to thank the Chairman for holding this hearing. He has
moved forward quickly to examine recent corporate failures, and I
appreciate his swift action.
We have all heard a great deal about the recent meltdowns at Enron,
Global Crossing, and other companies. A great deal of the controversy
seems to center around the reliability of the financial statements from
these companies. Our financial markets depend on timely, accurate,
reliable information. I believe that it is important to examine the
public policy implications of these collapses so that we can help
restore investors' confidence.
In particular, I am concerned with the use of off balance sheet
arrangements, which can be used to obscure the actual condition of a
company. I am hopeful that the Financial Accounting Standards Board
will ensure that such transactions are appropriately reflected in the
financial statements and disclosures.
I would like to take this opportunity to welcome one of my
constituents, Lynn Turner, to the Banking Committee. Lynn was the Chief
Accountant of the SEC from 1998 to 2001, and he currently serves as the
Director of the Center for Quality Financial Reporting at my alma
mater, Colorado State University.
I would also like to welcome our other witnesses and thank them for
being here today. I understand that you are all very busy. Your
expertise will be helpful as the Banking Committee grapples with the
many accounting issues that have been brought to light during recent
weeks.
Again, thank you for being here. I look forward to your testimony.
----------
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
Through the course of these hearings that the Committee has
conducted, we have heard a great deal about the importance of accurate
information for properly functioning capital markets. One of the most
essential tools for providing such information is the independent
financial audit.
Certified public accountants are supposed to provide objective
analysis to ensure that the investing public is presented with an
accurate picture of a company's financial condition. Unfortunately,
recent events provide clear examples of where firms have acted like
lapdogs instead of watchdogs. We have seen that too often the
``public'' responsibilities associated with the title ``certified
public accountant'' have been ignored.
The Enron case and the many others like it requires that this
Committee address a very basic question: Can the accounting industry be
relied upon to meet its responsibilities to the public? As I have noted
in some of my previous remarks, addressing this question is extremely
important. Fraud in the capital markets causes damage that goes far
beyond the losses of a particular group of investors. Fraud diminishes
investor confidence and ultimately stifles economic growth.
Because of the seriousness of the damage that it causes, I believe
we must not only severely punish fraud in our markets, we must also
find ways to deter it in the first place.
In the end, I do not think that we can legislate honesty or
integrity in accounting or any profession. But I do believe that we
must try to establish that those with responsibilities meet them or
face consequences for their failure to do so.
----------
PREPARED STATEMENT OF SENATOR JON S. CORZINE
Mr. Chairman, thank you for holding these important hearings, and
for your thoughtful approach to analyzing the many factors that affect
investor confidence in our financial markets.
In the wake of what we have witnessed at Enron, Tyco, and Global
Crossing, there is little doubt in my mind of the need for Congress to
take a close look at corporate governance and public company
accounting. These scandals have led to a crisis of confidence in our
markets and fed public cynicism about the integrity of our markets as
well.
These scandals did not occur in a vacuum. What we have witnessed is
the result of the obsessive zeal with which corporate financial
officers--due to greed and pressure from corporate management--felt
compelled to show increased earnings and growth, often at any cost.
This hearing, featuring the former chief accountants of the SEC, is
an important one in that it will give us a historical perspective of
the evolution of our financial reporting system and provide us with
insights as to how to best fashion a response aimed at restoring
investor trust in the numbers presented by our public companies.
If investors are to remain confident in our markets, America's
publicly-traded companies must embrace a culture of financial reporting
that is based on accurate, transparent disclosure. And if these
attempts at cultural reform are to succeed, the SEC must be a willing
partner.
I want to thank all of our witnesses for taking the time to join us
today. I look forward to their testimony.
----------
PREPARED STATEMENT OF WALTER P. SCHUETZE
Chief Accountant, U.S. Securities and Exchange Commission
1992 to 1995
February 26, 2002
Thank you, Mr. Chairman, Senator Gramm, and Members of the
Committee. My name is Walter P. Schuetze. My brief resume is attached
hereto.
Just a few comments about my experience and background. I was on
the staff and a partner with the public accounting firm KPMG and its
predecessor firms for more than 30 years. I was one of the Charter
Members of the Financial Accounting Standards Board from April 1973
through June 1976. I was a Member and Chair of the Accounting Standards
Executive Committee of the American Institute of Certified Public
Accountants in the 1980's. I was Chief Accountant to the Securities and
Exchange Commission from January 1992 through March 1995 and Chief
Accountant of the SEC's Division of Enforcement from November 1997
through mid-February 2000.
I need to mention that although I am retired, I am a consultant to
the Securities and Exchange Commission and several other entities under
consulting contracts. In addition, I have one remaining tie with my
former firm, KPMG, in that I am an insured under a group life insurance
contract obtained and administered by that firm; I pay the premium
attributable to me. The views I express here today are my personal
views.
I appreciate very much the opportunity to testify here today. Your
letter of January 16, 2002 inviting me to testify at this hearing says,
``A number of high-profile business failures in recent years,
including, most recently, the collapse of Enron Corp., have involved
significant accounting irregularities, and the February 26 hearing will
examine the issues raised by those failures for financial reporting by
public companies, accounting standards, and oversight of the accounting
profession. You should feel free to address those issues as you see
fit. The Committee would also appreciate any recommendations you may
have about ways to deal with the issues you discuss.'' I, indeed, have
a major recommendation, which I will get to at the conclusion of my
remarks.
The public's confidence in financial reports of and by Corporate
America, and in the audits of those financial reports by the public
accounting profession, has been shaken badly by the recent surprise
collapse of Enron, by recent restatements of financial statements by
the likes of Enron, Waste Management, Sunbeam, Cendant, Livent, and
MicroStrategy, and by the SEC's assertion of fraud by Arthur Andersen
in connection with its audits of Waste Management's financial
statements in the 1990's, which Andersen did not admit or deny in a
settled SEC action last summer. The public's confidence needs to be
regained and restored. If that confidence is not regained and restored,
the result will be that investors will bid down the price of stocks and
bonds issued by both the United States and foreign corporations; we
have seen evidence of that phenomenon in recent weeks. That is an
investor's natural response to increased risk or the perception of
increased risk. This will reduce the market capitalization of
corporations, which in turn will negatively affect capital formation,
job creation and job maintenance, and ultimately our standard of
living. So, we are concerned today with a very important matter.
You will hear or have heard many suggestions for improvement to our
system of financial reporting and audits of those financial reports.
Some will say that auditor independence rules need to be strengthened.
That external auditors should not be allowed to do consulting work and
other nonaudit work for their audit clients. That external audit firms
should be rotated every 5 years or so. That external auditors should be
prohibited from taking executive positions with their corporate clients
for a number of years after they have been associated with the audit
firm doing the audit unless the firm resigns as auditor. That peer
reviews of auditors' work need to be improved and done more frequently
if not continuously. That auditors should be engaged by the stock
exchanges and paid from fees paid to the exchanges by listed companies.
That the oversight of auditors needs to be strengthened. That
punishment of wayward auditors needs to be more certain and swift. In
that regard, Chairman Pitt of the SEC has proposed that there be a new
Public Accountability Board overseeing the external audit function;
this Board would, as I understand it, have investigative and
disciplinary powers. And so on and on. In my opinion, those
suggestions, even if legislated by Congress and signed by the
President, will not fix the underlying problem.
The underlying problem is a technical accounting problem. The
problem is rooted in our rules for financial reporting. Those financial
reporting rules need deep and fundamental reform. Unless we change
those rules, nothing will change. The problems will persist. Today's
crisis as portrayed by the surprise collapse of Enron is the same kind
of crisis that arose in the 1970's when Penn Central surprisingly
collapsed and in the 1980's when hundreds of savings and loan
associations collapsed, which precipitated the S&L bailout by the
Federal Government. Similar crises have arisen in Australia, Canada,
Great Britain, and South Africa. There will be more of these crises
unless the underlying rules are changed.
Under our current financial reporting rules promulgated by the
Financial Accounting Standards Board, management of the reporting
corporation controls and determines the amounts reported in the
financial statements for most assets. For example, if management
concludes, based on its own subjective estimates, that the cost of an
asset--say equipment--will be recovered from future cash flows from
operations without regard to the time value of money or risk, no write
down is required even when it is known that the current market price of
the asset is less than the cost of the asset. The external auditor
cannot require that the reported amount of an asset be written down to
its estimated selling price; the external auditor cannot even require
the corporation to determine the estimated selling price of the asset
and disclose that price in its financial statements. So when it comes
time to sell assets to pay debts, there often are surprise losses that
investors then see for the first time. Management also makes similar
assessments in determining the amount of inventory obsolescence, the
allowance for bad debts, and whether declines in the values of
investments below cost are ``other than temporary.''
Under our current accounting rules, corporate management often
records sales and trade receivables at 100 cents on the dollar even
though a bank or a factor would pay only pennies on the dollar for
those trade receivables. We saw that phenomenon in the past few years
in the telecom rage where sales and receivables were recorded followed
several months later by write offs of the receivables. On another
front, we currently are seeing swaps of assets and the recognition of
gains in what is effectively a barter transaction, even though the fair
value of what was exchanged is apparently negligible.
Except for inventories and marketable securities, none of these
asset amounts in the financial statements--trade receivables,
commercial and consumer loans receivable, real estate loans, oil and
gas reserves, mineral deposits, pipelines, plant, equipment,
investments--is subjected to the test of what the cash market price of
the asset is. Yet, we know that most individual investors, and, in my
experience, even many sophisticated institutional investors, believe
that the reported amounts of assets in corporate balance sheets
represent the current market prices of those assets; nothing could be
farther from the truth.
Under the FASB's definition of an asset, corporations report as
assets things that have no market price whatsoever; examples are
goodwill, direct response advertising costs, deferred income taxes,
future tax benefits of operating loss carry forwards, costs of raising
debt capital, and interest costs for debt said to relate to the
acquisition of fixed assets. I call these nonreal assets. Today's
corporate balance sheets are laden with these nonreal assets; this is
the kind of stuff that allows stock prices to soar when in fact the
corporate balance sheet is bloated with hot air. Of course, when it
comes time to pay bills or make contributions to employees' pension
plans, this stuff is worthless.
The same goes for liabilities. Corporate management determines the
reported amount of the liabilities for such things as warranties,
guarantees, commitments, environmental remediation, and restructurings.
Again, this is as per the FASB's accounting rules.
The upshot is that earnings management abounds. Earnings management
is like dirt; it is everywhere. SEC Commissioners have made speeches
decrying earnings management. Business Week, Forbes, Barron's, The New
York Times, The Wall Street Journal, and the Harvard Business Review
carry hand-wringing articles about earnings management. Earnings
management is talked about matter-of-factly on Wall Street Week and on
Bloomberg TV, CNBC, CNNfn, and MSNBC. Earnings management is a scourge
in this country. Earnings management is common in other countries as
well because their accounting rules, and the accounting rules
promulgated by the International Accounting Standards Board, are much
the same as ours.
We need to put a stop to earnings management. But until we take
control of the reported numbers out of the hands of corporate
management, we will not stop earnings management and there will be more
Enrons, Waste Managements, Livents, Cendants, MicroStrategys, and
Sunbeams. How do we take control of the reported numbers out of the
hands of corporate management? We do it by requiring that the reported
numbers for assets and liabilities, including guarantees and
commitments, be based on estimated current market prices--current cash
selling prices for assets and current cash settlement prices for
liabilities. And by requiring that those prices come from, or be
corroborated by, competent, qualified, expert persons or entities that
are not affiliated with, and do not have economic ties to, the
reporting corporate entity. And by requiring that the names of the
persons or entities furnishing those prices, and the consents to use
their names, be included in the annual reports and quarterly reports of
the reporting corporate entity so that investors can see who furnished
the prices.
Let me give you an example of what I am talking about. Pre-
September 11, 2001, the major airlines, to the extent that they own
aircraft instead of leasing them, had on their balance sheets aircraft
at the cost of acquiring those aircraft from Airbus and Boeing. Let's
say that cost was $100 million per aircraft. The market prices of those
aircraft fell into the basement post-September 11 to about $50 million
per aircraft and remain there today although prices have recovered
somewhat. Yet under the FASB's rules, those airlines continue to report
those aircraft on their balance sheets at $100 million and are not even
required to disclose that the aircraft are worth only $50 million.
Under mark-to-market accounting, the aircraft would be reported at $50
million on the airlines' balance sheets, not $100 million.
I could give you many more examples, but I will add just one more.
In the late 1970's, this country was experiencing great inflation. The
Federal Reserve Board raised short-term interest rates dramatically.
Long-term rates shot up. As a consequence, the market value of
previously acquired residential mortgage loans and Government bonds
held by savings and loan associations declined drastically. But the
regulations of the Federal Home Loan Bank Board and the FASB's
accounting rules said that it was okay for the mortgage loans and bonds
to be reported at their historical cost. Consequently, the S&L's
appeared solvent but really were not. This mirage allowed the S&L's to
keep their doors open and in so doing they incurred huge operating
losses because their cost of funds far exceeded their interest income
on loans and bonds in their portfolios. Some of the S&L's decided to
double-down by investing in risky real estate projects, also accounted
for at historical cost, and proceeded to lose still greater amounts,
which losses were also hidden on the balance sheet under the historical
cost label. (The Federal Home Loan Bank Board even went so far as to
allow S&L's to capitalize and report as assets losses on sales of
assets, but the FASB said no to that procedure.) Of course, when the
Federal Government had to bail out the insolvent S&L's in the 1980's,
the Federal Government paid for the losses that were hidden in the
balance sheet under the historical cost label and the operating losses
that had been incurred while the S&L's kept their doors open because of
faulty accounting. Had mark-to-market accounting been in place and had
the Federal Home Loan Bank Board computed regulatory capital based on
the market value of the S&Ls' mortgage loans, Government bonds, and
real estate projects, the S&L hole would not have gotten nearly as deep
as it ultimately did.
Various Members of Congress have said in recent hearings about
Enron that a corporation's balance sheet must present the corporation's
true economic financial condition. A corporation's true economic
financial condition cannot be seen when assets are reported at their
historical cost amounts. The only objective way that the true economic
financial condition of a corporation can be portrayed is to mark-to-
market all of the corporation's assets and liabilities. Recall my
earlier example about the cost of aircraft being $100 million and the
current market value being $50 million. Mr. Chairman and Members of the
Committee: Is there any question that the $50 million presents the true
economic financial condition and the $100 million does not? Moreover,
following today's FASB's accounting rules produces financial statements
that are understandable only to the very few accountants who have
memorized the FASB's mountain of rules. Indecipherable is the word
Chairman Pitt has used in recent speeches. On the other hand, marking
to market will produce financial statements that investors, Members of
Congress, and my sister, who also happens to be an investor, can
understand.
The various proposals that have been made to cure Enronitis will
not cure the problem. I liken our current accounting system to bridges
built from timber, which bridges keep collapsing under the weight of
eighteen-wheelers. The public demands that expert consulting engineers
be called in to oversee the building of replacement bridges. But the
replacement timber bridges keep collapsing under the weight of
eighteen-wheelers. More expert consulting engineers will not make the
timber bridges any stronger. What needs to be done to fix the problem
is build bridges with concrete and steel. The same goes with
accounting. In the 1970's, after the surprise collapse of Penn Central,
the auditing profession instituted peer reviews--where one auditing
firm reviews the work and quality controls of another auditing firm. In
the 1970's, auditing firms also instituted concurring partner reviews
where a second audit partner within the public accounting firm looks
over the shoulder of the engagement audit partner responsible for the
audit. These procedures have been ineffectual as shown by the dozens of
Enrons, Waste Managements, Sunbeams, MicroStrategys, Cendants, and
Livents that have occurred since then. Coincidentally, the Financial
Accounting Standards Board also came on the scene in 1970's; it was
going to write accounting standards that would bring forth financial
statements based on concepts. What happened was that the FASB wrote a
mountain of rules that produce financial statements that nobody
understands and that can be and are gamed by corporate management. What
all of that amounted to was continuing to build timber bridges that
keep collapsing under the weight of eighteen-wheelers. We need to stop
building timber bridges. We need to build concrete and steel bridges.
We need to mark-to-market all assets and liabilities.
Now, you may ask--how much will concrete and steel bridges cost?
Can we afford to build concrete and steel bridges? My response is that
we cannot afford not to build concrete and steel bridges. How much of
the cost of the S&L bailout was attributable to faulty accounting; the
amount is unknowable but no doubt was huge. How much does an Enron or
Cendant or Waste Management or MicroStrategy or Sunbeam cost? The
answer for investors is billions, and that does not count the human
anguish when working employees lose their jobs, their 401(k) assets,
and their medical insurance, and retired employees lose their cash
retirement benefits and medical insurance. By some estimates, Enron
alone cost $60-$70 billion in terms of market capitalization that
disappeared in just a few months. Waste Management, Sunbeam, Cendant,
Livent, MicroStrategy, and all of the others also cost billions in
terms of market capitalization that disappeared when their earnings
management games were exposed. And these costs do not include the
immeasurable cost of lost confidence by investors in financial reports
and the consequent negative effect on the cost of capital and market
efficiency.
By my estimate, annual external audit fees in the United States for
our 16,000 public companies, 7,000 mutual funds, and 7,000 broker-
dealers total about $12 billion. Let's say that $4 billion is
attributable to mutual funds and broker-dealers. (Incidentally, mutual
funds and broker-dealers already mark-to-market their assets every day
at the close of business, and we have very few problems with fraudulent
financial statements being issued by those entities. Mark-to-market
works and is effective.) That leaves $8 billion attributable to the
16,000 public companies. Assume that the $8 billion would be doubled or
even tripled if the 16,000 public companies had to get competent,
outside valuation experts (and not the public accountants because they
are not competent valuation experts) to determine the estimated cash
market prices of their assets and liabilities. We are then looking at
an additional annual cost of $16-$24 billion. If we prevented just one
Enron per year by requiring mark-to-market accounting, we easily would
pay for that additional cost. And when considered in relation to the
total market capitalization of the U.S. corporate stock and bond
markets of more than $20 trillion, $16-$24 billion is, indeed, a small
price to pay.
So the question arises: Who should mandate mark-to-market
accounting? I recommend that there be a sense of the Congress
resolution that corporate balance sheets must present the reporting
corporation's true economic financial condition through mark-to-market
accounting for the corporation's assets and liabilities. Then I
recommend that Congress leave implementation to the SEC, much the way
it is done today by the SEC for broker-dealers and mutual funds. There
will be many implementation issues, so the SEC will need more staff and
money.
My testimony today is a summary of a lengthy article that I wrote
about the definition of assets and liabilities, earnings management,
and mark-to-market accounting that was published last year in Abacus, a
University of Sydney publication, and which was the basis for the RJ
Chambers Research Lecture that I presented last year at the University
of Sydney. That article and lecture are being submitted for the record.
I will be pleased to answer the Committee's questions.
PREPARED STATEMENT OF MICHAEL H. SUTTON
Chief Accountant, U.S. Securities and Exchange Commission
1995 to 1998
February 26, 2002
Chairman Sarbanes, Senator Gramm, and Members of the Committee.
Thank you for inviting me to share my thoughts on the issues raised by
recent high-profile business failures, in particular the issues of
financial reporting by public companies, the efficacy of accounting
standards, and oversight of the accounting profession.
Let me begin with a few brief comments about my background and
experience. I was Chief Accountant of the Securities and Exchange
Commission from June 1995 to January 1998. Prior to holding that
office, I was a Senior Partner in the firm of Deloitte & Touche,
responsible for developing and implementing firm policy on technical
and professional matters relating to accounting, auditing, and practice
before the SEC. My career with Deloitte & Touche spanned from 1963 to
1995. As a retired partner, I receive a fixed retirement benefit from
that firm. Presently, I undertake from time to time independent
consulting and other assignments in the field of accounting and
auditing regulation and related professional issues. The comments I
offer today are my personal views.
As we gather today, the institutions responsible for financial
reporting in our capital markets are reeling from the fall-out of a
financial reporting scandal of colossal proportions. Reports on the
collapse of Enron to date have exposed massive manipulations of
financial reporting by management, inexplicable breakdowns in the
independent audit process, astonishing revelations of holes in our
financial reporting standards and practices, and stunning lapses of
corporate governance. The Enron debacle has become a poster child for a
system that seems to be out of control.
We have witnessed high profile failures of our financial reporting
system in the past and have encountered similar questions about the
performance of the key players in our financial reporting system.
Clearly, however, Enron is a cataclysmic event that has changed the
world's view of a system that we have often touted as ``the best in the
world.'' This time, the damage to the reputation of our financial
reporting system and its critical guardians is so severe that the
investing public can be expected, rightly so, to demand answers and
meaningful reforms.
So, we are now once again at a crossroad. As we reexamine the
partnership between the public and private sectors that has been the
basis for oversight of our capital markets, we must confront candidly
and honestly some challenging questions. Can we any longer believe in
and rely on the independent audit? Can we any longer believe that our
accounting and disclosure standards provide the transparency that is
essential to investors and the public? Can we rely on self-regulatory
systems to ensure audit quality and to root out and to discipline
substandard performance? Can we rely on corporate governance
processes--oversight by boards of directors and audit committees--to
ride herd on management and to see to it that auditors do their job?
Enron has changed, perhaps for decades to come, how we look at and
think about those questions.
The road ahead seems awesomely challenging. Where do we begin to
reform a system that suddenly seems very fragile, and perhaps seriously
flawed? What are the essential changes that we need to make? Today, I
would like to offer some perspectives and insights drawn from my nearly
40 years in accounting practice and public service. I also will share
some thoughts on needed reforms.
I begin with some essential views that I think all who have
important roles in and benefit from a vibrant capital market system can
agree on--business, government, auditors, standards setters, investment
bankers, analysts, and the investing public. We all share a common,
linked starting point:
Our capital market system is a national treasure that is vital
to the success of the economy. Indeed, our exceptional standard of
living depends on the success of that system.
Accordingly, we share a compelling common interest in assuring
the strength and liquidity of our capital markets. We all benefit
in the result.
This compelling common interest should shape our policy goals
and guide our thinking as we explore reforms. Other goals and
interests must not obstruct our vision.
The most critical, yet intangible, ingredient of a successful
capital market system is the confidence of investors and the public
that the markets are fair--confidence that the information flowing
into the markets is trustworthy and that investors can make
informed decisions and will not be misled.\1\
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\1\ Indeed, the focus of the securities laws is rooted in this view
of our capital markets. Historian David M. Kennedy described the events
that surrounded the enactment of the securities laws in his Pulitzer
Prize winning book, Freedom From Fear. In describing the formulation of
the securities laws, he wrote, ``For all the complexity of its enabling
legislation, the power of the SEC resided principally in just two
provisions, both of them ingeniously simple. The first mandated
disclosure of detailed information, such as balance sheets, profit and
loss statements, and the names and compensation of corporate officers,
about firms whose securities were publicly traded. The second required
verification of that information by independent auditors using
standardized accounting procedures. At a stroke, those measures ended
the monopoly . . . on investment information.'' He went on to observe,
``The SEC's regulations unarguably imposed new reporting requirements
on businesses. . . . But they hardly constituted a wholesale assault on
the theory or practice of free market capitalism. All to the contrary,
the SEC's regulations dramatically improved the economic efficiency of
decisions. . . . This was less the reform than it was the
rationalization of capitalism, along the lines of capitalism's own
claims about how free markets were supposed to work.''
As we look at the issues today, it should be abundantly clear that
there is no higher goal for financial reporting than providing useful
and reliable information that promotes informed investment decisions
and confidence in the system. Sometimes, however, we hear arguments
that financial reporting should take into account other policy goals in
the name promoting various economic benefits or market efficiency. That
view of the world is based on a curious, upside down logic. The truth
is, without investor confidence, arguments about how financial
reporting does or does not contribute to economic goals or market
efficiency simply are moot--they are a waste of time. If investors do
not have confidence or lose confidence in the integrity of the
information they receive, they will flee the markets, and we all will
pay a devastating price.
Independent Audits
In the past, the auditing profession has responded to challenges to
its performance with arguments that, on the whole, audits are effective
and that public expectations of the independent audit are unrealistic.
As the dialogue continues, attention turns to the standards that govern
financial reporting and auditor performance. After extended debate,
changes are proposed, and some are adopted. Opinion about whether the
changes will improve auditor performance or enhance investor
confidence, however, is mixed, and the ensuing periods of peace and
adjustment are uneasy. Investors and the public, who understand little
about how audits and auditors work, are left to wonder what the future
holds.
Today, in the light of all that has happened, we must find more
substantive and lasting remedies. Now is the time to design and
implement essential reforms, both through regulatory processes and by
reexamining and, if necessary, redefining relationships and reporting
responsibilities.
I believe that the road to a more lasting resolution begins with
full acknowledgement by the auditing profession of the reality that
seems so clear today. Failures in our financial reporting system are
more than aberrations. They seriously undermine the confidence of
investors and the public in the institutions that are supposed to
protect them. They ``poison the well.'' Pleas that the vast majority of
financial reports are of high quality, that most audits are effective,
and that financial reporting failures are few, miss the point. In
capital markets, a single catastrophic reporting failure is a disaster
in which losses to investors and the public can be, and often are,
overwhelming, wiping out decades of hard work, planning, and saving.
Debates about how many failures are tolerable are not only not
productive, they are also nonsense.
The urgent challenge is to find ways to restore and maintain
confidence in the independent audit. To achieve that goal, I believe
that the auditing profession will need to do three things:
First, it will have to embrace a role that is fully consistent
with high public expectations. Those expectations contain the seeds
of a fundamental conflict that we must deal with. And that
fundamental conflict is that, in public capital markets, insiders
have an advantage over public investors. In that arena, independent
auditors are expected to balance the scales by assuring that
financial reporting provides useful and reliable information to
investors and gives them a fair presentation of the economic
realities of the business. And they are expected to uncover and
report to the public financial improprieties of the kind that
existed at Enron.
Second, the auditing profession will have to tackle financial
reporting failures as a distinct issue with a distinct goal--zero
tolerance. We understand that, in life, ``zero defects'' are almost
never realized. Nevertheless, the public expects that the
profession will pursue that end--and with greater energy than in
the past--and with more success.
Third, it will have to accept and support necessary regulatory
processes that give comfort to investors and the public that the
profession is doing all that it can do to prevent future episodes
of failed financial reporting.
Regulatory processes that will build confidence in the auditing
profession will be truly independent; they will be open; they will
actively engage, inform, and involve the public; they will be
adequately resourced and empowered to accomplish their mission; and
they will be amenable to change as events dictate. I believe that the
critical ingredients of an effective regulatory process that can
restore and maintain public trust include:
Timely and thorough investigations of circumstances that may
involve fraudulent financial reporting.
Objective and fair assessments of the role and performance of
the auditor.
Timely and meaningful discipline of auditors and firms that
violate acceptable norms of conduct.
Regular oversight and periodic examinations of the policies
and performance of independent auditors.
Timely and responsive changes in professional standards and
guidance when a need for improvements is identified.
Specifically, I believe that those goals can best be accomplished
through an independent statutory regulatory organization operating
under the oversight of the Securities and Exchange Commission. That
organization should be empowered to require registration of independent
auditors of public companies, establish quality control, independence,
and auditing standards applicable to registered independent auditors,
conduct continuing inspections of the accounting and auditing practices
of registered firms, undertake investigations of possible financial
reporting failures, and conduct proceedings to determine whether
disciplinary or remedial actions, including fines, are warranted. To
carry out these responsibilities the statutory regulatory organization
will need appropriate subpoena and disciplinary powers. As a starting
point to implementation, we might consider reconstituting the existing
Public Oversight Board as a statutory regulatory organization and
expanding its mandate and powers to include the elements I have
outlined.
Accounting Standards
Strengthening the independent audit, though vital, is only part of
the needed reform of our financial reporting system. We also need to
examine critically and take action to strengthen the processes by which
our accounting standards are developed. As we have seen in the Enron
case, poor accounting standards and guidelines can exact their own
toll. They can be extremely costly to investors and the public. We
simply cannot tolerate financial reporting standards that enable those
who come to the markets seeking investor capital to ``hide the ball.''
Further, we cannot tolerate processes that fail to produce
accounting standards that are responsive to critical financial
reporting issues as they arise in the marketplace--and that fail to do
so on a timely basis. Current rules for accounting for SPE's, for
example, are nonsensical--they can only be explained by accountants to
accountants--or more disturbingly, perhaps, by accountants to deal
makers. Yet, the Financial Accounting Standards Board has studied
consolidation issues for years, and has done little more than tinker
around the edges. We have a right to insist that accounting rules be
clearly responsive to the underlying economics of transactions and
events. And it is not acceptable to sit by while financial market
innovations outstrip the development of needed guidance.
There seems to be a great deal of finger-pointing today about what
is wrong with U.S. accounting standards. Some have placed the blame for
Enron-like financial reporting failures on an accounting model that is
out of date. The popular rhetoric asserts that the essential problem is
that we are trying to apply an industrial age accounting model to an
information age economy. The solutions offered include such things as
more timely reporting, reporting that seeks to avoid impenetrable
complexity by requiring more understandable disclosures, and a greater
recognition in the financial statements of intangible assets. While
there are very real problems with our accounting model, and while the
ideas that have been offered may be well intended, they would do little
to remedy the challenges presented by an Enron.
Additional criticism is beginning to focus on the fact that U.S.
standards have become increasingly detailed, and suggestions have been
made that they should be broader statements of principle, applied with
good judgment and respect for the substance of underlying transactions
and events. I have sympathy for the desire to break the cycle of the
mind-numbingly complex accounting rules that have become the norm, but
to do that I think we have to confront realistically the reasons why
our standards have evolved the way they have, and what will be required
to avoid the same pitfalls in the future.
What the capital markets need and demand is accounting and
disclosure that provides a clear picture of the underlying economics
and furnishes information that is comparable among companies and
consistently presented over time. The issue and debate should not be
about whether accounting standards should be detailed or broad, but
rather about what formulation of standards and standards setting
approaches best accomplish the goals to which financial reporting
should aspire.
To fully appreciate the challenges of improving financial
reporting, it is useful to look for a moment at the forces at work in
shaping our accounting standards, and to reflect on the obstacles they
present. Here are some of the underlying pressures:
Business managers urge standards that provide the greatest
flexibility and room for judgment. They want to be able to manage
reported results, but yet be able to point to an accounting
standard that assures the public that they are following the rules.
Dealmakers and financial intermediaries want standards that
permit structuring transactions to achieve desired accounting
results--results that could obscure the underlying economics. In
that world, creative transaction structures are valuable
commodities.
Auditors are pressured to support standards that their clients
will not take issue with, and they often are restrained, perhaps by
commercial concerns, in their expected support for reporting that
is in the best interests of their investors and the public.
Legislators too often lose sight of the fundamental importance
of an independent standards setting process and neutral accounting
rules. Without that independence and neutrality, standards setters
cannot effectively perform their essential service to the investing
public.
The standards setters too often pull their punches, backing
down from solutions they believe are best--perhaps because of a
perceived threat to the viability of private sector standards
setting--perhaps because of the sometimes withering strains of
managing controversial, but needed change--perhaps because of a
loss of focus on mission and concepts that are supposed to guide
their actions.
Effectively meeting the expectations of investors and the public in
that environment requires a standards setting process that has the
independence to withstand the myriad of constituent pressures that it
inevitably will face and to make the tough decisions that inevitably
are required.
Now is the time for a critical reexamination of our standards
setting processes, and the willingness and commitment of capital market
participants to support a fully effective, independent standards
setter. If the public-private sector partnership for improving
financial reporting is to continue, we need to reenergize our
commitment to the needs of investors. Of critical importance is the
urgent need for those who have the greatest stake in transparent
financial reporting--buy side analysts, those who invest for retirees
and manage their funds, and other institutional investors--to take a
more active role in the standards setting and rulemaking processes.
To restore confidence in our standards setters, we should take
immediate steps to secure independent funding for the FASB--funding
that does not depend on contributions from constituents that have a
stake in the outcome of the process. We also should take immediate
steps to establish an independent governance process to replace the
current constituent-based foundation board. The leadership for
implementing these changes should come from leaders of unquestioned
objectivity and demonstrated commitment to the goals of high quality
financial reporting and the public interest. Perhaps the needed reforms
could be best developed and implemented under the auspices of an
independent commission made up of leading lights within the corporate
governance movement, heads of investment funds and retirement systems
responsible for managing and for investing the Nation's savings and
pension assets, academic leaders who are grounded in business and
economics, and former leaders of institutions responsible for capital
market regulation.
Corporate Governance
Perhaps one of the most practical and effective first steps in
reforming the financial reporting system would be to immediately
revisit and rewrite our corporate governance policies and guidelines to
clearly break the bonds between management and the independent auditor,
and to unmistakably spell out the responsibilities of boards of
directors and audit committees to shareholders and the investing
public. Management should be the subject of, not the manager of, the
independent audit relationship and process. The ultimate responsibility
for full and fair disclosure to shareholders, and the direct
responsibility for the independent audit relationship and the quality
of the audit process, should be clearly fixed with the board of
directors and its audit committee. The audit committee should be made
up entirely of independent directors.
Ensuring a relationship with the independent auditor that best
protects audit quality may require further measures such as periodic
rotation of auditing firms, limitations on hiring personnel from the
independent auditing firm, and further restrictions on nonauditing
services that an independent auditor may provide to audit clients. As
we confront those issues, it is important to keep in mind that investor
confidence is influenced by both the fact and the appearance of the
independence of the auditor. At the end of the day, governance of the
financial reporting process should provide comfort to the investing
public that the financial statements they receive have been subjected
to an effective and truly independent audit.
Conclusion
So yes, we are once again at a crossroad. As we reexamine the
partnership between the public and private sectors that has been the
basis for oversight of our capital markets in the past, we must
confront candidly and honestly some challenging questions. Are we
willing to fulfill, with commitment and enthusiasm, our clear
responsibilities to serve investors and the public? Are we willing to
exercise discipline to assure that we faithfully fulfill that
commitment? Are we willing to be spirited participants in regulatory
and governance processes that are essential to provide comfort to
investors that our capital markets can be trusted? Only clear
affirmative answers to these questions will assure that the partnership
can continue and flourish.
At the outset, I suggested that the common interest in preserving
and maintaining healthy capital markets far outweighs the concerns or
goals of any particular group or special interest. We have to keep
focusing on that fundamental tenet and on the goal of assuring that
confidence in our capital markets is preserved and that confidence in
our financial reporting and disclosure system is restored. Only a
continuing commitment to that goal will guarantee that we continue to
enjoy the best capital markets in the world.
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PREPARED STATEMENT OF LYNN E. TURNER
Chief Accountant, U.S. Securities and Exchange Commission
1998 to 2001
February 26, 2002
Chairman Sarbanes, Senator Gramm, Members of the Committee. Thank
you for asking me to share my thoughts regarding an issue of vital
importance to our Nation's capital markets. I had the good fortune of
serving as the Chief Accountant of the U.S. Securities and Exchange
Commission (SEC) from July 1998 to August 2001. Now, I have the
privilege of shaping the minds of students who are the future of the
accounting profession, as a professor in the College of Business at
Colorado State University (CSU).
Prior to joining the Commission, I was the Chief Financial Officer
(CFO) and the Vice President of Symbios, Inc., an international
manufacturer of semiconductors and storage solution products. I was a
member of the executive management team and had responsibility for our
financial reporting and disclosures, as well as our audits. I also
regularly interacted with our Board of Directors including the audit
committee. After graduation from CSU and the University of Nebraska, I
joined the widely respected international accounting firm of Coopers &
Lybrand, now PricewaterhouseCoopers. I rose through the ranks to became
a partner, after spending a 2 year fellowship with the SEC. As a
partner with the firm, I was the leader of the national high technology
industry audit practice, served as an SEC specialist, and also had
partner responsibility for a number of our audit clients. In addition
to teaching today, I also do limited consulting in the accounting
industry and business.
Why Reliable Numbers are Critical to the Success of the
U.S. Capital Markets
In business, we use numbers to report to investors, lenders,
regulators and other users of the financial statements, the economic
performance of a company. The numbers in the financial statements, just
like a score on a college student's test, tell investors how a company
has performed in comparison to expectations of management, the markets
and competitors. Without these historical numbers, it is difficult, if
not impossible, to gauge the future prospects of a company. Without
accurate numbers, investors are likely to be misled into making make
wrong decisions. In essence, those who prepare or aid in the
preparation of false and misleading financial statements take away from
investors their ability to make their own informed choice as to whether
they would invest in a company. When this occurs with increasing
frequency, as we have seen in recent weeks and years, investors
question whether they can invest with confidence without losing their
money.
Moving Toward a Solution
I commend the Chairman and this Committee for scheduling a series
of hearings on finding effective solutions to the issues that confront
the capital markets today; that have caused investors to lose trust;
that have unfortunately painted both the unscrupulous and the honest
with the same brush. There is no question in my mind that the SEC and
Justice Department, left unfettered and given sufficient resources,
will thoroughly investigate and bring to justice those who are found
culpable of the damage and destruction to the lives of thousands of
Americans who invested in or worked at Enron. But once their job is
done, it will be equally, if not more important, that the current
systematic failures are corrected. And those corrections will need to
be more than just a Band-Aid.
While I was at the Commission, we began work on a staff report that
identified concerns and issues surrounding the quality of financial
reporting and the accounting profession. The report was designed to
discuss not only the issues the staff had identified, but also the
progress that had been made by the profession on the issues and
recommendations for continuous improvement in the quality of audits and
financial reporting. We wanted to be sure a report card was created
against which future progress could be measured, similar to what the
General Accounting Office (GAO) had done with their report on the
profession in 1996. In that way, the investing public could be provided
an ongoing report card, hopefully prepared by the Public Oversight
Board (POB) on the progress being made toward ensuring investor
protection through higher quality financial reporting. While due to
time constraints, we were unable to complete the report, the SEC staff
did provide some, but not all, of our materials to the GAO. Perhaps
some of that may be used in their forthcoming report on the accounting
profession.
The Commission asked the POB to provide an annual report card to
the public on the implementation of the many recommendations of the
Panel on Audit Effectiveness. This Panel had been formed at the urging
of the SEC, to formulate recommendations on how audits could be made
more effective. Its members included the former Chief Executive Officer
(CEO) of PriceWaterhouse, two former SEC Commissioners, two former
CEO's of the American Stock Exchange, two former CEO's of public
companies and an academic.
The POB was also to issue two reports on the progress large
accounting firms had made in the implementation and operation of
quality controls ensuring their compliance with the auditor
independence rules. This project was undertaken due to serious concerns
by the SEC with respect to the lack of compliance with applicable rules
by these firms. Unfortunately, now with the decision of the POB to
disband, a situation in which they were probably left no choice, there
is no one left to fill out the report card.
Enron has brought to light many of the shortcomings the SEC staff
had identified with various facets of the accounting profession such as
peer review, the lack of an effective and timely self-disciplinary
process, the need for more effective auditing standards and concerns
about financial conflicts that impaired the independence of auditors.
As a result, the need for the full report has been somewhat mitigated.
Yet the recommendations for improving the deficiencies in the
quality of our financial reporting system are even more relevant today
than when I left the Commission. And it is that portion of what would
have been in the staff report to the Commission, if we had time to
complete it, I would like to share with you today. I will point out
that many of the recommendations the SEC staff were anticipating making
were already set forth in a series of speeches last spring and summer
that were titled ``The State of Financial Reporting Today; An
Unfinished Chapter I, II, and III,'' as well a speech entitled, ``An
Investor's Bill of Rights.'' Some of these recommendations come from
reports that are not new. They are recommendations that continue to
gather dust on a bookshelf as they continue to fail to be implemented.
The specific areas that the recommendations in the report would
have addressed include:
The self-governance of the profession.
The quality of audits including the standard setting process.
Auditor's independence.
Audit committees.
The quality of financial reporting including the standard
setting process.
These recommendations essentially are about one vitally important
principle, INDEPENDENCE. Independent oversight of the accounting
profession, independence of the accounting and auditing standard
setting process, independent auditors and audit committees and
independent analysts. Independence is a word that has served this
country well for the past 225 years and it will also serve to protect
the interests of the investing public. It is a concept that will
overcome the fears of investors arising from the arrogance, ignorance,
and influence they have listening to with respect to Enron and other
financial failures.
Independent Governance of the Profession
The quality and reliability of financial statements and disclosures
provided to investors are ultimately determined by whether there is
compliance with the applicable accounting rules. You can write all the
accounting rules you want to; you can require sufficient disclosures to
fill up a phone book; but unless someone assures investors the
established rules are being followed, they are meaningless. That is why
we have independent audits. Independent audits provide investors with
confidence that the numbers are accurate and reliable.
Since the financial frauds and failures arising from the 1972-1973
bear market, including cases such as Penn Central and Equity Funding,
the profession has attempted to ensure audit quality through a self-
governance process. While some argue that 99.9 percent of the audits
each year are okay, remember that Enron was once one of those 99.9
percent. The fact is we really do not know how many more audits are
like the iceberg below the water level, unseen until it is too late.
What we do know today, is that the increasing number of earnings
restatements, the number of massive financial frauds, the tens and
hundreds in billions of losses to investors and now Enron, accompanied
by the almost daily parade of financial reporting issues, highlight a
serious question in the minds of investors with respect to the quality
of audits. They also strike at the very heart of the credibility of my
once esteemed and proud profession. Yet the multitude of organizations
often referred to in the press these days as ``alphabet soup'' do not
yield an efficient or effective quality control process. A diagram of
this confusing and ineffective structure is attached hereto as
appendix.
It is well past time to establish an SEC supervised public
accounting oversight board in light of:
The American Institute of Certified Public Accountants (AICPA)
and profession having cut-off the funding for the POB in spring of
2000 when it attempted to fulfill its mandate to the public and
carry out an investigation of the lack of compliance with
independence rules.
The AICPA having a weak, if not totally ineffective self-
disciplinary group called the Professional Ethics Executive
Committee or PEEC. A group that conducts its meetings behind closed
doors, that often defers taking action on cases for years at a
time, that has no subpoena powers, and that has failed to take
action in a number of instances after the SEC has. The AICPA and
firms had stated to the SEC and public in press releases toward the
end of 2000 that they would work toward increasing the public
membership of this organization from the current three out of
twenty members. Andersen publicly said it would support an increase
in public membership to half of the Committee's total membership.
Unfortunately, this has become a broken promise.
The AICPA creating a for-profit portal and web of business
relationships called CPA2Biz, and along with a failed attempt at
establishing a business consulting credential. It is difficult to
understand how a not-for-profit organization can enter into this
web of for-profit relationships and not create conflicts with the
notion of being a public interest self-regulatory organization.
The POB itself has no disciplinary powers.
The POB has limited capabilities to ensure auditing standards
are written based on meeting the needs of the public for effective
audits, as opposed to being written by, and for, the general legal
counsels of the firms.
The Quality Control Inquiry Committee or QCIC that is often
trumpeted as investigating alleged audit failures in fact has no
subpoena powers. It only has
members from the profession, often retired partners from the Big 5
``club,'' lacks members from the public and only looks at documents
that are already publicly available. It has recommended cases to
the PEEC or Auditing Standards Board (ASB) for further action.
Action that too often fails to materialize.
We may now be faced with an unfortunate outcome of Enron, one
I truly hope does not become reality, of having four major
accounting firms. As I have previously expressed to the POB, this
in and of itself will result in the need for major revisions to the
existing system as the concentration of the public audit function
becomes extremely concentrated in just four global and large firms.
From small firms with a few offices at the time the Securities Acts
were passed, these businesses have grown to global organizations
that employ in some cases in excess of 100,000 on a global scale.
In light of these and other recent events, today we need to
establish an independent public accounting regulatory oversight body
for the accounting profession under the supervision of the SEC. That
body needs to have these critical elements:
It is conducted by an adequately funded independent
organization.
Its members are drawn from the public rather than the
profession.
Timely and effective disciplinary actions against those who
fail to follow the rules, regardless of whether they are small or
large firms.
It has the authority to issue auditing and quality control
standards that establish a benchmark for the performance of quality
audits and its disciplinary process, thereby serving and protecting
the investors as opposed to the interests of the profession.
It inspects the work of auditors on an ongoing basis to ensure
they have made the investing public, not the amount of consulting
fees they can generate, their number one priority.
I have heard some say that unless practicing accountants serve on
the board it will not have the necessary expertise. Yet in the United
Kingdom the accounting profession itself recommended a new framework
for the independent regulation of the profession that has an
independent oversight board, called the ``Foundation,'' without any
practicing accountants among its members. I believe you can get many
well-qualified public servants who understand audits and will protect
investors by drawing from the ranks of former auditors such as Charles
Bowsher, the former Comptroller General of the United States or some of
these distinguished gentlemen who sit next to me today.
I have also heard some say we should consider using one of the
existing self-regulatory structures that exist today. However, these
may well involve organizations where the members themselves have a
vested interest in the outcome of accounting and auditing standards.
For example, members of a stock exchange have a vested interest in the
numbers they must report, the disclosures they must make, and the
outcome of their audits. This creates a conflict that will not ease
investor's fears about the current lack of independence.
One reason for creating a private oversight board is the need for
an active inspection program that can discipline auditors when
substandard work is identified. An inspection requires very experienced
personnel who are typically partners and managers and who have
significant practical experience. These people would be no lower than a
GM-15 or Senior Executive Service in the Government personnel scale.
For a typical accounting firm office, it may take on average of ten
reviewers working 7 to 10 days to perform an inspection. Large offices
like those located in major metropolitan areas will take significantly
more staff. Given the large accounting firms today have a hundred
offices in just the United States, one can quickly see where it will
take significant manpower to perform timely and effective inspections.
Being able to attract, competitively compensation and retain such staff
will be a challenge for the oversight board. However given today's
budgetary pressures, this is probably easier accomplished in the
private board as opposed to the SEC.
Improving Audit Quality
Audit quality will be enhanced through effective independent
inspections by the oversight board I just described. Performance of
annual on-going independent inspections of the large accounting firms,
with perhaps no less than tri-annual inspections of smaller firms who
tend to audit fewer public issuers, should overcome the current system
of ``backslapping'' peer reviews. It is interesting to note that today
it is perhaps the smaller firms that face the most rigorous reviews.
This system of firm-on-firm reviews by the large firms reminds one of
grade school where the rule was ``I won't tell on you so long as you do
not tell on me.'' A system that time and time again I questioned the
credibility of the reviews being performed. A process that did not
examine audits such as Enron or Global Crossings where investors had
alleged a failure occurred, and did not mandate that all audits in
which a restatement had occurred to be inspected.
And when the SEC staff raised questions with the peer reviewers,
meaningful and satisfactory responses were generally not forthcoming.
The responses we did receive continually sounded like a rationalization
of whatever had been done. Yet the public continued to be provided with
the blue ribbon seal of approval by the very profession under scrutiny.
Eventually this led to the SEC removing the ``endorsement'' of the peer
review process from its Annual Report to Congress in 1999.
Further recommendations continue to need to be implemented to
improve audit quality. They include:
The 200 plus recommendations the Panel on Audit Effectiveness
made to the profession and accounting standard setters in August
2000 need to be adopted as proposed, without being watered down.
This includes a substantial rewrite of many of the auditing
standards to require certain forensic audit procedures be
incorporated into each audit, and to put sufficient detail into the
standards to ensure they can be enforced. The POB was charged with
overseeing the implementation of the Panel's recommendations. I
would encourage the GAO or an independent oversight board to
undertake that charge, as the POB will soon cease to exist.
Auditing standards need to be established by an independent
standard setting body.
No doubt some will argue that you need to have a knowledgeable body
of auditors to set auditing standards if you are going to be effective.
But keep in mind that for the past 20 plus years, the ASB has been
drawn almost exclusively from ``knowledgeable'' auditors with the major
accounting firms. And yet the Board's Statements on Auditing Standards:
Result in an audit report to investors that fails to provide
an adequate explanation of an audit, such as the fact the auditor
may not even have tested internal accounting controls, or while
generally accounting rules are followed, aggressive accounting
practices have been employed by the company to meet the earnings
expectations.
Today still do not require auditors to look at large unusual
adjusting journal entries that are a common characteristic of many
financial frauds.
Do not provide guidance to auditors on factors an auditor
would need to consider in assessing materiality until after the SEC
staff issued guidance on this subject in August 1999.
Still have not provided an auditing standard with
authoritative guidance on auditing ``cookie jar'' reserves despite
the request of the SEC staff over 2 years ago to provide such
guidance to help reduce the incidence of improper earnings
management.
Still permit auditors to consult on the design and structuring
of transactions which reduce, rather than improve the transparency
of disclosures, despite two previous requests from the SEC, as well
as a renewed request in recent weeks to address this abusive
practice.
Have recently adopted a new standard that will set the
requirements for auditors documenting their work that still does
not require sufficient documentation to permit an independent third
party to validate the work auditors have performed.
Simply put, auditing standards today, which are often reviewed and
edited by the legal counsels of the firms, are written to protect the
interests of the firms, not ensure quality audits that will protect
investors. Perhaps the greatest chief accountant of all times, Sandy
Burton was way ahead of his time in 1978 when he testified before
Congress stating that the current system would not serve investor
protection.
I do give the current chairman of the ASB credit for trying to
improve recently the quality of the auditing standards. Guidance has
been forthcoming on topics such as auditing revenues in selected
industries, as well as financial instruments many companies have
invested in. However, it has been the age-old story of too little, too
late. We need to change the process to one that will develop standards
for auditors and provide them with timely guidance before they and
investors hit the iceberg. Again, I point out that in the new system in
the United Kingdom, the establishment of auditing standards has been
lifted from the profession itself and been given to a new organization
under the auspices of the new independent oversight board.
Auditor's Independence
Auditor's independence has long been a hotly contested issue to the
profession and the SEC. But after cases such as Waste Management and
Enron, no longer are people asking, ``where is the smoking gun.''
Disclosures of consulting fees that run into tens of millions of
dollars and multiples of the audit fees are generating an outcry for
action. Once and for all, we need to adopt rules that will truly
protect the independence and integrity of the audit, and gain the
public's confidence that the auditors are working for them, not
management. Rules that will ensure investors that when they get the
auditor's seal of approval, they can trust the numbers. To accomplish
that we need to:
Close the revolving door between the audit firms, its partners
and employees, and the company being audited.
Require that in order for the auditor to be considered
independent, the firm must be hired, evaluated and, if necessary,
fired by the audit committee.
Adopt a rule that allows auditors to provide only audit
services to an audit client, unless the audit committee makes a
determination and discloses that the services provided by the audit
firm are (1) in the best interest of the shareholders, and (2) will
improve the quality of the company's financial reporting. This is
sometimes referred to as the exclusionary ban approach to auditor's
independence.
Prohibit an independent auditor from assisting a company
design and structure transactions, then provide their accounting or
tax opinion on what the appropriate accounting is for the
transaction, and then audit the accounting for that transaction.
This was discussed in the original SEC rule proposal. However,
companies and their auditors should be permitted to consult on the
proper accounting for a nonhypothetical transaction that the
auditor has not designed and structured, as that is a normal and
important process in any audit.
Require mandatory rotation of the audit firm every 7 years.
Some will argue that the exclusionary ban will have a negative
impact on the quality of audits or the financial strength of an
accounting firm. Others argue that tax services are an integral part of
performing an audit. To that I respond that if the service is integral
to the audit, then no one should be better situated to make that
assessment on behalf of investors than the audit committee. Under the
proposed recommendation the audit committee will have the option of
agreeing to those services that are in the best interests of the
investors.
Trying to make an across the board cut on which of these services
will or will not impair an auditor's independence, in a quickly
changing business environment, is not a long-term solution. As soon as
a new statute or rule is adopted, new services will be developed and
the issue will reappear.
The fact that auditors are paid by the management of the companies
they audit has also been brought up time and time again in recent
months. Some argue that the auditor would never risk their reputation
for the fees from a single audit. Yet at the Commission we saw
situations, some of which are now public, where the auditors identified
the problems with the numbers in the financial statements, discussed
them and still issued their unqualified reports. In fact, it is not the
magnitude of the fee to the firm that matters as much as it is the
magnitude of the audit and consulting fees to the profitability of the
office or the engagement partner's portfolio of business.
Ellen Seidman, then Director of the Office of Thrift Supervision or
OTS, testified before this Committee on September 11, 2001, regarding
the audit of the failed Superior Bank. In her opening statement the
Director stated ``Congress or the FBA's [Federal Banking Agencies]
could also encourage the AICPA and SEC to establish an `external
auditor rotation requirement' . . . its adoption would result in a
`fresh look' at the institution from an audit perspective, to the
benefit of investors and regulators.''
But others will argue that there is greater risk in the first year
of an audit, as the auditor has to get an understanding of the business
to ensure the proper issues are identified and dealt with. I do not
dispute the fact the auditor has a higher learning curve on the first
year of an audit. But in all my years in public accounting, I never
once heard my former firm or any other firm for that matter, say they
did not do what they needed to do, to get the necessary background to
perform a proper audit. Perhaps the real fact is that in some cases,
auditors propose a lower fee in the first year of an audit relationship
in order to gain the account, and this has a negative impact on the
quality of the first year audit.
Remember that investors have suffered their largest losses on
audits of companies that did not involve an initial audit, but rather
an ongoing relationship. Examples include:
Enron
MicroStrategy
Cendant
Rite Aid
Livent
Informix
WR Grace
Sunbeam
Lernout and Hauspie
Xerox
Lucent
Oxford Healthcare
Superior Bank
HBO McKesson
Waste Management
One final argument you will hear against the rotation of audit
firms is that they already do an internal rotation of audit partners on
the companies they audit. That will probably also be true for some of
the above companies. But once a firm has issued a report on the
financial statements of a company, there is an inherent conflict in
later concluding that the financial statements were wrong. This is
especially true if the company has accessed the capital markets using
those financial statements and as a result, that the accounting firm
has significant exposure to litigation in the event of a restatement of
the financial statements. By bringing in a new firm every 7 years, you
get an independent set of eyes looking at the quality of the financial
reporting that have no ``skin in the game'' with respect to the
previous accounting.
Engaging Audit Committees
It was in 1940, after the discovery of a large fraud at McKesson &
Robbins that the Commission first encouraged the establishment of
independent audit committees. More recently in 1999, with the strong
support of the stock exchanges and the accounting profession, the audit
committees adopted new rules effective in 2001, to enhance the
oversight of the financial reporting, disclosure and audits of public
companies.
In light of Enron and questions surrounding the oversight of its
audit committee, recommendations that can further enhance the vital
role and quality of audit committees include:
The audit committee should directly hire, evaluate and, if
necessary, fire the auditor. This process should not involve the
management team making the selection or recommendation to the audit
committee. It needs to be a truly independent process.
The exceptions provided for in the rules of the stock
exchanges, which permit an audit committee member who is not
independent, should be eliminated.
The definition of an independent director should be modified
to prohibit the company from engaging the director for any services
other than those provided as a director, and ban financial payments
on behalf of the director, such as contributions to charitable
organizations or similar types of payments.
The audit committee, consistent with the recommendations of
the Panel on Audit Effectiveness, should be required to preapprove
all nonaudit services.
The audit committee, consistent with the recommendations of
the Panel on Audit Effectiveness and legislation previously passed
for financial institutions, should require the CEO and CFO to
provide to the audit committee a report by management that clearly
states management's responsibility for establishing, maintaining
and ensuring an effective system of internal accounting controls
exists. In the Rite Aid and Xerox cases, investors learned that
there had been material weaknesses in internal controls but only
when the auditor was fired and a report filed with the SEC, months
after the audits had been completed. The report on internal
controls should be audited by the independent auditor and provided
to investors in the annual report. The investors have a right to
know whether adequate controls exist to ensure that the financial
statements and disclosures comply with Generally Accepted
Accounting Standards. If the executives are nervous about signing
such a report, I suggest investors should be nervous about the
numbers.
As in some foreign jurisdictions, the CEO and CFO should be
required to sign and certify to the audit committee and investors
that the financial statements comply with the applicable rules and
include disclosure of all material information. There should be
criminal and civil penalties for intentional misrepresentations to
the public or to the auditors.
Companies should be required to provide their audit committees
with appropriate training and understanding of the business and its
financial reporting to ensure their ability to carry out their
obligation to investors.
Enhancing the Quality and Transparency of U.S. Accounting Standards
Let me shift gears and switch to the topic of accounting standards.
I believe our financial reporting system, including the accounting
standards we use in assembling the numbers, remains the best in the
world. That is difficult to comprehend in light of Enron, but one only
has to examine closely the Asian crisis of a few years back to
appreciate the quality of our financial reporting. The SEC staff report
did include a section on international issues affecting the quality of
financial reporting. Many of the recommendations that would have been
in that section are included in the 2000 Annual Report of the SEC to
Congress or a paper I presented in November 2001 presented at the SEC
Major Issues conference and published in Accountancy Regulation. As
that paper notes, there have been many earnings restatements required
for foreign issuers. In fact, the SEC staff will review a draft of the
financial disclosures of foreign issuers in part to help them
facilitate getting the numbers right the first time.
I would like to digress a moment to thank the Chairman and his
staff for their unyielding support of our efforts during the recent
years, as we at the SEC tried to improve the quality of financial
accounting standards and reporting with initiatives on earnings
management and auditor independence. The SEC and its staff became the
targets of a constant barrage of criticism from some members of
industry, the accounting profession and Congress for issuing Staff
Accounting Bulletins that would hopefully stem the tide of restatements
from improper ``big bath'' charges, recognition of revenue before it
was earned, and intentional misstatements of earnings while hiding
behind the disguise of ``materiality.'' Yet, Senator Sarbanes and his
staff never wavered in their commitment and stood by us in getting
these changes made to protect investors. He also stood with us on the
proposed rules on auditor's independence. For that I am very grateful.
But the job of improving accounting standards is not complete. Our
rules and standard setting process here in the United States requires
significant improvements to provide investors and regulators with
greater transparency. Improvements that need to be made include:
Revising the structure of the Board of Trustees to bring it in
line with the Trustees of the International Accounting Standards
Board (IASB), chaired by former Federal Reserve Chairman Paul
Volcker. Currently the majority of the members of the Financial
Accounting Foundation (FAF), who serve as the trustees for the
Financial Accounting Standards Board (FASB), are selected based
upon their representation of a particular constituent group. As
with the IASB, these selection criteria should be changed to one
where the board members are all representatives of the public
rather than any particular special interest.
One way to accomplish this would be for the Independent Public
Accounting Oversight Board I previously discussed, to serve as the
Trustees for the FASB. One of the major advantages to this would be the
accounting standard setting, and enforcement of those standards
residing within a single organization. In turn when the disciplinary
process identifies shortcomings in the standards, they could then be
promptly referred to the standard setter for timely action.
It should also be pointed out that several years ago, after a drawn
out discussion with the SEC, the FAF agreed to place a minority of
public members on the Board of Trustees. However, the FAF has refused
the request of the SEC to modify its bylaws to make this change
permanent.
Create an independent ``no strings attached'' funding
mechanism for the FASB. This again could be accomplished by a fee
charged to issuers and/or members of the exchanges, all of who
greatly benefit from the work of the FASB.
The FASB needs to develop accounting standards that reflect
the reality of the actual economics of the underlying transactions.
Senator Allard from my own State of Colorado has recently
highlighted the need for timely issuance of such standards and I,
as I am sure other investors do, commend him for that position.
Standards that permit hundreds of billions of dollars in synthetic
lease financing off balance sheet liabilities to be hid from the
eyes of investors; that permit companies to avoid consolidation of
special purpose entities for which the company itself has the
majority, if not practically all of the risks and rewards of its
operations; and that result in the value of compensation in the
form of stock options to be excluded from the income statement are
not transparent standards. They are better described as a chapter
from Grimm's Fairy Tales.
The FASB needs to develop and implement a project management
system that prioritizes the needs of investors, and then
establishes accountability and responsibility for meeting those
needs in a more timely fashion. For example, in the mid-1970's the
SEC asked the FASB to address the issue of whether certain equity
instruments like mandatorily redeemable preferred stock are a
liability or equity. Investors are still waiting today for an
answer. In 1978, the Cohen Commission requested the FASB to require
disclosure in a single footnote of all the transactions that were
affecting the comparability of the financial statements from one
period to the next. This is a disclosure that would have gone a
long way toward addressing some of the problems created by pro
forma earnings but again nothing has been done. In 1982, the FASB
undertook a project on consolidation. One of my sons born that year
has since graduated from high school. In the meantime, investors
are still waiting for an answer, especially for structures, such as
special purpose entities (SPE's). In 1985, the SEC asked the FASB
to provide guidance for financial instruments, a project still
underway today. In 1998, the FASB was asked to provide guidance to
reduce some of the abuses of ``big bath'' charges, but they
continue to this day unmitigated. Time and time again the FASB has
asked the SEC to defer to it to establish standards. Yet the
standards never come. As a result, in the future the SEC should
give the FASB a timetable for completion of these standards and if
that timetable is not met, the SEC should act promptly to protect
investors.
The FASB Trustees should undertake to restructure the Emerging
Issues Task Force (EITF) of the FASB. The EITF establishes
Generally Accepted Accounting Principles for many of the new and
emerging types of accounting transactions but does not have
investor protection and transparency as a key part of its mission
statement. Rather it often establishes rules that ``grandfather''
past accounting practices that are questionable at best. This
should surprise no one as the EITF comprised solely of members from
industry and the accounting profession. The EITF needs major
revisions to its charter, should require public representation, and
as with the IASB, should not be able to pass a new rule without the
explicit approval of the FASB.
The SEC should require that companies disclose key performance
indicators or KPI's. KPI's, such as backlog, plant utilization
rates, revenues generated from new product introductions, etc.
provide a very powerful useful tool that gives investors greater
predictive capability with respect to trends in the business.
The SEC proposed new rules to increase the transparency of
``reserves'' and large writedowns in the value of assets such as
plant and equipment and goodwill. As the Association for Investment
Management and Research (AIMR) has recently requested, the SEC
should quickly issue final rules similar to those proposed.
The SEC should ensure financial statements are written using
``Plain English'' through its review and comment process. While
complex financial instruments transactions may be beyond simple
descriptions, there are plenty of opportunities to improve the
readability of financial statements.
In recent weeks the AICPA has seemingly laid the problems
associated with Enron at the doorstep of the FASB. They have argued
that the lack of transparent accounting standards was the cause of
Enron's financial reporting standards. They fail to acknowledge there
were problems with the audits while stating the financial reporting
model is broken. But as Jack Bogle, the highly respected founder of the
Vanguard funds has stated, perhaps it has been the markets and not the
model that were wrong. Perhaps the ostrich is once again placing its
head in the sand.
Another issue being bantered about involves the issue of whether
today's accounting standards should be principles based rather than
detailed rules. This is not the first time this issue has been raised,
and I can assure you it will not be the last. The predecessor to the
FASB, the Accounting Principles Board (APB) did write some principles
based standards. For example, in 1964 the APB issued a standard on
accounting for leases. That standard stated in principle when a lease,
as many are, is an installment purchase of the equipment, it should be
reported as a liability on the financial statements. But this standard
was no more successful than the current detailed FASB rule on getting
this off balance sheet debt back on the balance sheet. We also have
broad guidance on accounting for property, plant, and equipment and the
associated depreciation. But that has not stopped the abuses of
understating depreciation and then taking large write-offs of assets
when it is convenient. The predecessor to the APB issued what some
consider broad principles standard for reporting of inventories. But a
recent survey by Andersen and a 1999 report by the Committee of
Sponsoring Organizations (COSO) illustrate that overstatement of
inventories continue to be a major source of earnings misstatements and
SEC enforcement cases. And finally, the FASB standard that establishes
when many liabilities are to be reflected in the financial statements,
Standard No. 5, is a very broad principle standard that has been
responsible for such aggressive accounting practices like ``big bath''
charges and understatement of liabilities for environmental costs. The
real issue is not simply one of broad versus narrow detailed rules. It
is a cultural issue of a lack of compliance with both the spirit and
intent of the standards. It is an issue of professionalism.
One stark reality today is that before the ink dries on a new FASB
standard, the investment banking community and accountants are joining
forces to find ways to structure transactions to get around the new
rules. And while the spirit of a rule may clearly say no, I have heard
time and time again from a CFO or auditor, ``where in the rules does it
say I cannot do it.'' It is time to get away from this mentality and a
good starting point would be to prohibit auditors from designing and
structuring transactions, such as SPE's, that result in less, rather
than more, transparency for those they are reporting to.
Strengthening the SEC
Let me move on to perhaps one of the most important thing for the
markets today. That is ensuring we have an adequately staffed and
resourced securities regulator. Today, that does not exist.
There are approximately 12,000 actively-traded public companies who
file 12,000 annual reports, 36,000 quarterly financial statements, and
thousands of initial public offerings, registration statements,
proxies, and tender offers. In recent years, the Division of
Corporation Finance has been staffed with approximately ninety
accountants to review these documents. In the Division of Enforcement,
the typical caseload is around two hundred to two hundred and fifty
cases. There are approximately twenty to twenty-five accountants in the
Washington, DC office and maybe another thirty or forty around the
country to investigate these cases. In the private sector, it is not
unusual that three to four accountants assist in preparing for
testimony on a financial fraud case. In a case such as Enron, many more
staff would be dedicated to such a project. Finally about twenty to
twenty-five accountants are working in the Office of the Chief
Accountant. This Office provides a service to the public accounting
firms and companies, similar to what the national accounting and
auditing offices of each of the Big 5 accounting firms provides to
their own audit clients and offices. They also have oversight
responsibility for all the activities of those entities in the alphabet
soup. Comparatively speaking, the national offices of the Big 5
accounting firms are each typically a multiple or two larger than the
Office of the Chief Accountant.
As you can plainly see, it is physically impossible within their
current budgetary handcuffs for the SEC staff to carry out their
mandate to ensure full disclosure and timely enforcement of the laws
and regulations. The Panel on Audit Effectiveness recommended the SEC
provide additional resources to combating financial fraud. I hope
Congress will respond to the Panel report and provide the necessary
funding for doubling the size of the accounting staff in the Division
of Corporation Finance and the Office of the Chief Accountant, as well
as reasonable compensation levels for existing staff. The SEC Division
of Enforcement should also double or triple the number of accountants
and attorneys involved with combating financial fraud. Its Financial
Fraud Task Force needs to become a permanent fixture within the
Division of Enforcement.
The SEC also needs to be provided with the resources to acquire
technology that can aid in the electronic screening of filings for
potential issues and unusual trends in financial performance. SEC
Chairman has indicated he wishes to hire a highly qualified Chief
Information Officer. This is long overdue and will require additional
funds. But new and enhanced technologies can be a powerful, efficient,
and effective tool in identifying problems at an earlier date.
The statutory authority of the SEC to undertake certain types of
actions should also be evaluated. Recent cases involving Baymark and
California Micro Devices have raised serious questions as to whether
the standard of recklessness the SEC applies to Rule 102(e) proceedings
against accountants, is too high a standard by which to measure
unprofessional conduct by an accountant or auditor. Rule 102(e) is the
regulation by which the SEC may censure an accountant in a public
company or an auditor and deny them the right to practice before the
Commission. The rule is used to protect the integrity of the system and
processes that are key to efficient markets. It requires that an
accountant must be reckless, or have multiple incidences of improper
professional conduct in order to be sanctioned. As a result, in cases
involving negligence or other unprofessional behavior that is less than
recklessness, a Rule 102(e) sanction baring the practice of the
accountant before the Commission or in a public company cannot be
pursued.
It should be noted that some professionals have challenged the SEC
with respect to whether a Rule 102(e) proceeding may be initiated
against an accountant within a public company, if they are not a
currently licensed CPA. Today, many of the CFO's, Controllers, and key
financial reporting people do not have, or have not maintained a
current CPA license. In essence, the lack of current SEC actions
pursuant to Rule 102(e) against nonlicensed accountants sends a strong
message. I think it is the wrong message that CFO's and Controllers are
better off without their licenses than they are with them.
Let me switch briefly to the subject of the chief financial and
principal accounting officers. Today, CFO's at the major American
corporations turn over approximately four times faster than they did at
the beginning of the 1990's. And while the turnover 10 years ago was
often tied to one's retirement, it is much more likely today to be tied
to a company missing an earnings estimate. Way too often today the CFO
becomes the ``fall guy'' for such misses while the CEO's, chief
operating officers, vice presidents of manufacturing, marketing and
other key management positions stay on. And as surveys have shown, it
is all too often the CFO who is pressured by these other members of
management to stir the pot and cook the books. When the CFO doesn't
like the recipe that is handed to him or her, they are shown the door.
As a result, I also believe the SEC should make a change to its
rules for Form 8-K. A Form 8-K should be required to be filed whenever
a chief financial officer or chief accounting officer is terminated.
The report should require disclosure of whether the audit committee
approved the termination and whether there were any disagreements
regarding financial accounting or disclosure matters. Perhaps a similar
disclosure should be required for audit committee members.
Another challenge to the authority and ability of the SEC to
enforce the securities laws involves access to the work papers of
auditors of foreign issuers, or U.S. issuers with operations audited by
a foreign affiliate of the U.S. firm. Time and time again I watched as
the public accounting firms failed to provide timely access to the
foreign work papers, thereby dragging out the case and hoping it would
be dropped due to turnover in the assigned SEC staff. In its
international concept release issued in 2000, the SEC noted this was a
significant issue it faced in enforcing the SEC's rules. And the SEC is
not the only regulator to have been confronted by this issue. In the
BCCI case the Federal banking regulators also had to endure
difficulties in gaining access to the work papers of the foreign
affiliates of the accounting firm. With foreign registrants now
comprising approximately 10 percent of all actively traded companies,
either the Congress or SEC should act quickly to protect investors
before investors are unwittingly exposed to greater risk.
Finally, Section 10A of the Securities Act needs to be modified.
Currently, auditors are only reporting a small handful of violations of
the law. They define their responsibility very narrow to require
reporting only when they have identified an illegal act, have
unquestionably proved it is an illegal act, and did not resign before
they had to report it. As a result, when financial reporting is
questioned as it has been at Enron, this narrow definition of the rule
will not result in a Section 10A report to the SEC. I think most
investors would agree that is a definition that is too narrow and that
fails to protect the public.
Bringing Education Current with the Times
I have discussed recommendations for standard setters, regulators,
and preparers. Let me shift for a moment to a group that all too often
is missed in the equation. That is the educators and the all-important
role they play.
The most valuable asset of the accounting profession and public
accounting firms is the people who make up our organizations. Great
people who are talented, well educated, and motivated make for great
organizations while ``weak'' people are nothing less than as the
television show aptly calls it, the weakest link!
Accordingly, I give credit to the current leadership of the AICPA
for its efforts to boost enrollment in our colleges and universities of
the best high school students and its efforts to interest them in the
accounting profession. It is important that accounting firms and
industry provide support for this initiative.
During the recent debate on auditor's independence we noted that
the salary gap between the starting pay for accounting college
graduates entering the profession, and those who chose other fields of
study or employment opportunities in business, had grown very
significantly over the past 10 years. This salary differential sends
the wrong signal to students about to choose a major field of study.
Clearly, we need to correct this problem in addition to considering the
level of investment going into those who choose to enter the accounting
profession as auditors, as well as the tools they need to perform
effectively.
Today, we also need to bring down the ``silos'' that still exist in
the business colleges. Educators need to take concrete steps to change
the all too typical dinosaur of an accounting curriculum that is based
on the accounting silo. They need to stop competing with the finance,
management, marketing, or computer science ``silos'' and seek to
integrate these programs in a broad-based accounting curriculum. Today,
these ingredients need to be blended together to meet the needs of
students and the profession.
Good auditors and financial managers need a broad spectrum of
knowledge. For example, to be a good auditor today, you must understand
marketing and distribution channels, how risk management is effectively
and efficiently achieved through the use of various financial as well
as managerial techniques to develop effective strategic and tactical
plans. And of course, each of these areas of study is affected by the
rapid change in technology.
Universities need to reflect these changes in their curriculum now.
Certainly this will in all likelihood require more than what a student
is able to learn in a 4 year program. Keep in mind, while many of us
were in college, technology meant punched cards fed into a computer,
management was done in an environment of paper and calculators, not in
a real time on-line mode, and almost all of the financial instruments
used today had not yet been created. In the past, we talked about
interstate business and commerce, now it is the integrated global
economies. In simple terms, this means we must also realize that if our
new hires are to have the basic understanding they will need to be
successful in their respective roles, they will need an enhanced course
of study. The enhanced program must be both more broadly based in
business, more integrated and still steeped in the accounting
contribution unique to our discipline. At the same time, it is
imperative that the basic skills taught in financial accounting and
theory, income tax and auditing courses today, must continue as part of
the curriculum. Accordingly, I do not believe this can all be
accomplished in 4 short years. I believe we need advanced programs. The
result will be students who leave the university with a better
education, as compared to the body of knowledge new graduates had 10 or
20 or 30 years ago. However, the accounting firms and business must be
willing to compensate the students who invest in this greater body of
knowledge.
Independent Analysts
The last piece to ensuring quality financial information is
provided to investors is to reestablish the independence of analysts. I
would encourage the Committee to gain a clear understanding of how
analysts are evaluated and ranked, how and by whom their compensation
is set, and who has access to, edit privileges or control over their
research reports. As long as the investment-banking arm of Wall Street
has influence over the work of the research analysts or their
compensation, analysts will not be able to provide independent
research.
I would also encourage the Committee to ask the question of what
role the investment bankers played in structuring the off balance sheet
partnerships of Enron, what access to nonpublic information they
received, and whether any of that information was used in an improper
or illegal fashion.
Instruments of Justice
One last piece of the Enron puzzle that has received increasing
public attention, is the role the attorneys played. As the general
counsel of the SEC so eloquently stated just last week, the legal
profession is the one profession engaged in the business of justice.
Lawyers are the instruments of justice.
Yet the investing public and employees of Enron are wondering how
justice has been served. Those who have lost their jobs or their life
savings see a system blind to justice.
I hope that this Committee will explore this important issue, and
consider if the influence of a few, through the power of the dollar,
won out over truth and justice for all.
Closing
Hopefully the recommendations I have made today have given you an
understanding of what the SEC staff was striving for in their report to
the Commission. As you can see, it provides a benchmark for measuring
the progress, or lack thereof, by the profession in making substantive,
meaningful change. As you can also see from the attached chart, these
recommendations for a new system of regulation will also result in a
much simpler, reliable, and effective system of oversight of financial
reporting.
So let me just finish as I began, with independence. One out of
every two adult Americans have invested in the U.S. capital markets
that are the crown jewel of our economy. They have done so because they
had trust and confidence in a system that provides the numbers
investors need to make wise investment decisions. They have trusted
that an independent public watchdog was on the beat.
But that trust now lies shattered and will not be easily restored.
In the 200 plus year history of the markets, every time that confidence
has been shattered, our markets have sustained losses, investors have
fled to safer havens and the capital vital to funding American business
and job opportunities has dried up. We cannot let that happen again. We
must act quickly to make real, not just cosmetic changes that will
restore the confidence of investors and the American public. The public
deserves nothing less from Congress, the accounting profession,
regulators, analysts, and other members of the financial community.
PREPARED STATEMENT OF DENNIS R. BERESFORD
Former Chairman, Financial Accounting Standards Board
1987 to 1997
February 26, 2002
Good morning, Chairman Sarbanes, Senator Gramm, and other Members
of the Senate Banking Committee. I am Denny Beresford, a Professor of
Accounting at The University of Georgia, and I am honored to have been
invited to appear before you today.
My Background
First, let me briefly describe my background. Before joining the
faculty at The University of Georgia in July 1997, I served for 10\1/2\
years as Chairman of the Financial Accounting Standards Board. Before
my FASB appointment, I was a partner with the accounting firm now known
as Ernst & Young. I spent 10 years in the Los Angeles office of E&Y and
then 16 years in the firm's national office in Cleveland. For the last
10 years of my time with E&Y I was partner in charge of accounting
standards. I am now a retired partner of E&Y and I collect a fixed,
monthly retirement amount from the firm.
In addition to my full-time teaching duties, I am involved in
professional committees that follow and comment on new financial
reporting developments. I also continue to speak and write on financial
reporting matters. Additionally, I have served as a consultant to audit
committees of public companies and I have provided expert witness
services to several corporations and accounting firms. Finally, I am a
Director of National Service Industries, Inc., a New York Stock
Exchange listed company, and I am Chairman of NSI's Audit Committee.
One other fact that probably should be noted for the record is that
I was a shareholder of Enron Corp. (Enron) for a very brief period last
fall. I purchased 2,000 shares on November 5 and sold them on November
14, incurring a loss of $7,241. I blame no one but myself for this poor
investment decision.
The comments that follow are my personal views. They should not be
attributed to Ernst & Young, The University of Georgia, or any other
organization or individual with whom I may have some association.
What You Have Asked Me to Do
The letter inviting me to appear today asked for my comments on
``financial reporting by public companies, accounting standards, and
oversight of the accounting profession'' in light of recent high-
profile business failures including Enron. The letter also invited my
recommendations about ways to deal with the issues I discuss.
In considering my response to those requests, please keep in mind
that I am no longer an ``insider.'' There are, no doubt, certain
changes that have taken place in the accounting and auditing world of
which I am not fully informed at present. But with over 40 years of
total experience and about 25 years working at reasonably high levels
in the accounting profession, I hope that my comments will be of some
value to you.
Overview
My comments will relate primarily to financial reporting matters
because that is the area where I spent most of my professional career.
To put things in perspective, this statement begins with some comments
about the current state of financial reporting. It then moves to
several areas in which I have both comments and recommendations for
improvement. The last section summarizes the most important of my
recommendations.
An Admonition
Recently, there has been a great deal of criticism of accounting
and auditing practices in the United States relating to Enron and
several other high profile cases. It is quite appropriate that your
Committee and other groups in Washington try to determine the root
cause of the Enron matter and penalize any deserving individuals or
organizations after determining the facts. It is also quite appropriate
that your Committee and other groups in Washington consider whether
there are changes that can be made to accounting or auditing rules and
regulations to lower the chance that similar problems will occur in the
future. However, I believe it is critical that these latter efforts
keep in mind that our current system of financial reporting produces
excellent information in the vast majority of situations. Care must be
taken to see that criticism is constructive--that it leads to
improvements in the current system and not to damaging it.
I do not think that any of us fully understand all that happened in
the Enron matter. Even with the restated financial information now
available, the Powers report, and the volumes of newspaper and magazine
articles analyzing the situation, there remain many unanswered
questions regarding Enron's business practices and the way it accounted
for them. However, it does appear to me that the basic accounting
problem boils down to the fact that Enron failed to comply with
Generally Accepted Accounting Principles (GAAP). Enron first admitted
this when it eliminated the $1 billion plus notes receivable related to
its stock issued to the special
purpose entities (SPE's). Enron admitted additional accounting errors
when it subsequently restated its financial statements to consolidate
certain SPE's that it determined did not qualify for ``off balance
sheet'' treatment under GAAP. As I will cover later, the accounting
principles for SPE's certainly warrant further consideration. But the
rules we have now would have produced more appropriate information if
only Enron had followed them.
As a former standards setter, I am aware of the dangers of the law
of unintended consequences faced by all rulemakers. As you are well
aware, often in trying to resolve one issue, a rule can create other
problems that were never intended. The less thorough and considered the
process leading to the new rule, the more likely this will occur.
Some have argued that the Enron problems were ``caused'' by the
legislative reforms designed to reduce frivolous lawsuits. Others
believe the ``cause'' was the failure to legislate reforms to limit the
scope of work performed by public accountants. Still others see the
root of the problems as easy money, an investment system fraught with
moral hazard, and/or a decline in societal ethics or moral standards,
for which there is no lack of opinion as to where to place the blame.
Each of these opinions certainly has emotional resonance and there
may be some element of truth in each of them. However, what seems more
likely, based on what we know today, is that the collapse of Enron had
more to do with human errors, some perhaps innocent, some perhaps not,
that remained undetected because of a massive breakdown in the systems
and controls that either were, or should have been, designed to
discover them.
These are very real problems for Enron. They should be investigated
and any wrongdoing appropriately penalized. In the process, any
systemic problems that are discovered should be appropriately
addressed. However, as of today, there is no evidence that the Enron
problems extend to a majority of corporate executives, board members,
outside accountants, or outside lawyers. Therefore, I would caution
against immediate widespread reform that could well invoke the law of
unintended consequences.
I am not suggesting that this will be an easy task. I am well aware
that Congress has an enormously difficult balancing act. It must get to
the bottom of the Enron situation and ensure that appropriate actions
are taken. At the same time, it must do so in a manner that does not
unnecessarily create a chilling pall over a mostly well-designed
economic model and the vast majority of those who play by its rules. To
this end, generally it has been proven more effective and less
disruptive if, when possible, deliberative, private sector action,
rather than a legislative solution, is the chosen reform vehicle.
The body that is responsible for establishing most of GAAP at
present is, of course, the FASB. Much of what I will say in the
remainder of this statement will focus on the work of the Board. That
Board has served with distinction for nearly 30 years and I am
confident that hearings like this will lead to suggestions to further
improve the FASB's processes. In January 1990, I wrote an article for
the Journal of Accountancy that included the following summary of the
FASB:
The FASB is unique. It is a private-sector institution
performing a public function that is defined in a Federal
statute. This means it carries the weight of public
expectations as expressed both in the Securities Exchange Act
of 1934 and in repeated Congressional investigations and
hearings over the years. With Government looking over its
shoulder, the Board must serve a private-sector constituency
made up of several important segments whose interests often are
at variance with one another. Thus, the Board's relationship
with its constituents is a continuing test of a sophisticated
and subtle democratic process. The process does not work unless
divergent private viewpoints are heard and can be reconciled.
The Board's responsibility is to try to do that--in a manner
that will best serve the public interest.
Understanding Financial Reports Requires Education and Diligence
To further put into context my following remarks, I would like to
cite one of my favorite quotes from the accounting literature. FASB
Concepts Statement No. 1, ``Objectives of Financial Reporting by
Business Enterprises,'' states the following:
Financial reporting should provide information that is useful
to present and potential investors and creditors and other
users in making rational investment, credit, and similar
decisions. The information should be comprehensible to those
who have a reasonable understanding of business and economic
activities and are willing to study the information with
reasonable diligence (paragraph 34, emphasis added).
It is important to keep in mind these comments about ``reasonable
understanding'' and ``reasonable diligence'' as you and others evaluate
the current financial reporting system and consider the need for
further improvements. Most businesses are complicated and attempts to
portray their economic activities in a few financial statements and
accompanying footnotes necessarily involves numerous tradeoffs. Because
of this, relatively few investors are experts at reading corporate
financial reports.
Let me illustrate this point with a personal experience. I
presently teach both graduate accounting students and MBA candidates.
Most of the MBA students have had relatively little exposure to
financial accounting and at the University of Georgia we expect them to
be able to absorb the basics in 37.5 classroom hours of instruction.
While my students are intelligent and highly motivated individuals,
only rudimentary principles of accounting can be absorbed in this
amount of time. So, our MBA graduates who become business executives,
investment bankers, etc., are not expert accountants by any stretch of
the imagination.
And these women and men are among the most sophisticated
individuals in our society with respect to business and accounting
matters. Most Americans do not have graduate degrees in business or any
specific education in accounting matters. It is clearly unreasonable,
in my view, to expect most Americans to understand all of the nuances
of financial reports.
I note this primarily to dispel the notion that financial reports
must somehow become fully understandable to any individual who invests
in stocks or bonds of public companies. It just is not going to happen.
While we should strive to make those reports more accessible to all, I
think a more realistic objective is to work on improving information so
that financial analysts, lending officers, and other relatively
sophisticated intermediaries can use that information to provide better
advice to individual investors and other appropriate parties.
Please do not misunderstand. It may sound as though I am saying
that accounting is some sort of secret language that only CPA's with
years of experience can speak, but that is not what I mean to
communicate. As I indicated earlier, my MBA students can assimilate a
good, general understanding of basic financial statements and
accounting principles in one semester. As a further illustration, over
the past year and a half I have written a series of articles on
corporate reporting for our local newspaper and many readers have told
me that the articles help them gain a basic understanding of financial
statements.
However, being able to generally grasp the financial reports of
one's small business or church, for example, does not necessarily lead
to being able to decipher Enron's incredibly complicated financial
statements. Enron was a complex business with energy and
telecommunications operations, extensive trading activities, and
sophisticated financing vehicles. Being able to reduce all of that to
something like a Reader's Digest article that nearly all adults could
understand is not a realistic expectation.
Congress Should Not Get Involved in Technical Accounting Issues
I was pleased to see that one of the comments in former SEC
Chairman Arthur Levitt's op ed piece in The New York Times on January
17. In referring to the FASB, he said:
This important agency must also be free from Congressional
pressure, which is often applied when powerful corporations
seek to undermine new accounting rules that might hurt their
earnings.
I strongly agree that Congress must guard against becoming a
hindrance to the accounting standard setting process. However, as with
all perceived conflicts of interest, lines delineating ``doing the
right thing'' from ``helping a client or constituent'' often can become
blurred. A case from my personal experience where Congress allowed
itself to become too involved in the technicalities of the reporting
process was the debate over accounting for employee stock options in
the early and mid-1990's. As many of you may recall, the FASB had
proposed that companies account for the expense represented by the fair
value of stock options granted to officers and to employees. The
business community and accounting firms strongly opposed this proposal
and a number of corporations engaged in a lobbying effort to stymie the
FASB's initiative.
Certain Members of Congress were sufficiently influenced by the
appeals from corporate executives that they were persuaded to introduce
legislation to counter the FASB's proposal. The legislation would have
prohibited public companies from following any final FASB rule on this
matter. More importantly, the legislation would have imposed
requirements that the SEC repeat the FASB's process on any new
accounting proposals, thus effectively eviscerating the FASB. Faced
with the strong possibility that its purpose would have been eliminated
by this legislation, the FASB made a strategic decision to require
companies to disclose the effect of stock options in a footnote to the
financial statements but not record the expense in the income
statement.
Unfortunately, this was not the only example of Congressional
interference in the FASB's technical decisionmaking. In the 1970's,
Congress overrode the Board with respect to the accounting for oil and
gas exploration costs. More recently, legislation very similar to that
proposed in connection with the stock options matter was introduced in
connection with accounting for derivative financial instruments. For
the even more recent project on accounting for business combinations
and goodwill, Congressional hearings were precipitated by corporate
complaints of alleged unfavorable economic consequences of the FASB's
proposals. And legislation was proposed that would have delayed
implementation of that new accounting rule.
I have noted that two Members of this Committee are considering
whether the Federal Government should take over responsibility for
setting accounting standards. In support, a recent Wall Street Journal
article refers to critics of the FASB, who claim in part that the FASB
has been ``too quick to cave in on critical issues.'' One of the
examples given was the decision to scrap the proposal on accounting for
stock compensation. I find this ironic. I am confident that the FASB
could have and would have stood up to companies that disagreed with its
conclusions on stock compensation. It ``caved'' only under
Congressional pressure that would have effectively legislated it out of
business. Contrary to being an argument for Government accounting
standards setting, this is one of the very good reasons for the
Government to stay out of the technical accounting standards setting
business.
As President Bush said in his recent State of the Union address,
``Through stricter accounting standards and tougher disclosure
requirements, corporate America must be made more accountable to
employees and shareholders and held to the highest standards of
conduct.'' The FASB has the mandate and the will to adopt stricter
accounting standards and tougher disclosure requirements. However, it
cannot achieve those goals when Congress urges lesser requirements.
Congress must guard against emotional appeals from constituents that
accounting rules will ``ruin their businesses'' or ``destroy the
economy.'' Reporting the substance of actual business decisions and
activities is unlikely ever to have that result.
Congress, of course, has both the right and responsibility to
provide strong oversight in this area. The FASB holds a public trust
and Congress is entitled to examine how the Board is carrying out that
duty, particularly in trying times like those at present. However, my
view is that Congress' primary role in this area should be to see that
the FASB is fulfilling its public obligations appropriately. Congress
ought not to interfere with individual technical decisions.
Let me offer an example, of a situation about which I am very
familiar, of how Government oversight activities have been successful
in influencing positive change in the private sector. The FASB
currently is subject to oversight by the Financial Accounting
Foundation (FAF). In turn, the SEC actively oversees the FAF, and
Congress oversees the SEC and determines that the Commission carries
out its responsibilities with respect to both the FAF and the FASB.
The Trustees of the FAF are responsible, by charter, for three
major things. First, they appoint the members of the FASB (as well as
its sister organization, the Governmental Accounting Standards Board).
Second, they raise the funds necessary to finance the FASB's
activities. Third, they oversee the FASB to make sure that the Board is
carrying out its responsibilities in an unbiased and appropriate
manner. By charter, the Trustees are not allowed to interfere with or
otherwise influence the FASB's technical decisions on accounting
standards matters.
During Arthur Levitt's tenure at the SEC, he (and others) perceived
that the Trustees of the FAF were not always sufficiently supportive of
the FASB. He felt that there were instances where the Trustees acted in
a way that might have been seen as endorsing the business community's
views on specific technical issues rather than supporting the FASB's
independence and due process. He, therefore, proposed changes in the
composition of the FAF Board of Trustees. He suggested that several
more ``public'' members be added in place of some with close ties to
the accounting profession and business community.
After months of debate, the FAF agreed to reorganize and several
public members were added, including the current Chairman, Manuel
Johnson (former Federal Reserve Vice Chairman), and David Ruder (former
SEC Chairman). In my view, this was a significant improvement. It is
now more evident that the FAF Trustees are acting to support the FASB
and to make sure it is doing its job properly rather than the earlier
perception that it was somehow trying to influence the Board's
decisions.
This is a very good example of how Government oversight led to
actions that resulted in positive changes in the private sector. It is
particularly noteworthy that these changes were accomplished in a
manner that supported, rather than undermined, private sector
accounting standards setting activity.
The SEC's Role is Vital
A fair amount of the rhetoric surrounding the Enron situation has
focused on the SEC and particularly Chairman Harvey Pitt. Some
journalists and other commentators have pointed to Chairman Pitt's
background as counsel to the AICPA, Andersen, and other accounting
firms and have raised questions about whether he will vigorously pursue
whatever remedies are called for with respect to Enron and to Andersen,
as well as appropriate system wide changes. Some of those individuals
also have pointed to Chairman Pitt's remarks to the AICPA Council
meeting a few months ago as an indication that there will be a ``kinder
and gentler'' SEC with respect to dealing with accounting matters.
I have a different perspective. I do not know Chairman Pitt well,
although I did meet him a number of years ago in his previous
employment at the Commission. But I have worked closely with SEC
Commissioners, accounting staff, and many other SEC staff members for
the past 25 years or so. I have found them to be first-class
professionals who are dedicated to the public interest. While my
knowledge of Federal Government agencies is limited, it would be hard
for me to believe that there could be another agency that is as
professional and accomplished in performance of its responsibilities
than the SEC. I am confident that Chairman Pitt will carry on the
distinguished record of the SEC.
Having said that, it is my perception that working relationships
between the SEC and the accounting professionals had become
increasingly strained and even confrontational in the past several
years. Based on many conversations with auditors and corporate
executives, I sensed a much more cynical attitude on the part of many
of the SEC's accounting staff members. I also experienced this directly
in a couple of cases in which I consulted with companies that had to
discuss an accounting issue with the SEC staff. Rather than a spirit of
cooperation in order to achieve the most appropriate outcome for the
investing public, too often an attitude of ``you are obviously guilty
of some wrongdoing if you have to come see us'' seemed to have existed
when some companies or auditors approached the SEC staff to discuss
contentious issues. In fairness to the SEC, some business executives
and their auditors and lawyers pride themselves on finding the
loopholes in the rules that will allow them to do what they want
regardless of the substance of the transaction or the spirit of the
rules.
Whatever the cause, the trend has been much more reluctance by
companies to seek SEC input on the front end of difficult accounting
matters. Recent comments by Chairman Pitt and Chief Accountant Bob
Herdman encouraging companies and auditors to talk to the SEC on the
front end represents an extremely positive step, in my opinion. While
the SEC has enforcement powers to correct reporting that is identified
as being inappropriate, it does not have the resources to review all
companies' reports and determine their propriety. It must rely on the
private sector (corporate executives and independent auditors) to do
the right thing. There must be a high degree of trust among regulators,
reporting companies, and auditors for the reporting system to work
best. Therefore, I commend Chairman Pitt and Chief Accountant Herdman
for their efforts to create a more positive environment in which all
interested parties can work together to improve both individual
companies' reporting and the overall system. At the same time, I am
confident that the SEC will act decisively when individual companies or
their auditors have not performed in a professional manner.
On January 22, the SEC issued FR- 61 ``Commission Statement About
Management's Discussion and Analysis of Financial Condition and Results
of Operations.'' This release provides SEC views on matters that public
companies should consider disclosing in their calendar 2001 and later
annual reports. The matters covered relate to off balance sheet
arrangements, trading contracts for which fair values must be
estimated, and related party transactions. This release closely
followed recommendations from the Big 5 accounting firms on those
matters, all of which were issues for which Enron's disclosures have
been criticized. I believe these SEC recommendations will result in
additional useful information to investors and other readers of annual
reports. This is an excellent example of how positive interaction
between the accounting profession and the SEC can lead to immediate
gains to the investing public. Enhancing trust and cooperation between
the parties, as the SEC apparently is trying hard to do, is likely to
lead to additional positive actions like this one.
It Takes Too Long to Issue Accounting Standards
SEC Chairman Pitt's Public Statement announcing his proposal for a
new auditing profession oversight board included the following
admonition: ``We need more prompt action by the FASB, the Nation's
accounting standard setter.'' I agree 100 percent with that comment.
It simply takes too long to develop new accounting standards. When
I was appointed as Chairman of the FASB in September 1986, an item in
The Wall Street Journal stated, ``Mr. Beresford will likely urge the
FASB to be more timely in setting standards.'' While I did try to
improve timeliness, I failed miserably in actually moving things along
more quickly. We adopted a strategic objective of completing major
projects in no more than 3 years, but even that very modest goal has
not been achieved. The recently completed accounting for business
combinations project lasted approximately 5 years and many earlier
projects lasted much longer.
The FASB has explained many times that it only deals with topics
for which many solutions are highly controversial. Accordingly, it
takes a certain amount of time to properly research those matters,
debate them among the Board members, and then seek public comment on
the preliminary conclusions. Also, the Board's open due process
(including comment periods for constituents to submit their views on
proposals, field-testing of proposals, public hearings, and other
procedural steps) necessarily adds time.
Those due process steps are appropriate in order to give all
interested parties an opportunity to inform the Board about pertinent
information relating to the matter in question and to challenge the
Board's preliminary thinking. Such an open process leads to better
standards and also contributes to the FASB's credibility in the
business community. Thus, efforts to achieve earlier solutions to new
accounting challenges should not come at the expense of significantly
shortcutting due process.
Rather than reducing its interaction with constituents, I believe
that the FASB could reach earlier resolution on many projects by
streamlining its internal processes. There are at least three ways in
which this could be done.
First, would be for the Board to limit the content of its standards
to the most significant matters related to the issues in question. At
present, too often the Board members feel compelled to address great
levels of detail in order to achieve a standard that answers all
possible implementation questions. This is done, in large measure, to
try to avoid the possibility of corporations applying a standard in a
manner that the Board did not intend (sometimes referred to as
``scoundrel prevention''). Dealing with such great detail not only
takes more time, it also leads to lengthy and complicated accounting
standards that actually may result in less desirable outcomes. I will
say more on this point later.
Second, would be for the individual Board members to not strive for
what they personally believe are conceptually pure answers when doing
so would significantly delay finalizing reasonable guidance for
practitioners. The Board bases its standards on an underlying
conceptual framework, much like the U.S. Constitution is the
fundamental base for legislation on specific matters. The FASB
conceptual framework is necessarily general in many respects, and when
Board members debate topics they often disagree among themselves on
appropriate solutions while referring to the same underlying concepts.
I admit to being more of a pragmatist than a theorist. However, I
believe that the FASB (as well as other parties involved in
establishing guidance for accounting and auditing practitioners) should
keep in mind the overriding goal of reasonably prompt problem
resolution. Even after 5 or 10 years of effort, reasonable people will
disagree as to whether an individual accounting standard is
conceptually pure or best serves the needs of financial statement
users. A timely answer is better than an arguably more theoretically
pure one delivered at a much later date.
A third reason why progress is slow on most major projects at the
FASB is the relatively small size of the staff. There are seven Board
members and approximately 45 staff members. Nearly all of the research,
memoranda drafting, and the other technical procedures necessary to
prepare a matter for debate by the Board members is performed by the
staff. The Board members become deeply involved in projects by studying
staff memos, reading all comments letters from constituents,
deliberating issues in public meetings, and through various other
procedures. However, the Board is able to move only as fast as the
staff can prepare matters for its consideration.
Increasing the staff by 10 -15 people would almost certainly allow
projects to be considered more rapidly. This would, of course, require
additional funding (see later comments on funding). It would also
require finding enough qualified people willing and able to work for
the FASB, which has not been easy to do in recent years. Funding and
candidate identification are tough challenges, but the FAF Trustees
should consider those to be critical objectives in order to allow more
timely attention to important accounting issues.
Accounting Rules Have Become Too Complex
Notwithstanding the complexities of today's business world, one of
my major concerns is that accounting rules and regulations have become
too complicated and that has added to the burden of those who are
reasonably informed and are reasonably diligent about studying
corporate reports. Corporate executives and auditors who have direct
responsibility for delivering financial reports to the public have a
very difficult time keeping up with and understanding all of the
accounting rules. As just one example, the FASB's pronouncement on
accounting for derivatives is about 250 pages long and a Derivatives
Implementation Group met for over 2 years to develop a few hundred
additional pages of interpretive guidance. I have heard senior partners
of major accounting firms say that only a handful of specialists within
their firms are fully conversant with all of the rules on this
important topic.
I certainly do not mean to pick on the FASB--after all, much of
what the Board did on the derivatives project was well along before my
term ended. But it does seem as though things have become too
complicated and it is time to step back to see if more general
standards can work as well or better.
It may be helpful to comment on the genesis of all this complexity.
It was not always thus. The trend toward more detailed standards
resulted, in part, from the attitude of some that whatever was not
explicitly required by the rules need not be done, and perhaps more
importantly, whatever was not explicitly excluded, was by definition
permissible. Others, who may have understood and wished to apply the
rules in their much broader context, nevertheless, for competitive
purposes, called for ``more definitive guidelines'' (thus the birth of
the term ``scoundrel prevention''). However, it seems the pendulum has
swung too far.
To a certain extent, the FASB took a step toward more generalized
standards in its recently completed standards on accounting for
business combinations and goodwill. Those standards are still pretty
complicated, but they provide for a considerable amount of management
judgment in deciding whether and when the value of goodwill has become
impaired, for example. Some parties will, no doubt, call for more rules
to specify how to make those impairment decisions and I urge the FASB
to continue to resist those requests. The overemphasis on detail will
not be reversed overnight. However, over time this is something I
believe the FASB must strive for.
Accounting standards are necessary in order to cause reports by
various companies to be reasonably comparable. Similar to the rules of
football, without some standardized approaches to accounting, sorting
out the winners and losers in the business world would be much more
difficult. However, like the compromise over Instant Replay for NFL
games, often the parties involved in the process are willing to accept
fewer or less specific rules so that the game flows more smoothly but
still within some appropriate boundaries.
In January, the FASB announced that it ``. . . discussed a number
of potential projects to simplify the U.S. accounting literature in
order to improve its effectiveness and usability.'' Among the actions
that the Board decided to take was to ``Evaluate the feasibility of
issuing standards that are less detailed and have few, if any,
exceptions or alternatives to the underlying concepts.'' This is a good
first step and I look forward to the FASB devoting more time to
reducing complexity of accounting standards over time.
Some will argue that if the Board makes its standards more general
and limits the amount of detailed guidance they provide, it may lead to
more inconsistencies in financial reporting. However, to the extent
that the FASB staff, the SEC, accounting firms, or others identify such
inconsistencies, the FASB Emerging Issues Task Force can deal with them
on a timely basis. The SEC Chief Accountant has indicated a desire to
work more closely and cooperatively with the EITF in providing guidance
on new issues that demand quick attention. The FASB should keep this in
mind and be willing to limit its standards to more general approaches
in the future.
The Consolidation Project and SPE's
In spite of the fact that the real accounting issues in the Enron
matter had to do with a lack of substance in certain transactions,
attention has centered on the accounting for SPE's largely because they
were the vehicles used to obscure the transactions' substance.
Originally, the SPE's were accounted for ``off balance sheet,'' which
means that the entities were not included in Enron's consolidated
balance sheet, income statement, and other financial statements.
Subsequently, the company restated its information for several years to
consolidate those SPE's with Enron's other assets, liabilities,
revenues, expenses, etc. The result was a significant increase in the
liabilities reflected in Enron's balance sheet and a significant
reduction in Enron's net income for those earlier years.
The FASB's Emerging Issues Task Force developed the existing
accounting guidance for SPE's about 10 years ago with considerable
input from the SEC accounting staff. The need for this arose because
the existing authoritative accounting guidance on consolidation related
primarily to situations involving ownership of voting interests. The
general rule was then, and is now, that entities in which a corporate
parent owns more than a majority of the voting equity interests should
be included in consolidated reports. Those entities for which ownership
was 50 percent or less generally are not included in consolidation (are
off balance sheet). (In the case of SPE's, to qualify for off balance
sheet treatment the sponsor must own no equity in the SPE. At least 3
percent of the capitalization of the SPE must come from unrelated
parties--the remaining 97 percent generally comes from borrowings from
financial institutions. Thus, the 3 percent of capitalization
represents 100 percent of the equity ownership of the SPE.)
Many parties believe, however, that there are situations where one
entity ``controls'' another even without majority stock ownership. The
FASB has been working to develop a definition of control and
implementation guidelines for at least 15 years (since Statement 94 on
consolidation of majority owned subsidiaries was issued in 1987). Two
separate exposure drafts of proposed new rules for consolidation based
on control were issued for public comment but most constituents
vociferously opposed them, and they were not adopted as final rules.
Many of the comments on the most recent proposal urged the Board to
defer consideration of the broader control/consolidation matter but
work to develop better accounting for the increasing number of special
purpose entities. A few months ago the Board agreed that it should
concentrate its near term efforts related to the consolidation project
on SPE matters. According to the Board's most recent Technical Plan, it
expects to issue proposed new guidelines in this area no later than
June 30, 2002.
Why has it taken the FASB so long to resolve this matter? I am not
sure that I have a fully satisfactory answer to that question. However,
let me mention some of the concerns I had with the control notion
during the time I was at the Board, as well as subsequently when I sent
my own comment letter on the latest proposal to modify general
consolidation requirements.
Control is a hard notion to define in a way that can be applied
consistently in practice. Relatively early in my time at the FASB I
remember a meeting where we discussed the project in an open meeting
with SEC Commissioners. David Ruder was the new SEC Chairman at that
time. When we brought this matter up I recall Chairman Ruder saying
something like, ``Good luck--the SEC has been wrestling with the
definition of control since the 1930's and we still aren't satisfied we
have gotten it right.'' The FASB was convinced at that time that it
could ``get it right'' but many years of subsequent debate have proven
Chairman Ruder to be quite prophetic. With each iteration of definition
and supporting implementation guidance, the Board has ultimately
concluded that consistent application in practice was unlikely.
Beyond these implementation challenges, there is the matter of what
reporting actually best serves users of financial statements in this
area. Should all corporate relationships somehow result in
consolidation? I don't want to bury Committee Members in accounting
esoteria, but let me give one example.
Should a real estate operator have to consolidate all of the
limited partnerships in which it serves as the general partner, even
when its interest in each partnership is only 1 percent? If that were
done, the consolidated financial statements would show large amounts of
assets, liabilities, and ``minority interest'' and only a small amount
of stockholders' equity. The income statement would show large
revenues, expenses, and then a line called ``less minority interest''
to arrive at a small amount of net income. The statement of cash flows
apparently would show all of the cash receipts and disbursements of the
limited partnerships, even though nearly all of the consolidated cash
would not be available to the ``parent.'' Many knowledgeable
accountants and financial analysts have said that this would not be
meaningful or informative reporting.
The matter above is what I would call a more general consolidation
accounting matter. The SPE matter is a specific application. Until very
recently, most FASB Board members believe that it was inappropriate to
deal with a narrower topic (i.e., SPE's) without resolving the overall
consolidation matter.
Consolidation is only one matter relating to the overall topic of
so-called off balance sheet financing. Off balance sheet financing
represents a very broad and challenging accounting matter.
Unfortunately, there is not even a common definition of this term of
which I am aware. However, it probably would include such matters as
SPE's, leases, take or pay contracts, through-put arrangements, and
many more situations where a company will be able to use something in
its future operations in exchange for agreed upon payments.
At the extreme, this could include simple executory contracts, such
as the University of Georgia's agreement to employ me for the 2002-2003
school year. Should Georgia record an asset for the ``value'' of my
future services and a liability for the amount the University has
agreed to pay me? Most accountants probably would say no, because this
contract involves both future services and future payments. But that is
also the case for most of the off balance sheet financing arrangements
that have been criticized recently.
The accounting problem is to agree on what represents an asset and
on what represents a liability, and when such amounts should be
recorded in balance sheets. Some of these arrangements are treated as
assets and liabilities under current GAAP, such as capital leases and
SPE's that meet consolidation rules. For many other arrangements, the
future cash obligations need to be disclosed in financial statement
footnotes even if assets and liabilities are not recorded in the
balance sheet.
I have heard more than one commentator on the Enron matter say that
we must record all of ``these'' contracts as liabilities. However, I
have yet to hear one of those commentators say exactly what she or he
means by ``these.'' The new disclosures recommended by the SEC to be
included in Management's Discussion and Analysis will provide
additional information beyond what is already required by the GAAP, and
that is a positive step. The FASB's current attention to SPE's also is
a positive step. However, it is important that the broader off balance
sheet financing matter be studied carefully before cluttering up
corporate balance sheets with amounts that might provide little or no
incremental information to users, and may even confuse them.
A key reason why many of these arrangements are allowed to be kept
out of balance sheets at present is that the company does not own the
asset in question. A third party has legal title to the asset and has
agreed to make it available over time to the company. If you have
signed a lease for an apartment in Washington for the next year, do you
consider that to be an asset? I suspect that most of you do not, and
corporations often feel the same way about their future obligations.
In the debate about consolidation, it is important to keep the
bigger picture in mind. Would consolidation of more entities actually
improve users' understanding of a company's financial position and
results of operations? In the vast majority of cases, including more
entities in consolidation would have negligible effects on net income
for the reporting company. It would increase both the assets and
liabilities in the balance sheet and change certain ratios,
particularly debt to equity. (The Enron situation, involving a very
substantial adjustment to net income through consolidation of three
SPE's, was fairly unique--caused by the reversal of gains on things
that Enron had sold to the SPE's or on ``hedges'' that did not provide
real economic protection.)
Some would argue that more information is being provided to careful
readers of financial statements under current GAAP as compared to what
might result from more consolidation. This is because companies must
disclose in footnotes certain information about entities in which they
have a significant ownership interest but less than necessary to
require consolidation. If all of those entities were consolidated, the
individual amounts would become buried in the parent's balance sheet
numbers, the footnote disclosures would no longer be presented, and the
results would arguably be less meaningful.
A Few Comments on International Accounting
To some extent the degree of detail in accounting standards has
been described as general vs. detailed, or principles vs. rules-based.
A recent article in Business Week suggested that the off balance sheet
financing vehicles used by Enron would never have been allowed in the
first place under European accounting. The article noted that the new
International Accounting Standards Board is using a principles approach
and avoiding the United States tendency toward very detailed rules.
Applying principles, auditors in Europe supposedly would have been able
to stand up to clients and insist that SPE's be accounted for on
balance sheet. Further, according to the December 13, 2001 issue of
Accountancy Age (a United Kingdom publication), ``Sir David Tweedie,
International Accounting Standards Board Chairman, and Allan Cook, UK
Accounting Standards Board Technical Director have indicated Enron's
collapse could not have happened under existing UK or global rules.''
Mr. Cook also was quoted as saying, ``The IASB would probably have it
on the balance sheet.''
In evaluating such remarks, you and others should keep in mind that
Enron corrected its financial statements to consolidate the troublesome
SPE's in order to comply with existing U.S. GAAP. Further, any such
remarks about other countries' accounting standards must be considered
in the context of the rigor of auditing practice and regulatory
enforcement, for which U.S. practice is far superior to the rest of the
world.
As stated earlier, I am in favor of less complicated and less
detailed accounting principles, which is the approach being pursued by
the IASB. That said, it is important to note that, on balance, our U.S.
financial reporting system remains the best in the world because of the
combination of comprehensive accounting principles, required audits by
independent accountants, and regulation and enforcement by the SEC. No
other country or area of the world has an overall system of financial
reporting that is as reliable and informative as ours.
The IASB activity should be commended and supported by U.S.
parties. At the same time, I believe it is imperative that neither the
SEC nor the FASB take action in the near term that would have the
effect of watering down Generally Accepted Accounting Principles in our
country. Convergence of accounting standards around the world is an
admirable long-term goal. However, for the next 5 to 10 years, at a
minimum, we must not dilute United States reporting solely for the
purpose of harmonization.
Funding of the FASB
One of Arthur Levitt's recommendations in his New York Times op ed
piece is that alternative funding be put in place for the FASB in order
to improve its independence from the business community and accounting
firms. This would allow the organization to cover its operating
expenses through a ``broad-based user fee,'' in Mr. Levitt's words. A
number of alternatives for funding the FASB have been suggested in the
past and this matter is certainly worth further consideration by the
Trustees of the FAF and other interested parties.
At present, approximately two-thirds of the FAF's annual budget
comes from selling publications and from similar operating activities.
The remaining one-third represents voluntary contributions made by
AICPA, individual accounting firms, and approximately 1,000
corporations. The total contributed by corporations represents about 15
percent of the FASB's budget in total, and individual amounts generally
do not exceed $50,000 (the vast majority are much less). Corporations
occasionally threaten the FASB that they will cease contributing if the
Board adopts a certain technical position. By and large, however, the
number of donors who actually do this is very small.
One suggestion that has been made in the past is that permanent
funding should somehow be put in place. To cover the current operating
needs of the FASB and GASB would necessitate a permanent endowment fund
somewhere in the neighborhood of $300 million (the FAF's current
reserve fund is about $29 million). It is unlikely that corporations,
accounting firms, investment bankers, and others directly involved in
the FASB's activities would be interested in or able to provide this
level of funding. Perhaps Congress could find a spare $300 million
lying around, but most parties believe the strings likely to be
attached to any such funding would undermine the private sector nature
of the Board.
Another possibility would be for a fee to be assessed on all public
companies and perhaps other parties interested in the financial
reporting process, such as accounting firms and investment bankers.
This apparently is what Mr. Levitt has in mind. If this could be done
through the stock exchanges or in some other way that does not involve
the Government, this idea might be worth pursuing. However, it is more
likely that the SEC or even Congress would have to get involved in this
kind of arrangement and such a relationship to the FASB's funding would
be detrimental to the Board's independence.
An advantage of the present system is that having some dependence
on voluntary contributions means that the FASB is subject to a sort of
market test of its effectiveness. The Board's technical actions are,
and should be, independent in nature. However, it is also important
that the FASB not be so distanced from its constituents that too large
a number of them become unwilling to continue financial support. Most
contributing accounting firms and corporations recognize that they are
not going to get their way on technical issues just because they make a
contribution. But if the Board begins acting in a way that somehow
ignores the input from constituents, the contribution mechanism is a
way for them to express their significant dissatisfaction.
To be clear, no contribution to the FAF, or threat of withholding a
contribution, affected any of my decisions at the FASB in any way
whatsoever. And I know that that was true for all of the individuals
with whom I worked at the Board.
Audit Committees
As was noted earlier, I recently became the Chairman of the audit
committee of a public company. Even before doing this I had worked with
a number of the audit committees while I was still in public accounting
and I have consulted with some committees in my present position. Based
on these experiences, I believe that audit committees can and do serve
an important function in the financial reporting system. And I was
particularly pleased to see the changes over the past few years that
require audit committee members to be independent board members and
require those members to be reasonably qualified for their
responsibilities.
While audit committees play an important role in the reporting
system, they do not have primary responsibility for appropriate
financial reporting. That duty rests with corporate financial
management, and independent auditors play a critical part as well. But
the audit committee can set an important tone at the top. Audit
committee members also can ask tough questions of management and
outside auditors, and demand answers that are understandable to them.
But even the best audit committee is not going to guarantee that a
financial reporting problem will not occur.
There is one area where I think audit committees can be improved.
That is in the qualifications for membership. While all members are
presently required to be ``financially literate'' and at least one must
have ``accounting or related financial management expertise,'' I
believe those requirements can be clarified and strengthened. At least
a majority of audit committee members should have significant
accounting, auditing, finance, or legal expertise. General management
responsibility without direct involvement in one of those areas should
not be sufficient for those individuals.
Also the person with ``accounting or related financial management
expertise'' should have strong skills in that area. Since the
introduction of the new audit committee membership requirements, it
appears as though there has been only a trickle of new board member
appointments from backgrounds as chief financial officers or
controllers of corporations, or as audit partners from accounting
firms. Making these requirements more stringent could encourage
companies to invite more individuals with CFO/audit partner background
to join their boards. And adding legal expertise to audit committees
could assist committee members in understanding the complex
organizational and transaction structures employed by many companies
today.
Significant accounting, auditing, finance, and legal expertise are
essential prerequisites for members so that the complex issues that may
be presented to them will not intimidate them. Members with such
qualifications are more likely to ask management the probing questions
necessary to ensure an understanding of the substance of the issues
brought to their attention. In particular, members with audit expertise
will be better able to effectively judge the performance of the
internal and outside auditors.
Raising the bar for audit committee membership will not by itself
protect against future Enrons, but it should certainly help improve the
overall quality of financial reporting.
Summary
To summarize, this is a critical time for financial reporting and
the auditing profession. It is important that the issues raised by the
Enron matter and other recent business/accounting/auditing failures be
studied and used to evaluate what changes can be made to improve the
system. However, it is equally important that the baby not be thrown
out with the bathwater. The current system is not foolproof but it
works well in the vast majority of cases. Consideration of changes
should call attention to and build on the strengths of the current
system rather than undermining it. My principal suggestions for
improvement are as follows:
In discharging its important oversight of the effectiveness of
the current system of financial reporting and auditing, Congress
should take care not to become involved in individual technical
accounting issues.
Business executives, outside lawyers, the accounting
profession, and the SEC must work as cooperatively as possible on
both general reporting matters and individual company matters.
The FASB needs to improve its processes in order to resolve
accounting issues much more quickly. This can be done through a
combination of less detailed standards, less concern about
``conceptually pure'' answers in all cases, and additional staff.
An ongoing goal of the FASB should be to lessen the detail of
accounting standards. In return, outside lawyers and accountants
must ensure they balance client advocacy with protection of the
public trust.
The FASB needs to quickly develop better guidelines for when
SPE's should be consolidated and what disclosures about SPE's are
appropriate.
The goal of long-term internationalization of accounting
standards should not diminish in any way the current quality of
reporting in the United States.
Qualifications for audit committee membership should be
further clarified and strengthened.
RESPONSE TO QUESTION RAISED BY SENATOR MILLER FROM DENNIS R.
BERESFORD
Q.1. Mr. Beresford, I asked Mr. Schuetze what would have
happened in the Enron situation if we had had mark-to-market
accounting. You restated my question and answered ``no''
meaning it would not have stopped the Enron situation. Can you
tell me why?
A.1. Enron had to correct its previous financial statements
because of three matters:
Improperly recording notes receivable for the issuance
of Enron stock to special purpose entities (SPE's) as
assets and increases in stockholders' equity.
Failure to consolidate certain SPE's for which ``off
balance sheet financing'' treatment was not permitted under
Generally Accepted Accounting Principles.
Certain other adjustments that Arthur Andersen
previously had permitted Enron not to record because they
were considered immaterial at the time.
These errors do not involve mark-to-market accounting
matters. Mark-to-market generally means that amounts recorded
as assets or liabilities in the balance sheet are adjusted at
the end of each accounting period to the estimated fair value
at that date. The above items were either omitted from Enron's
financial statements or incorrectly shown as assets and equity
rather than being offset.
On the other hand, Enron did use mark-to-market accounting
in connection with its energy and other trading activities. To
the best of my knowledge, no one has suggested that Enron was
not following Generally Accepted Accounting Principles in doing
so, However, I understand that for many of these contracts the
estimates of period end values involved predictions of energy
and other prices several years into the future. While mark-to-
market accounting is considered by many accountants to be the
most relevant way to report contract positions, others point
out that the resulting values may not be very reliable in some
cases.
It appears that Enron's need to correct certain of its
earlier financial statements caused investors, lenders, and
trading partners to lose confidence in the company. This
apparently led to liquidity problems, and the subsequent
bankruptcy, as loans became due earlier than expected. Thus,
accounting errors played an important role in Enron's demise.
However, a greater use of mark-to-market accounting would not
have prevented those particular errors nor provided any
obviously superior information to users of Enron's financial
statements.
This article by Walter P. Schuetze appears in Abacus
A Journal of Accounting, Finance, and Business Studies
Volume 37, Number 1, February 2001, ISSN 0001-3072
Published for the Accounting Foundation, University of Sydney
by Blackwell Publishers
WHAT ARE ASSETS AND LIABILITIES?
Where is True North? (Accounting that My Sister Would Understand)
by Walter P. Schuetze
This is a paper about what I think financial accounting and
reporting ought to look like--about my vision that the singular focus
of financial accounting and reporting should be on cash, that is, cash
itself, contractual claims to cash, things (assets) that can be
converted into cash, and obligations to pay cash, and that assets and
liabilities should be stated at fair value in corporate balance sheets.
I call this formulation True North.
I previously have written about how we should keep financial
accounting and reporting simple. (See, ``Keep It Simple,'' Accounting
Horizons, pp. 113 -117, June 1991.) I also have written about how
assets should be defined for accounting purposes. (See, ``What is an
Asset?'' Accounting Horizons, pp. 66 -70, September 1993.) This piece
builds on those two earlier pieces. This piece deals with definitions
of assets and liabilities that should be recognized (that is,
displayed, shown, or reported) in corporate balance sheets and how the
recognized assets and liabilities should be measured when reported in
those balance sheets.
The rules for financial accounting and reporting in the USA have
become vastly too voluminous, too detailed, too complex, and too
abstruse. At this writing in July 2000, the Financial Accounting
Standards Board has issued 139 Statements on Financial Accounting
Standards (Standards). Public companies in the USA, and foreign
companies whose securities are listed in the USA, must follow the
Standards in the preparation of their financial statements or in the
reconciliation of their home-country financial statements to USA
Standards. Because some of those 139 Standards superseded a prior
Standard, the count of the currently effective Standards is about 100.
In addition to Standards, there is previously issued literature
inherited by the FASB at its formation in 1973 from the American
Institute of Certified Public Accountants, namely, Accounting Research
Bulletins and Accounting Principles Board Opinions. This legacy
literature has the standing and authority of a Standard. The FASB
itself also has issued numerous Interpretations of Standards and also
has issued Technical Bulletins prepared by the FASB's staff. The FASB's
staff also has issued numerous Special Reports dealing with various
accounting matters dealt with in Standards, for example, ``A Guide to
Implementation of Statement 125 on Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities,'' and
guidance for implementation of Statement of Financial Accounting
Standards No. 133, ``Accounting for Derivative Instruments and Hedging
Activities.'' The FASB's Emerging Issues Task Force has issued several
hundred ``consensuses,'' each dealing in extreme detail with quite
specific accounting problems. (The ``Issues Summaries'' for the July
2000 meeting of the Emerging Issues Task Force run to more than 300
typewritten pages, of which many pages are single spaced.)
The American Institute of Certified Public Accountants has issued
numerous Audit and Accounting Guides, Statements of Position, and
Practice Bulletins, with most of these documents having been vetted by
the FASB and its staff prior to the issuance of those documents by the
AICPA. The AICPA also has issued Technical Practice Aids, which are not
vetted by the FASB or its staff prior to issuance.
As well, the Securities and Exchange Commission and its staff have
issued numerous rules, regulations, releases, and bulletins dealing
with financial accounting and reporting.
All of this literature constitutes Generally Accepted Accounting
Principles, which is required accounting by public companies in the
USA. As well, the large public accounting firms have issued their own
guidance or interpretation or ``how to'' guides that instruct the
firms' partners and staff on various FASB, AICPA, and SEC
pronouncements. These firm-prepared documents often run to hundreds of
pages. For example, shortly after the FASB issued Statement 133,
``Accounting for Derivative Instruments and Hedging Activities,'' in
June 1998, itself more than 200 pages in length, several accounting
firms issued their own guidance on how to apply Statement 133, which
guidance constituted more than 400 pages in the case of one firm and
500 pages in the case of another firm. I have all of these documents in
my office, but many are on the floor because my bookcase is full. And
all of this is before mentioning Standards issued by the International
Accounting Standards Committee since its inception in the early 1970's.
The volume and the complexity of those pronouncements have become
overwhelming--on a par with the Internal Revenue Code and the related
Regulations in the USA. The volume and complexity have become too, too
much for: (a) those insiders who are responsible for and prepare
financial statements and reports; (b) those outsiders who audit those
financial statements and reports; (c) those outsiders such as
investors, creditors, underwriters, boards of directors and audit
committees, and analysts, who use those financial statements and
reports; and (d) those outsiders who regulate the preparation, audit,
and dissemination of financial statements and reports.
The hapless user of the financial statements and reports has almost
no grip on the rules governing financial reporting and thus, in many
cases, does not understand the financial statements and reports.
Indeed, in a survey of 140 star, sell-side analysts, Epstein and Palepu
found that, ``Footnotes [where asset and liability recognition and
measurement are described] seem to frustrate analysts the most. When
asked which components of the annual report they often have a hard time
understanding and which they would like explained more, star analysts
rated the footnotes first. Thirty-five percent of the analysts have
difficulty understanding the footnotes, and 55 percent would like
further explanation of the footnotes.'' (See, ``What Financial Analysts
Want,'' by Marc J. Epstein and Krishna G. Palepu, Strategic Finance,
April 1999.) Imagine that. Star, sell-side analysts do not understand
the accounting. Buy-side analysts (institutions) cannot be any better
equipped to understand the accounting. Is it any wonder that the London
School of Business advertises a Financial Seminar for Senior Managers
that enables Senior Managers to ``decode published financial
statements.'' (See, The Economist, November 14, 1998, p. 101.)
Financial analysts are not alone. I was Chief Accountant to the SEC
(January 1992 to March 1995) and was Chief Accountant of the SEC's
Division of Enforcement (mid-November 1997 to mid-February 2000). While
on staff at the Commission, I tried to explain relatively simple
accounting issues and accounting rules to the Commission's legal staff
and its litigators, FBI agents, U.S. Postal Inspectors, and Assistant
U.S. Attorneys in the Department of Justice so that they could bring
and prosecute civil and criminal cases before administrative law
judges, Federal judges, and juries. I had minimal success even on
simple issues. The litigators and prosecutors are very reluctant to
bring accounting fraud cases unless smoking guns are evident, such as,
for example, fake invoices or boxes filled with bricks instead of lap
top computers or incriminating memos.
Financial accounting and reporting should be based on intuition,
not inculcation. There really should be nothing complicated about it.
It is not like medicine. It is not like the law. It is not rocket
science. Ordinary people, chief executive officers, line operating
managers, members of boards of directors, investors and creditors and
regulators, who are not accountants, should be able to look at
financial statements and reports and understand the information
portrayed and conveyed. After all, it is the nonaccountants who use
financial statements and reports to make investment, credit, and
regulatory oversight decisions, not to mention corporate governance
decisions. But ask members of boards of directors, members of audit
committees of boards of directors, members of the investing and credit-
granting public,
financial analysts, and members of regulatory oversight bodies to
explain, in plain English, the meaning of the representations in the
financial statements and reports they use to make decisions and there
is no response. I repeat--there is no response. They must turn to the
accountant to furnish the explanation. The accountant's explanation
turns out to be not in plain English at all but arcane jargon
understandable only to other accountants and not necessarily all other
accountants but only the initiated ones. The much-proclaimed
transparency in corporate financial accounting and reporting in the USA
is in fact a considerable illusion insofar as the numbers (dollar
amounts) in the financial statements and reports are concerned. The
numbers are not very transparent at all. Only accountants know how the
numbers are derived, and sometimes only a very few accountants.
I say again, preparation of financial statements and reports, their
use, and their regulation should be based on intuition, not
inculcation. The way it is now, however, to be fully conversant with
all of the financial accounting and reporting requirements means that
one has to live in a medieval, unheated, stone building in the
Pyrenees, wear a brown robe with a rope belt, a skull cap, and clogs,
and memorize accounting literature (dogma). I recently received a
mailing from the AICPA advertising a 2 day course on Accounting for
Business Combinations at a price of $1,295 or at $1,035 for AICPA
members. Can you believe that? Two days and over a thousand dollars to
learn about one accounting problem.
There are more than 330,000 CPA's in the USA. No more than a few
hundred of them know the workings of the Standards on (1) leases, (2)
foreign currency translation, (3) pensions, (4) post-retirement
benefits other than pensions, (5) interest (whether and when to
capitalize interest cost), (6) deferred income taxes, (7) investments
in debt securities, (8) impairments of carrying amounts of loans
receivable or long-lived operating assets, (9) transfers and servicing
of financial assets and extinguishments of liabilities, and (10)
derivative instruments and hedging activities. Moreover, each one of
these areas has such detailed, complex, abstruse rules that the few
hundred CPA's who are expert in accounting for derivatives often are
not the same few hundred CPA's who are expert in accounting for
pensions. Each monk knows one Book of the Bible.
I liken the use of financial statements and reports to driving an
automobile. Automobiles are powered by internal combustion engines, but
drivers of autos do not need to know anything about what makes the auto
go except that gasoline (or petrol) is necessary and that the engine
oil needs to be replaced occasionally. That is virtually all that I
know about my auto. Comparing accounting to the auto, one needs to be
the equivalent of a mechanical engineer to use and drive the auto
called financial accounting and reporting. We accountants are doing
accounting for accountants' sake, not for use by investors, creditors,
underwriters, analysts, boards of directors, and the regulators who are
the people that we accountants should aim to please.
How overwhelming today's accounting is demonstrated by the response
to a proposal for improving the effectiveness of audit committees. The
Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit
Committees, co-chaired by John Whitehead and Ira Millstein, in one of
its ten recommendations about improving the effectiveness of Audit
Committees, recommended that the Audit Committee, in the annual report
to shareholders, attest that Audit Committee members believe, based on
discussions with management and the external auditor, that the
financial statements conform to Generally Accepted Accounting
Principles. (See, Recommendation 9 of the Report and Recommendations of
the Blue Ribbon Committee on Improving the Effectiveness of Corporate
Audit Committees, issued in 1999, at www.nyse.com.) That recommendation
was soundly rejected by commentators in financial and legal circles. In
response to a reporter, the General Counsel of the Securities and
Exchange Commission said that, ``The reference to Generally Accepted
Accounting Principles has created some fear and confusion because audit
committee members have been concerned that they do not know the
intricacies of the accounting rules. Audit committees understand
accurate, full, and fair disclosure, and that things may not be
materially misleading, but they do not necessarily understand the
nuances of Generally Accepted Accounting Principles.'' (See, The Wall
Street Journal, July 14, 1999, p. C14.) (The SEC, in its new rule on
Audit Committees, did not require that the Audit Committee give the
opinion suggested by the Blue Ribbon Committee. Instead, the SEC
amended its rule to require only that the Audit Committee publicly
state that it reviewed and discussed the audited financial statements
with the auditor and that the Audit Committee recommends the inclusion
of the audited financial statements in the Form 10 -K or 10 -KSB.)
(See, SEC Release 34.42266, December 22, 1999.) The new rule does not
require the Audit Committee to give an opinion about compliance with
Generally Accepted Accounting Principles. In my opinion, most members
of audit committees, if not virtually all members of audit committees,
could not give the opinion suggested by the Blue Ribbon Committee
because the accounting is beyond their ken. Incidentally, I think it is
a fair question to ask: How can boards of directors and audit
committees satisfy their governance responsibilities if they do not
understand the accounting numbers?
I use my sister as a guidepost when I think about accounting
issues. She has no university education. She runs a successful, small
business located near my home town of Comfort, Texas. She prepares
financial statements for her business to run her business and so that
the other owners of the business may see how well the business has done
under her leadership. In the financial statements of her business,
assets are cash, contractual claims to cash, and things that the
business owns and that can be sold for cash--all at fair value, that
is, the amount of cash any of the noncash assets would fetch in an
immediate sale for cash less cost to sell the asset. When she consults
me about the preparation of the financial statements for her business
and I try to explain to her the Standards that we accountants use to
prepare financial statements, her eyes glaze and she blames my
accountababble on my having sat for too long in the hot Texas sun. She
recently bought out one of her competitors and paid about $100,000 in
excess of the fair value of the identifiable net assets acquired. The
competitor agreed not to compete against my sister's business for 5
years. I told her that the $100,000 represented the cost of the
noncompete agreement and purchased goodwill, which, under Generally
Accepted Accounting Principles, should be reported as assets. She
laughed at me. Try to pay salaries, rent, the electric, or dividends
with those assets, she says. That kind of accounting may be okay for
Wall Street but not for Main Street in Comfort, Texas. Moreover, she
says, those so-called assets will not earn a penny. The $100,000 is
gone--irretrievably gone. It is spent money. Whether her business earns
any additional net-after-tax cash flows as a result of buying out her
competitor and getting him to agree not to compete with her business
for 5 years will be decided by the former competitor's customers--
whether they decide to patronize her business and buy her business'
services. She does not control what those potential customers may do.
Not an asset today, she says. Maybe tomorrow, if and when those
customers buy her business' services and generate additional, after-tax
cash for her business. Not a fit and proper asset to be recognized in
advance of sales to customers, however. In short, in accounting
parlance, the $100,000 is a quintessential ``gain contingency'' that
should not be recognized as an asset until it materializes in the form
of cash.
Moreover, there is no over-arching theme to this huge body of
literature governing financial statements and reports to which the
uninitiated, or even the initiated, may refer. The FASB says that the
information in financial statements and reports has to have ``decision
usefulness.'' But the numbers in balance sheets for reported assets and
liabilities are the result of mechanically applying all of the rules
and literature described above without regard to whether the result is
understood by and makes sense to the people who actually use it.
Remember my reference earlier to the findings of Epstein and Palepu
about star, sell-side analysts who do not understand the notes to the
financial statements. As a guide or standard, ``decision usefulness''
is so nonspecific and allows so much judgment and leeway that it is not
helpful. What we need instead is a definition of True North in
accounting. Everyone knows where North lies on a compass, and we can
navigate toward it in our daily journeys in accounting. Decision
usefulness, on the other hand, can lie anywhere on the compass. Under
the current rules, in addition to cash, we have the following as to
assets representing contractual claims to cash:
(a.) Receivables, generally at the amount of cash expected to
be collected and generally not reduced for the time value of
money or otherwise reduced to fair value. This category
includes such items as trade receivables, amounts due to the
reporting enterprise by a counterparty under a currency or
interest rate swap agreement, insurance premiums due from the
owner of an insurance policy, income tax refunds, and amounts
due from vendors/suppliers under cooperative advertising
agreements. Amounts of receivables not yet billed are included
in this category. For example, companies that perform
construction work for the U.S. Government often show ``unbilled
receivables'' as assets on their balance sheets.
(b.) Loans receivable having fixed or determinable amounts.
Examples are commercial or residential mortgage loans and loans
made by banks and insurance companies to individuals as a
result of the individuals' using credit cards to buy goods and
services, to small businesses, and to large commercial
customers, at the present value of the amount of cash expected
to be collected based on the effective interest rate in the
loan. If the carrying amount of a loan is deemed not to be
collectible in full, then the carrying amount of the loan is
reduced to (i) the fair value of any collateral, (ii) the
market price of a similar loan if such a price exists, or (iii)
the revised, expected cash flows reduced for the time value of
money using the interest rate implicit in the loan at its
inception. (The cost of originating loans is added to the
``cost''--cash advanced to the borrower--of the loans.)
(c.) Securities representing an interest in indeterminate
cash flows from ``securitized'' loans receivable, at the fair
value of the security, with changes in that fair value being
recognized (i) in income by traders such as broker-dealers and
some banks and (ii) in shareholders' equity (net assets) by
other holders such as banks if the security is classified as
``available for sale.'' Classification of such a security as
``held to maturity'' by the owner would have the security being
reported at historical cost. These kinds of securities arise in
transactions where the originator of loans, such as mortgage
loans and automobile loans, sells tranches of the loan
portfolio to investors such as insurance companies, mutual
funds, and trusts administered by banks.
(d.) Securities representing contractual, fixed, or
determinable cash flows, such as bonds, based on fair value or
historical cost of the security.
(e.) Refundable cash deposits, such as the portion of an
insurance premium that would be recaptured if the policy were
cancelled.
As to assets such as inventory, land, plant, equipment, and patents
(sometimes called ``nonmonetary items'') that are not cash and claims
to cash, we have the following:
(f.) The amount of cash paid, at some time in the past, for
an item other than cash or a claim to cash plus related
expenditures, which is called ``historical cost.'' For example,
the amount of cash paid for land plus brokers' fees, legal
fees, appraisal fees, documentary fees, and other fees
applicable to the acquisition of the land. These fees could be
material in relation to the cash price paid for the land. Other
examples include amounts of cash paid for such things as plant,
equipment, copyrights, patents, and TV or radio broadcasting
rights. The amount of cash paid--the cost--is reduced by
periodic charges made to income so as to allocate the cost to
periodic income on what is said to be a rational and systematic
basis.
(g.) The portion of a lump-sum purchase price paid for two or
more assets acquired together, as, for example, in a business
combination, that is allocated to one of the assets acquired,
which amount generally would be the fair value of the asset.
For example, the amount of cost allocated to land acquired in a
business combination would be the fair value of the land but
would not include the various fees described in (f ) above.
(h.) The fair value of an asset at the time it was received
by the reporting enterprise in return for the issuance of a
debt or equity instrument, also said to be ``historical cost''
of the asset--for example, the fair value of land contributed
to the reporting enterprise in exchange for stock. If, however,
the land is contributed to the reporting enterprise by a
promoter or controlling shareholder, then the cost to the
reporting enterprise is not the fair value of the land but
instead is the historical cost of the land to the contributor
(an SEC rule). (Note that the ``historical cost'' of land under
f, g, or h could be three different, possibly materially
different, amounts for the same parcel of land.)
(i.) Net realizable value, the amount of proceeds expected on
sale of an asset such as work-in-process or finished goods less
cost to complete and cost to sell.
( j.) Current market prices in the case of certain equity
securities but not others such as when the owner of the equity
security is said to have significant influence but not control
of the investee in which case the so-called equity method of
accounting is required (See k.).
(k.) Historical cost of certain equity securities plus the
arithmetic share of the investee's earnings and other changes
in the investee's net assets said to be attributable to the
investor (accounting by formula).
(l.) Fair value of assets at the date of the write-down of
the carrying amount of those assets whose carrying amount was
deemed to be impaired, which carrying amount after the write-
down is then said to be ``new historical cost.''
(m.) Fair value of exchange-traded and over-the-counter
derivative contracts having a positive value.
(n.) Deferred income taxes, which are solely the result of
computations done only by accountants, reduced, in some cases,
by an allowance, the need for and amount of which is determined
solely by management based on its judgment.
(o.) Valuation allowances for certain assets, some allowances
involving discounting, such as allowances for losses on
individual loans where the discount rate is the rate of
interest inherent in the loan when it was originated, and some
allowances involving no discounting such as allowances for
deferred tax assets and allowances for loan losses that are
said to relate to portfolios of loans instead of individual
loans. The amounts of these allowances are determined solely by
management based on its judgment.
(p.) The amount of cash paid for certain services to be
received in the future such as advertising (prepaid
advertising), placement of a manufacturer's product on shelves
in grocery stores (slotting fees), and cash advances to writers
for books or movies to be written or scripted, at the amount of
cash paid reduced by periodic charges made to income to
allocate to income the amount paid on what is said to be a
rational and systematic basis.
(q.) The right, perhaps through a so-called barter exchange
or by use of barter credits issued by a barter exchange, to buy
goods or services at a price less than the posted price or rack
price. Examples are advertising space, radio or TV time, or
hotel ``nights.'' Such rights also arise when vendors agree
that customers may, based on the volume of their prior
purchases, buy goods or services in the future at a discount
from the posted price. (Do you have credits for airline miles
that you have earned that you can use for upgrades to first
class or for free tickets?) Some people believe that such a
right or credit is a future economic benefit that should be
recognized as an asset. Let me illustrate with an example.
Suppose I buy groceries from the nearby supermarket. The bill
is $42.00. When the cashier checks me out and gives me my
receipt, the cashier also gives me a coupon that allows me to
buy a bottle of 100 aspirin tablets at $5.75 instead of the
shelf price of $6.75. The price reduction of a purchase in the
future of a bottle of aspirin tablets at $5.75 instead of $6.75
is, in the minds of some, a future economic benefit that should
be recognized as an asset under today's Generally Accepted
Accounting Principles--recognized as an asset by allocating a
portion of the $42.00 to the ``value'' of the coupon, I
suppose. I am not making this up. But that is the kind of goofy
answer that one can get under today's accounting for ``future
economic benefits.'' (More on ``future economic benefits''
later.) My sister would shake her head in disbelief.
(r.) The amount of cash paid for certain things that only
accountants call assets, for example, the cost incurred by
banks to originate loans receivable, the cost incurred by
insurers to originate certain types of insurance policies, the
cost of so-called direct-response advertising, interest cost,
and finally, the cost of purchased goodwill. (At this writing,
some commentators are urging the FASB to rescind FASB Statement
2 (and Interpretation 4 thereof) which requires that the cost
of R&D be charged to expense when incurred: Those commentators
would have corporations recognize as an asset some or all of
its R&D expenditures.)
(s.) And last, some items that are solely the result of
computations done only by accountants, such as amounts produced
by applying the Standards related to pensions and deferred
income taxes.
As to liabilities, under the current rules, some amounts are:
(i) What is to be paid in cash to vendors (accounts payable),
to employees (wages payable), to counterparties under
derivative contracts, to owners (dividends declared and
payable), and to taxing authorities, sometimes based on tax
returns as filed and sometimes based on what management of the
enterprise says will be the final tax payable after negotiation
or litigation with taxing authorities.
(ii) Proceeds of borrowings.
(iii) Refundable cash collected from customers in advance of
delivery of goods or services to those customers.
(iv) Deferred or unearned revenue, which is an amount
representing cash collected from a counterparty in return for
services to be rendered, reduced by credits to earned revenue
that are determined based on services rendered or on what is
said to be a systematic and rational basis.
(v) Manditorily redeemable stocks generally measured at the
redemption amount (an SEC rule, not a Standards rule).
(vi) A calculated amount for promises to repair or replace
faulty product.
(vii) Fair value of exchange-traded and over-the-counter
derivative contracts having a negative value.
(viii) Deferred income taxes, which are based solely on
computations done only by accountants.
(ix) Whatever management of the reporting enterprise says
will be a cash outflow in the future in respect of
noncontractual bonuses to employees, ``restructurings,'' plant
closings, or similar events.
(x) And last, a calculated amount for pensions and post-
retirement benefits other than pensions.
The preceding discussion about various assets and liabilities
assumes that the U.S. dollar is the unit of measure in the financial
statements. If the unit of measure is not the U.S. dollar but a foreign
currency, then another complexity is added in that the foreign currency
amounts, determined using U.S. Generally Accepted Accounting
Principles, would be ``translated'' into U.S. dollars using the current
exchange rate. This procedure produces different ``historical cost''
amounts for identical assets if there has been a change in exchange
rates between the time the assets were acquired and the date of the
balance sheet: For example, three identical IBM computers, bought at
the same time for the same price and located in three different
countries, say Canada, Mexico, and the USA would be shown at three
different historical cost amounts in the balance sheet.
Then because all of these amounts are expressed in Arabic numbers,
we add them up as if they were cut from the same bolt of cloth and call
them ``total assets'' and ``total liabilities.'' And reporting services
such as Moodys', Standard & Poors, and Value Line and analysts and
investors compute and use things like return on assets and return on
equity based on this potpourri of numbers.
What a cacophony! What the user of the financial statements hears
is nothing but noise. It is as if each musician in the orchestra is
playing from his or her self-selected sheet of music, one of the Three
Tenors is singing in Italian, the second in German, and the third in
French, all without a conductor.
How did all of this happen? Well, its origin lies mainly in the
fact that the staff of the SEC, in its early days (and lately as well),
would not accept write ups of assets to fair value, and did not require
writedowns to fair value except in extreme cases, because it thought
the fair value numbers were too soft. Because we accountants were told
by the SEC that we could not put current fair values in balance sheets
but instead had to use historical cost, we accountants set about to try
to make income the right number. Since the 1930's when our Federal
securities laws were enacted, we have been trying to recognize,
measure, and present income as opposed to assets and liabilities or net
assets. In trying to get the right income number, we often put debits
and credits on the balance sheet so as not to ``distort'' income. So as
to time the recognition of these debits and credits in income when the
time is thought to be ``right'' or based on management's intent. It is
as if the balance sheet is a holding pen for expenditures to be
released to expense sometime in the future when the time is right.
(Visualize a pen full of sheep awaiting their turn to be sheared.) We
defer costs on the balance sheet and try to attach them or match them
with revenue or allocate them to income on a causal basis or what is
said to be a systematic and rational basis. We use different inventory
costing methods--average cost, first in, first out, and last in, first
out. A reporting enterprise may use almost any inventory costing method
except what is called ``base stock.'' On occasion, we see companies
changing from one acceptable inventory cost method to another. Methods
of calculating depreciation, depletion, and amortization expense run
from accelerated methods to straight line to units of production. We
often see changes in method. Estimated useful lives and salvage values
or end values of the same kinds of fixed assets can vary significantly
from company to company. Whether the carrying amounts of fixed assets
are impaired is a judgment by management, for it is management that
estimates the future cash flows from the asset in making the assessment
about impairment. None of these deferrals, allocations, estimates of
future cash flows, or formula-driven amounts can be verified or
authenticated by reference to an actual phenomenon in the marketplace.
Most of this accounting is, in the end, highly judgmental. This
accounting is what I call ``feel good'' accounting. The AICPA's
Committee on Accounting Procedure (1939 -1959) promulgated accounting
rules designed to get income to be the correct number, through ``feel
good'' accounting. That is, we like the financial statement results
even though we may not be able to articulate why the results are what
they are except by referring to the manner in which the amounts were
determined. The accounting results, in many cases, cannot be audited or
verified or authenticated by reference to any evidential matter coming
from an outside source, but somehow we feel good about the numbers. An
extreme example of feel good accounting is from the Committee on
Accounting Procedure in Chapter 10 of the Accounting Research Bulletin
No. 43, ``Taxes: Section A, Real and Personal Property Taxes,''
paragraphs 10 -13, which reads as follows:
``10. In practice, real and personal property taxes have been
charged against the income of various periods, as indicated
below:
(a.) Year in which paid (cash basis).
(b.) Year ending on assessment (or lien) date.
(c.) Year beginning on assessment (or lien) date.
(d.) Calendar or fiscal year of taxpayer prior to assessment
(or lien) date.
(e.) Calendar or fiscal year of taxpayer including assessment
(or lien) date.
(f.) Calendar or fiscal year of taxpayer prior to payment
date.
(g.) Fiscal year of governing body levying the tax.
(h.) Year appearing on tax bill.
``11. Some of these periods may coincide, as when the fiscal
year of the taxing body and that of the taxing payer are the
same. The charge to income is sometimes made in full at one
time, sometimes ratably on a monthly basis, sometimes on the
basis of prior estimates, adjusted during or after the period.
``12. The various periods mentioned represent varying degrees
of conservatism in accrual accounting. Some justification may
be found for each usage, but all the circumstances relating to
a particular tax must be considered before a satisfactory
conclusion is reached.
``13. Consistency of application from year to year is the
important consideration and selection of any of the periods
mentioned is matter for individual judgment.''
The best way to sum up all of those alternatives of how to account
for property taxes is to say that the accounting is whatever makes us
feel good.
The AICPA's Accounting Principles Board (1959 -1973) also issued
feel good accounting rules; witness pooling-of-interest accounting and
amortization of the cost of purchased goodwill over 40 years. To a
large extent the FASB is doing the same; witness gains and losses on
derivative contracts not being entered into earnings until the time is
right; witness deferred gains and losses under pension accounting;
witness the manner in which the carrying amount of fixed assets is to
be assessed for impairment by reference to management's estimate of
future cash flows from the asset instead of the fair value of the
asset; witness the judgmental nature by which valuation allowances for
loans receivable and deferred income tax assets are determined. Feel
good accounting rules can be set only by and through a political
process, that is, who has the most votes or who can shout the loudest.
Feel good accounting produces numbers for noncash assets and
liabilities that are the result of keeping income smooth or steady, or
better yet, steadily increasing, but smoothly. To take what otherwise
would be variable, lumpy earnings and smooth the earnings. (Visualize a
huge, yellow Caterpillar bulldozer pushing the hills of economic change
into the valleys of economic change.)
The FASB has been in business since 1973. The FASB said, in its
Concepts Statement 3, issued in 1980, that it ``. . . expects most
assets and liabilities in present practice to continue to qualify under
the definition in [Concepts Statement 3].'' These words were carried
forward by the FASB in Concepts 6 issued in 1985. (See, paragraphs 170
and 177 of Concepts Statement 6.) The Board in Concepts Statements 3
and 6 thus blessed--and poured into concrete--what was practice in the
early to mid-1980's, which practice continues in large measure today in
2000 in the USA. Unless the FASB changes its Conceptual Framework or
unless the FASB itself is changed, there will not be much movement away
from feel good accounting. The question arises: Is it time to start
thinking about changing the FASB?
Today, most articulated definitions of an asset refer to ``economic
benefit'' or ``future economic benefit'' or ``probable future economic
benefit.'' For example, the FASB's definition is ``probable future
economic benefit.'' The full definition of assets from the FASB's
Concepts Statement 3, which originally was issued in 1980 and which now
is included in paragraph 25 of Concepts Statement 6, is as follows:
``Assets are probable future economic benefits obtained or controlled
by a particular entity as a result of past transactions or events.'' In
paragraph 26 of Concepts Statement 6, the FASB lists three essential
characteristics of an asset, as follows: `` (a) it [an asset] embodies
a probable future benefit that involves a capacity, singly or in
combination with other assets, to contribute directly or indirectly to
future net cash inflows, (b) a particular entity can obtain the benefit
and control others access to it, and (c) the transaction or other event
giving rise to the entity's right to or control of the benefit has
already occurred.'' The FASB goes on, in the same paragraph of Concepts
Statement 6, to say: ``Assets commonly have other features that help
identify them--for example, assets may be acquired at a cost and they
may be tangible, exchangeable, or legally enforceable. However, these
features are not essential characteristics of assets. Their absence, by
itself, is not sufficient to preclude an item's qualifying as an asset.
That is, assets may be acquired without cost, they may be intangible,
and although not exchangeable they may be usable by the entity in
producing or in distributing other goods or services. . . .'' THAT IS
MIND- BOGGLING STUFF. I can tell you from experience that most
accountants that I know do not understand the FASB's definition of
assets. Ordinary folk--investors, creditors, analysts, underwriters,
CEO's, line managers, members of boards of directors, and audit
committees, journalists, judges, and juries--are mystified by that
babble. (That is one reason why I no longer tell people at dinner
parties that I am an accountant. When I do, they appear to feel sorry
for me, avert their eyes, and silently hope that the hostess has seated
all the accountants together at one table away from the other folk.)
The FASB's definition of an asset is so complex, so abstract, so
open-ended, so all-inclusive, and so vague that we cannot use it to
solve problems. It does not require exchangeability of that which is
called an asset; therefore, it allows all expenditures to be considered
for inclusion as assets. The definition does not discriminate and help
us to decide whether something or anything on the margin is an asset.
That definition describes an empty box. A large empty box. A large
empty box with sideboards. Almost everything or anything can be fit
into it. The FASB, in its September 7, 1999 exposure draft on
accounting for Business Combinations and Intangible Assets, is even
proposing to put the cost of purchased goodwill into that box. The five
FASB members who assented to the publication of that exposure draft
believe that the cost of goodwill is an asset. The two dissenters, who
dissent for reasons unrelated to the initial accounting for the cost of
purchased goodwill at the date of the business combination, in obiter
dictum, say that they too think that the cost of purchased goodwill is
an asset. A very large box indeed!
I have seen numerous situations at the SEC, particularly in
litigated enforcement cases, where there are long-winded briefs by
issuer-registrants, their independent auditors, and their expert
witnesses, quoting extensively from the FASB's Concepts Statement 6 to
support a debit balance in the balance sheet as a fit and proper asset,
fully meeting the FASB's definition of an asset. One sees similar,
long-winded briefs in private, civil litigation. In that litigation,
both sides, both the defendant and the plaintiff, and all of their
expert witnesses, are citing the very same passages from the FASB's
Concepts Statement 6 in support of their positions regarding the
worthiness or unworthiness of a debit balance in a balance sheet as an
asset. What we have, then, in the lawyers' words, are teams of swearing
accountants--one swearing ``thus and so'' and another swearing ``such
and that,'' both invoking the same words in the same literature--and
they cannot resolve what should be a simple question: Whether something
is an asset.
What generally happens in practice under the FASB's definition of
an asset is that assets are not recognized in the balance sheet unless
the reporting enterprise acquires them by paying cash or agreeing to
pay cash in the future, or someone contributes something to the
reporting enterprise in return for a debt or equity security issued by
the enterprise. Then an asset is said to have a cost. In fact,
accountants sometimes think of the asset and talk about it in terms of
its cost, not in terms of the asset itself or the future benefit that
may flow from it. That is, the asset is the cost, and the cost is the
asset. For example, if an enterprise discovers something of value, say,
oil or gold, we do not recognize it as an asset because the enterprise
has no cost in that something. When the FASB proposed sometime ago that
business enterprises recognize as assets things received from others in
a so-called nonreciprocal exchange, for example, land received from a
government, some accountants objected. One of the reasons for the
objection was that the enterprise receiving the asset had no cost in
the asset. I refer to this phenomenon as the cost-per-se-is-the-asset
syndrome.
I will cite some examples of costs equal assets. (I am aware that
the FASB has said in paragraph 179 of Concepts Statement 6 that costs
are not themselves assets. In my experience, however, most preparers
and auditors of financial statements continue to equate costs with
assets in their conversations and in the way they prepare and audit
financial statements. After all, the FASB said in Concepts Statement 3
and 6 that then ``present practice'' would continue, and in that
practice costs equal assets.) The AICPA's Accounting Standards
Executive Committee, without objection from the FASB, issued a
Statement of Position entitled ``Reporting on Advertising Costs'' that
says so-called direct-response advertising costs are to be reported as
assets if the advertising activity results in probable future economic
benefits. Thus, the cost is the asset. In oil and gas accounting,
either successful efforts as described by the FASB in FASB Statement 19
or full cost as described by the SEC in Regulation S-X, the asset
represented in the balance sheet is the cost of finding the oil and gas
reserves, not the value of the reserves themselves at time of discovery
or anytime thereafter. In FASB Statement 34, interest cost is an asset.
In FASB Statement 60, the cost of issuing insurance contracts is an
asset. In FASB Statement 86, the asset is the cost of developing
computer software, not the future benefit that will flow from the
software. In Accounting Principles Board Opinion 21, the cost of
raising debt finance is an asset, a ``deferred charge.'' And finally,
in APB Opinion 16 and in the FASB's September 1999 exposure draft
dealing with Business Combinations and Intangible Assets, the cost that
is left over in a business combination after the purchase price is
allocated to the identifiable assets and liabilities is an asset; it is
called cost of acquisition in excess of the fair value of net assets
acquired, or cost of purchased goodwill. (In a letter dated June 15,
2000 to the FASB commenting on the FASB's September 1999 exposure draft
on accounting for ``Business Combinations and Intangible Assets,'' I
call it a glob.) Along this same line, the International Accounting
Standards Committee says that development costs, the ``D'' in ``R&D,''
may be recognized as an asset under certain conditions. In all of these
cases, it is the cost itself that is identified as the asset, not the
probable future economic benefit. It is this same line of reasoning,
that a cost can be an asset, that leads some people to suggest that the
FASB should reconsider FASB Statement 2 and allow for recognition of
research and development costs as an asset.
Generally, when assets are acquired for cash, the fair value of the
assets acquired, or the future economic benefit, is approximately equal
to the cash paid (laying aside the difference between bid and ask
prices and costs of actually buying assets, such as brokers' fees.) So
at least at the date of acquisition of the asset, cost equals fair
value and future economic benefit. (We all know that, soon after the
acquisition of an asset, say, land, cost, and fair value begin to
diverge and often become quite far apart.) The cost of many assets
recognized under the FASB's definition does not, at the time of
acquisition, represent anything close to the ``probable future economic
benefit'' to be derived from the asset. For example, the probable
future economic benefit of a successful, direct-response advertising
campaign may be many multiples of the cost. The cost of prepaid
advertising or direct response advertising only by chance will be equal
to the present value of increased net cash flows that may result
because of the advertising. The future economic benefit of a discovery
of mineral deposits generally bears no relationship whatsoever to the
cost of finding the deposits. The future economic benefits of a
successful research and development project also bear little or no
relationship to the cost incurred.
Defining an asset as a probable future economic benefit is to use a
high-order abstraction. Under such an approach, if an enterprise owns a
truck, the truck per se is not the asset. The asset is the future
economic benefit, that is, the present value of the cash flows that
will come from using the truck to haul lumber, or coal, or bread. Yet,
in today's practice, the asset represented on the balance sheet is a
truck. Readers of the financial statements see the asset as a truck.
The readers do not see it as the economic benefit that will come from
using the truck to haul lumber. I think most people, even most
accountants, think of the asset as a truck instead of an abstraction,
instead of the present value of future cash flows, or the future
economic benefit, to be derived from using the truck to haul lumber.
I think that we should account for real things such as trucks, not
abstract future economic benefits. I suggest that we adopt a different
definition of an asset. A simple one. One that is not a large empty
box. One that is not a high-order abstraction. I suggest that we adopt
the following definition: ``Cash, contractual claims to cash, things
that can be exchanged for cash, and derivative contracts having a
positive value to the holder thereof.''
My definition would comprehend only real things, not abstractions.
Real things such as trucks can be sold for cash. Real things can be
pledged as collateral for a borrowing of cash. Real things can be given
to charity. Exchange-traded derivative contracts having a positive
value can be closed out for cash. The positive value of an over-the-
counter derivative contract can be turned into cash by entering into an
equal and offsetting contract. Abstract probable future economic
benefits cannot be sold, pledged, or given to charity. My definition
would not accept a cost as being an asset. A critical feature in my
definition is exchangeability of the asset, which is explicitly not a
feature of the FASB's definition of an asset. (See, FASB's Concepts
Statement 6, paragraph 26.)
Let me list a few of the things my definition would include.
Obviously, cash. Obviously, claims to cash such as trade receivables,
loans receivable, demand deposits at banks, certificates of deposit,
cash surrender value of life insurance policies, bills, notes, and
bonds issued by governments, corporations, partnerships, individuals,
and trusts. Cash paid in advance for the future use of land and
buildings would be included as an asset if the cash could be recaptured
from the lessor by the lessee at its option. That definition would
include raw materials, finished goods, common stocks issued by other
enterprises, land, buildings, equipment, mineral deposits, air rights,
water rights, broadcast rights, patents, and copyrights. Work-in-
process inventory and fixed assets in the process of construction might
be included if they can be sold for cash in their present condition or
state. Growing crops would be excluded because a crop generally cannot
be sold separately from the land, but the value of the growing crop
would increase the fair value of the land, which can be sold. Also
included would be futures, forward, option, swap, and swaption
contracts having a positive value; exchange-traded derivative contracts
can be closed out with the receipt of cash, and over-the-counter
derivative contracts can be offset with equal and opposite contracts
thereby producing cash.
Let me list some of the things that would be excluded: Any cost as
such, such as preopening costs, debt issue costs, interest cost, and
advertising cost. Costs of opening new stores or branches. Employee
training costs. Costs of restructuring a business. Assets that arise in
proportional consolidation, such as 33\1/3\ percent of cash or accounts
receivable or plant held by a joint venture in which venture the
reporting enterprise has a one-third interest would be excluded. (The
one-third interest in the joint venture itself would, however, be an
asset.) Receivables sold with or without recourse and thus owned and
controlled by another enterprise would be excluded because the
receivables were sold and are not owned by the seller and cannot be
sold again by the seller. Assets owned by others and leased by the
reporting enterprise would be excluded for the same reason unless the
lease itself were transferable either directly or through a sublease
and had a positive value. ``Prepaid advertising'' would be excluded
unless the advertiser could get back its money at its option or could
sell the advertising space, say, a billboard or an appearance on
someone else's web site. Costs of R&D or only D would not be an asset.
Nor would so-called deferred tax assets be assets. Cost of purchased
goodwill, or any other goodwill, would be excluded. It is significant
to note, in that regard, that the Association for Investment Management
and Research, which represents stock analysts in the USA, has
recommended that the cost of purchased goodwill not be recognized as an
asset. (See, Financial Reporting in the 1990's and Beyond, Association
for Investment Management and Research, 1993, pp. 48 and 49 and AIMR's
letter to the FASB dated December 7, 1999, which is AIMR's response to
the FASB's exposure draft on ``Business Combinations and Intangible
Assets.'')
The use of my definition of an asset would vastly simplify the
practice of accounting. Vastly simplify financial accounting and
reporting. I believe that it would appeal to investors, creditors, and
other users of financial statements. I think that the results of
applying my definition would appeal to ordinary men and women who walk
up and down Main Street in the USA, and those who walk up and down Main
Street in other countries as well. They would understand the result. My
sister would understand the result. I think that ordinary people who
are not accountants think that when they see an asset on a balance
sheet that the asset is something real, and that the dollar amount
associated with the asset represents value, that is, that the asset can
be exchanged for cash for approximately the dollar amount at which the
asset is represented in the balance sheet. That the asset can be
pledged as collateral for a borrowing. That the asset may be given to
the Red Cross. Accounting should not be done for the benefit of
accountants. Accounting should result in the financial statements and
reports that ordinary people can understand and therefore be able to
use to make investment and credit decisions and regulatory oversight
decisions.
Accountants could use my definition as a working tool. They could
use it to identify things to be reported as assets on balance sheets.
They could use it to identify, through exclusion, things not to be
reported as assets on balance sheets, which is not possible today. We
would dispense with all of the long-winded, legal briefs about the
fitness of debit balances as assets and the teams of swearing
accountants. Assets would be real things. Exchangeable things. Defining
assets as real things, and reporting those real things at their fair
value, would make balance sheets rock solid and less prone to challenge
and thereby reduce litigation against companies and their auditors.
Would make balance sheets relevant, living documents instead of what
they are now--dimly lit basement parking garages for collections of
antique costs. Assessing and auditing the recoverability or impairment
of something that is just a cost, a cost not associated with a real
thing, is more than hard; it is impossible. One cannot look to the
marketplace and find the value of a cost. All that the auditor can do
is look at numbers that management puts on a sheet of paper or a
computer monitor about how management believes that cost will be
recovered. That is not gathering competent, evidential matter. That is
not auditing. If an auditor is allowed to accept management's assertion
about the value of that which is reported as an asset instead of having
to find competent, evidential matter from sources outside the reporting
enterprise to support that value, then audits have no purpose or worth.
Scrap audits and save the costs of audits.
I repeat, the definition of an asset that is in use today is too
inclusive, overly complex, and vague. It does not work. I suggest that
standard setters take another look at the definition and include the
feature of exchangeability.
The FASB's definition of a liability suffers from a similar
infirmity as its definition of an asset. The FASB says in Concepts
Statement 6, paragraph 35, that, ``Liabilities are probable future
sacrifices of economic benefits arising from present obligations of a
particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events.''
Footnote 22 expands on those words in the definition as follows:
``Obligations in the definition is broader than legal obligations. It
is used with its usual general meaning to refer to duties imposed
legally or socially; to that which one is bound to do by contract,
promise, moral responsibility, and so forth (Webster's New World
Dictionary, p. 981). And it includes equitable and constructive
obligations, as well as legal obligations (pars. 37-40).''
Most people know what a legal obligation is. But most people do not
know what an equitable or constructive obligation is, or what an
obligation arising from moral responsibility is. Even the FASB does not
know, for it has not articulated what those obligations are and what
their characteristics are so that we can recognize them when we see
them. Therefore, every time the FASB wants to require some accounting
because of what the FASB sees as an equitable or constructive
obligation, or what an obligation arising from a moral responsibility
is, the FASB has to write a detailed rule for accountants to use in
drawing up financial statements. Look, for example, at our accounting
in the USA for workers' pension benefits. Long before any benefit is
vested in the employee, the FASB instructs us to recognize a pension
liability. The idea is that the workers are earning the pension benefit
over time and a liability for an equitable or constructive obligation
should be recognized prior to vesting of the benefits. But only the
FASB knows what that equitable or constructive obligation is, how it is
defined, when it should be recognized, and how it should be measured.
The ensuing liability number, computed as per the FASB's formula,
cannot be audited or verified except by checking the calculation, which
is no audit at all. A perfect example of feel good accounting.
Yet another example of feel good accounting is a recent phenomenon
in the USA, dating from the late 1980's and early 1990's. That is the
accounting for so-called restructurings. The FASB's Emerging Issues
Task Force, in Consensuses 94-3 and 95-3, said that it is OK to
recognize a liability to pay termination bonuses or stay bonuses to
workers that will be discharged before the workers' rights to that
bonus are vested. EITF 94-3 and 95-3 are the ultimate in feel good
accounting. Management of the enterprise recognizes a liability if it
says that it will make future expenditures although there is no
requirement for those expenditures to be made; in fact those
expenditures may be avoided at will. The rationale is that management
creates, by its proclamation to make the expenditures, a constructive
or equitable obligation. If management does not make a proclamation
about future expenditures for termination bonuses or stay bonuses but
simply lays off workers and pays the workers termination bonuses in the
ordinary course of business, then there apparently is no constructive
or equitable obligation in advance of the cash disbursement to the
terminated employee. I wonder, how loud must management's proclamation
be in order to create an accounting liability?
The FASB's definition of a liability is as infirm as its definition
of an asset. We cannot solve the question, at the margin, of what is
and what is not a liability because the definition is so open-ended.
I suggest that we define liabilities by reference to future cash
outflows required by negotiable instruments, by contracts, by law or by
regulation, by court-entered judgments or agreements with claimants,
and derivative contracts having a negative value. I think that a
liability recognizable for accounting purposes should be one of the
following:
1. A future cash outflow required by a negotiable instrument,
such as a recourse promissory note, issued by the reporting
enterprise, and accrued interest thereon. (The unpaid amount of
a nonrecourse note secured only by a specific asset would be
netted against the fair value of the asset for it is only the
net amount of cash that the owner could get on sale of the
asset. If the amount of unpaid debt exceeds the fair value of
the asset, there is no liability to report because the future
cash outflows related to the debt maybe avoided at will by
walking away from an asset having a net value of zero.)
2. A future cash outflow required by the terms of a contract
under which the counterparty has completed his/her/its
obligations. Examples are: (a) accounts payable to suppliers of
goods, which goods have been delivered to and accepted by the
reporting enterprise, (b) accounts payable to suppliers of
services where the counterparty has performed according to the
terms of the contract, (c) salaries and wages for work done by
employees, (d) deposit accounts of banks and thrifts, (e) death
benefits payable to beneficiaries under life insurance policies
as a result of the insured's death (not an actuarially
determined amount but the actual amount payable to the owner's
estate or to other beneficiaries), (f ) vested pension benefits
as to working and retired employees in excess of the fair value
of any pension plan assets held by trustees, which assets may
be used to pay only pension benefits, (g) amounts payable to
counterparties under derivative contracts, (h) outstanding
stock of the reporting enterprise, which stock must, by its
terms, be redeemed for cash by the reporting enterprise
(manditorily redeemable stock), and (i) future ``dividends'' on
issued and outstanding stock that unconditionally must be paid
in cash by the reporting enterprise, including cumulative
dividends on so-called perpetual preferred stock.
3. A future cash outflow required by a contract at the option
of the counterparty. Examples are: (a) sales returns by
customers, (b) warranties related to defective product (in
which case the cash outflow may be for parts and labor to fix
the product), (c) cash surrender value of life insurance
contracts issued (not an actuarially determined amount but the
actual amount refundable to owners of the policies at the
owners' requests), (d) refundable portion of magazine
subscriptions, (e) refundable portion of fire, flood, and other
casualty insurance premiums, (f ) refundable portion of cash
collected in advance from a counterparty prior to the reporting
enterprise's having delivered goods or services to the
counterparty, as to which amount the counterparty would have an
enforceable claim if the reporting enterprise fails to deliver
the goods or services, (g) claims payable to insureds under
various kinds of insurance policies.
4. A future cash out flow required by a Federal, State, or
local law or regulation. Examples are: (a) amounts withheld
from employees' salaries to be remitted to a governmental body
by the reporting enterprise, (b) sales tax, value-added tax, or
similar tax collected by the reporting enterprise from its
customers to be remitted to a governmental body by the
reporting enterprise, (c) tax based on taxable income or
taxable capital of the reporting enterprise (the amount is to
be determined by reference to the tax return filed or to be
filed, not some greater or lesser amount to take into account
contestable or negotiable matters), (d) decommissioning of
nuclear plants, and (e) remediation of contaminated water or
ground.
5. A future cash outflow that would be required on default or
rescission of an executory contract that is unperformed as to
both counterparties. Examples of executory contracts are those
for the use of property (leases) and those to acquire property
(inventory purchases).
6. Derivative contracts (futures, forwards, options, swaps,
and swaptions) having a negative value over and above the
amount of cash currently payable, which is included in 2(g)
above.
7. A future cash outflow required by a court-entered judgment
or an agreement with a claimant. An example is a future cash
outflow to an employee or an outsider as a result of a claim
relating to a bodily injury.
Under the above definition of a recognizable liability, a
proclamation by management that it intends to make certain future cash
disbursements, no matter how loud that proclamation, would not qualify
as a recognizable liability. For example, a proclaimed intention to pay
year-end cash bonuses to employees would not be a recognizable
liability if management may change its mind and not pay the bonuses and
if no law or regulation requires that the bonuses be paid. An announced
intention to pay termination bonuses, or stay bonuses, to employees who
eventually may be terminated pursuant to a ``restructuring'' also would
not be a recognizable liability if no contract or law or regulation
requires the enterprise to terminate the employees and pay the
termination bonuses. An announced intention to spend more money than is
required by law to remediate contaminated ground would not be a
recognizable liability for the expenditure may be avoided at will
without penalty.
No ``reserve'' or ``valuation allowance'' or ``provision'' of any
kind would be a recognizable liability or an offset to any asset
amount. Journalists, judges, and other ordinary folk think that
``reserves'' or ``provisions'' are vessels containing green money. This
is evident from reading The Wall Street Journal, The New York Times,
legal briefs, and court opinions. We need to get rid of the terms
``reserves'' and ``provisions.''
Computed amounts would not be recognizable liabilities under the
definition, for example, deferred tax liabilities, actuarially
determined amounts of pension benefits to be paid to working and
retired employees, and actuarially determined amounts payable to owners
of life insurance policies or the beneficiaries of the policies.
As I define assets to be recognized in balance sheets, they are the
reporting enterprise's cash, claims to cash, and other things that are
owned by the reporting enterprise and are exchangeable for cash. As I
define liabilities to be recognized in balance sheets, they are the
reporting enterprise's future cash outflows. All recognized assets and
liabilities would be reported at fair value. True North.
``Fair value'' of course needs to be defined. The FASB's definition
of the fair value of an asset is as follows, from paragraph 7 of FASB
Statement 121: ``The fair value of an asset is the amount at which the
asset could be bought or sold in a current transaction between willing
parties, that is, other than a forced or liquidation sale.'' (The
definition of fair value for a financial instrument in FASB Statement
107 is, except for a minor wording difference, the same as in FASB
Statement 121.) That definition does not work very well. Owners of
assets often contend that they would not be willing sellers at the
prices offered by potential buyers. Owners also often contend that
because of lack of liquidity, ``abnormal'' market conditions, whatever
abnormal is, or because of other reasons, prices being offered by
potential buyers are for ``forced'' or ``liquidation'' sales. Those
matters are so judgmental that the FASB's definition does not work at
the margin. I have seen it not work in enforcement cases at the SEC
where respondents will not write down the carrying amount of assets
because they say the prices being bid are for forced or liquidation
sales and that the respondents would not be willing sellers at those
prices. So the Standard does not work.
I would define fair value of assets as follows: The estimated
amount of cash the asset would fetch in an immediate sale whether or
not under duress, without recourse or guarantees, less the estimated
amount of cash that would have to be paid out to accomplish the sale.
This suggested definition is clear and permits no judgments about the
state of the market or the willingness of the seller to sell at prices
being offered or bid by potential buyers.
I would define the fair value of liabilities as follows: The least
amount of cash that the counterparty would accept in an immediate and
complete liquidation of his/her/its claim against the reporting
enterprise.
Let me list a few of the beneficial effects that adoption of my
proposal would have.
1. Users of financial statements and reports would understand
the line-item descriptions and numbers in the balance sheet,
namely, what the reporting enterprise owns and what it owes,
with all measurements based on immediate cash prices. True
North. There would be no balance sheet deferrals followed by
(arbitrary) allocations of those deferred amounts to future
periods. There would be no need for pages and pages of
footnotes that describe the recondite procedures used to
calculate amounts in financial statements as now is the case.
However, there would need to be disclosures about the
assumptions made in estimating the fair value of assets and
liabilities so that users of the financial statements would be
fully informed.
2. Financial accounting and reporting under my approach (a)
would be vastly simpler than what we have today and (b) would
be understood by investors, creditors, underwriters, CEO's,
line operating managers, analysts, journalists, editors,
lawyers, judges, U.S. Senators and Representatives, and
ordinary folk who walk up and down Main Street here in the USA
and in other countries. Members of boards of directors and
audit committees would understand the line-item descriptions
and numbers in the balance sheet. Corporate governance would
take a quantum stride forward.
3. Fraud in audited financial statements would virtually
cease to exist because opportunities for cooking the books no
longer would be available. Auditors would be responsible, as
they are today, for auditing cash and other transactions
involving assets (as defined herein). Auditors would confirm
with banks the amount of cash on deposit. Auditors would
confirm with counterparties the amounts owed to the enterprise.
Auditors would confirm payables with counterparties. Auditors
would observe inventory counts. Auditors would go to outsiders
to get opinions from outsiders regarding what the outsiders
believe are the fair values of the enterprise's individual,
exchangeable assets. Auditors would go to outsiders to get
opinions about the fair value of the enterprise's liabilities.
Auditors could not accept management's opinion about the fair
value of assets or liabilities unless that opinion were
corroborated by outsiders. In other words, auditors would get
competent evidence supporting management's assertions in the
balance sheet. That is what auditing should be about. For an
exhaustive discussion of what auditing should be about, I
commend to all Peter Wolnizer's book entitled Auditing as
Independent Authentication published in 1987 by Sydney
University Press.
We in the USA have seen many frauds that were perpetrated by
so-called improper revenue recognition. We have labored to try
to write rules for when and in what amount revenue may be
recognized. We have lots of rules telling us when revenue may
be recognized and how to measure it. The latest iteration is
the SEC's Staff Accounting Bulletin 101 issued December 3,
1999. But looking at revenue recognition as being the problem
is to look down the wrong end of the pipe. Every line item and
every amount in the income statement (or in a statement of
changes in net assets as I would have in my scheme of things)
is fathered in the balance sheet. There is no sales transaction
to report until the enterprise receives cash or a promise by
the counterparty to pay cash. Auditors should look at the
balance sheet. That is were the DNA is. Auditors should ask a
commercial bank or a factor what amount of cash it would pay,
without recourse or guarantees, for the receivable arising from
the sale. If the bank or factor says 100 or 95 or 84 or 39 or
zero, then report the receivable, and therefore the sale, at
that amount. Then disclose the name of the bank or factor that
gave the opinion so that users of the financial statements will
know who gave the opinion. Under my scheme of things,
fraudulent financial reporting because of improper revenue
recognition would disappear.
4. The FASB could stop writing complex accounting rules,
which no one except accountants understand, and not very many
accountants at that. The FASB, or some other body, would have
to develop standardized valuation techniques for use by
reporting enterprises and outside valuation experts when
estimating the cash sales price of an asset if there is no
liquid market for that kind of an asset. Guidance would be
necessary to estimate the cash sales price of many fixed
assets, for example, a railroad between Massachusetts and
Florida, a petrochemical plant in Texas, a shoe factory in
Brazil, a semiconductor manufacturing facility in Taiwan, and a
salmon farm in Scotland.
Nowadays, we have amounts in balance sheets for fixed assets
that are just numbers; the numbers have no information content
whatsoever. Depreciation lives, methods, and salvage values are
(almost) whatever management wants them to be. Whether the
carrying amount for those fixed assets is impaired is
determined by reference to all of the future, undiscounted cash
flows attributable to the assets--cash flows projected by
management as far as the eye can see. What an irrelevant
methodology.
Let's assume that a company owns a fleet of commercial
aircraft having a cost of 100. The value of aircraft declines
to 80 because the price of fuel goes up but the owner of the
aircraft cannot put through increases in the price of tickets
sold to passengers. Under the current standard in the USA, so
long as all future net cash flows related to the aircraft,
projected as far as the eye can see, without reduction for risk
and the time value of money, equal or exceed 100 no write-down
is made to reduce the carrying amount of the aircraft to 80. I
used as an example a fleet of aircraft because we can learn the
going price of aircraft fairly easily and at little cost. The
concept is the same for any asset as to which there are not
readily available price quotations, such as a railroad or a
petrochemical plant or a shoe factory or a computer chip
manufacturing plant or a salmon farm. (I would point out that
there are many kinds of assets as to which the fair values can
be obtained from outside parties at a relatively small cost
considering the information value of those fair value amounts.
Examples are land-, air-, and ocean-going transportation
equipment, pipelines, office buildings, apartment buildings,
shopping malls, warehouses, mineral reserves, and maybe even
satellites.)
FASB Statement 15, ``Accounting by Debtors and Creditors for
Troubled Debt Restructurings,'' was issued in 1977. Before
being amended by FASB Statement 114, FASB Statement 15 said
that the total of all future cash inflows related to a
receivable were to be compared to the carrying amount of the
receivable to measure any loss on the receivable. So long as
the undiscounted future cash inflows, no matter how distant,
equaled or exceeded the carrying amount of the receivable, no
loss was to be recognized. Never mind that the fair value of
the receivable or the underlying collateral might be far less
than its carrying amount. Statement 15, issued in 1977,
retarded the thinking of an entire generation of accountants
and significantly increased the U.S. Government's losses in the
S&L mess in the 1980's because losses kept growing, and piling
up on balance sheets, but were not recognized as such in income
statements under Statement 15 until the Federal Government took
over the assets. U.S. taxpayers then took the hit in the S&L
bailout. Although the FASB somewhat, but not completely, fixed
the loan-loss measurement problem in FASB Statement 114,
``Accounting by Creditors for Impairment of a Loan,'' issued in
1993, the FASB then repeated the same FASB Statement 15 mistake
in 1995 when it issued Statement 121, ``Accounting for
Impairment of Long-Lived Assets to be Disposed Of.'' Statement
121 says to look to the total of future cash inflows from long-
lived assets, no matter how distant, compare that undiscounted
amount to the carrying amount, and recognize no loss unless the
total cash inflows are less than the carrying amount, even
though the fair value of the asset might be significantly less
than the carrying amount. The thinking of yet another
generation of accountants is being retarded now under Statement
121.
5. The debate over purchase versus pooling accounting would
disappear. With all assets (as defined herein) and liabilities
(as defined herein) being reported as such in the balance
sheet, and all at fair value, every business combination would
be reported by combining the assets and liabilities of each
party to the business combination--all at fair value. No debate
about who acquired whom. No debate about whether the cost of
purchased goodwill is an asset.
6. The debate over accounting for stock options issued to
employees would not exist. No cash or other asset goes out of
the enterprise and no obligation to pay cash arises when a
stock option is granted or exercised, so there is no decrease
in assets or net assets and therefore nothing to account for
except for the cash received when the option is exercised. When
the focus is on cash inflows and cash outflows and changes in
the fair values of real assets and liabilities as it is in my
proposal, it is clear that the issuance of stock options to
employees, and exercise of those options, is a rearrangement of
the ownership interest between the various owners and potential
owners--not a decrease in corporate assets. The value of what
one owner relinquishes to a potential new owner or a new owner
is not imputed to the reporting enterprise. The reporting
enterprise accounts for its assets and changes in them, not its
owners' assets.
7. Earnings management would disappear as an issue. In the
USA, I have seen earnings being managed almost at will by chief
executive officers and chief financial officers. Loading
accrued liabilities or ``reserves'' in good times and drawing
them down in lean times. Or drawing down reserves or estimated
liabilities, such as for warranties, whenever it is necessary
to ``make the numbers.'' Changing assumptions so as to time the
recognition of write-downs of the cost of long-lived assets
instead of when the value actually declined. Projecting net
cash inflows, or increasing net cash inflows, as far as the eye
can see to justify not writing down the cost of long-lived
assets. Earnings management is a scourge in the USA. Earnings
management is the ultimate in accounting gimmickry. By
participating in this gimmickry, accountants not only have
cheapened their image but also have raised serious questions
about the substance of what they do as well.
8. We could stop arguing with banks about the size of their
allowances for loan losses. Whether such allowances may be
recognized only for loans that are already bad or for loans
that may go bad as well. The loans would be reported at their
fair value, which comprehends all credit risk. I know that we
will need guidance from the FASB, or some similar body, on how
to estimate those fair values, but at least then we would be
trying to get a relevant number that can be audited by
reference to an outside source instead of an allowance that is
determined judgmentally by management as it is today.
9. We no longer would be arguing with banks and insurance
companies about whether their bond holdings are for trading,
held for sale (not trading), or held to maturity, with each of
the three approaches producing a different income number. Going
through these convoluted discussions gives accounting and
accountants a bad name. Ordinary folk think that we accountants
are practicing a dark art.
10. Huge gains and losses, mostly losses, on sale or
discontinuance of assets would disappear. Users of financial
statements today have a hard time interpreting how these gains
and losses should be factored into previously reported income
from an analytical standpoint. Changes in fair value of assets
would be recognized as changes take place, not on sale or
discontinuance.
11. It is now in vogue in the USA for the directors to
discuss with the outside auditor what the auditor thinks about
the ``quality'' of the company's accounting. (See,
Recommendation 9 of the Report and Recommendations of the Blue
Ribbon Committee on Improving the Effectiveness of Corporate
Audit Committees, issued in 1999, at www.nyse.com.) (Also, See,
the AICPA's Practice Alert 2000 -2002, dated February 2000,
entitled ``Quality of Accounting Principles--Guidance for
Discussions with Audit Committees.'') That dialogue would not
be necessary under my proposal. The basis of every company's
financial statements would be the same as every other
company's: What the company owns and what it owes, with the
fair values of those things being determined by reference to
facts or opinions received from outsiders instead of being
based on a management-determined number. True North.
12. Students who aspire to be accountants could learn
financial accounting and reporting in a very short time. As it
is now in the USA, students must have 5 years of university
study to become certified public accountants. Although I taught
a few staff training courses when I was in public practice, I
have no training on how to teach. However, I venture that I
could teach students in 1 year, maybe less, how to do financial
accounting and reporting my way. Thus, graduating students
would not be so deeply in debt on student loans as they are
today when they graduate.
Estimating cash selling prices for assets for which there is no
ready market would be the largest challenge in implementing my
proposal. We cannot look up prices for most assets in business
publications. We would need guidance from the FASB, or some similar
body, on how to estimate those prices. The FASB soon will face that
issue if and when it requires that all financial instruments be
reported at fair value. Developing that guidance no doubt would give
rise to debates about how to estimate those prices. What kinds of
models to use in estimating those prices. What the inputs to the models
should be. That debate would, however, be about something that would be
important and relevant for making investment and credit decisions.
Currently, the debates that the FASB has with its constituencies about
when to report and how to measure various assets and liabilities are
not debates but are (shouting) arguments about whether a particular
expenditure is an asset or an expense and recondite procedures to be
used to compute financial statement amounts, for example, pension
liabilities and deferred taxes. The only reason that the FASB wins
these arguments is a political one, to wit, the SEC requires that
public companies in the USA follow the FASB's rules. Resolution of such
debates should turn on relevance of information, logic, merit, and
substance, not political clout.
My accounting would be simple. It would have a simple, singular
focus--cash. All assets and liabilities would be stated at fair value.
We all would know where North lies on that accounting compass. The
results of the accounting could be audited or verified or authenticated
by auditors by reference to facts and opinions about the fair values of
assets and liabilities--facts and opinions obtained from people outside
the reporting enterprise. Real auditing. Investors, creditors,
underwriters, analysts, CEO's, line managers, members of boards of
directors and audit committees, lawyers, judges, regulators,
journalists, editors, U.S. Senators and Representatives, and ordinary
people who walk up and down Main Street here in the USA and other
countries as well would understand that accounting. My sister would
understand it.
* * *
Walter P. Schuetze was the Chief Accountant to the Securities and
Exchange Commission of the United States of America and the Chief
Accountant of the Commission's Division of Enforcement, a charter
member of the Financial Accounting Standards Board, a member and chair
of the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants, and a practitioner of public
accountancy with the firm of KPMG LLP.
2001 RJ CHAMBERS RESEARCH LECTURE
Great Hall, The University of Sydney, NSW, Australia
by Walter P. Schuetze
November 27, 2001
A Memo to National and International Accounting and Auditing Standard
Setters and Securities Regulators (A Christmas Pony)
Chancellor, Vice-Chancellor, distinguished guests. Thank you,
Chancellor, for those kind introductory words, and thank you Dean
Wolnizer for the invitation to present the RJ Chambers Research
Lecture. It is indeed a pleasure for me to be here in Sydney delivering
this lecture. I long have admired Professor Chambers' work. I wish I
had met him.
I graduated from The University of Texas in Austin in the summer of
1957. I went to work on August 1, 1957 for an accounting firm in San
Antonio, Texas by the name of Eaton & Huddle. Tom Holton, one of the
partners of Eaton & Huddle, hired me. After Eaton & Huddle merged with
Peat, Marwick, Mitchell & Co., now KPMG, Tom Holton eventually became
Chairman of KPMG. Mr. Holton will attest that I have been talking
about, making speeches about, and generally advocating and promoting,
market value accounting since the late 1950's. By ``market value
accounting,'' I mean estimated selling price for assets and estimated
settlement price for liabilities. Without knowing it, I was sounding
like Chambers in the 1950's, although not so eloquently.
I had not read Chambers until I joined the Financial Accounting
Standards Board. I was at the FASB from March 1973 through June 1976.
While I was there, I read Chambers' book entitled Accounting,
Evaluation and Economic Behavior and discovered that he and I shared
the same view about accounting for assets. Unfortunately, there was no
way to get market value accounting adopted by the FASB in its early
days. The climate was just not right. In fact, in 1975, when the FASB
issued Statement 12 on ``Accounting for Certain Marketable
Securities,'' the FASB could muster only three out of seven votes for
mark-to-market of marketable equity securities.\1\ Similarly, in 1985,
in FASB Statement 87 on ``Employers' Accounting for Pensions,'' the
mark-to-market for off balance sheet pension plan assets, mostly stocks
and bonds, is smoothed out so as not to affect employers' pension plan
expense too much in any particular year.
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\1\ FASB Statement 12, issued in 1975 and now superseded by
Statement 115, required lower of cost or market accounting for the
portfolio of marketable equity securities held, which is awful
accounting. In Statement 12, I wanted to require mark-to-market for
every security in the portfolio as did two other Board members, Messrs.
Litke and Sprouse, who dissented to the issuance of Statement 12. But
because we needed five votes to issue a standard and because our
constituents were telling us that practice was so diverse that a
standard, some standard, was necessary, I bit my tongue and signed the
document without dissenting.
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The climate for introducing market value accounting into financial
statements did not change until 1990, in the aftermath of the savings
and loan crisis and the consequent U.S. Government bailout of insolvent
savings and loan associations. On September 10, 1990, the U.S.
Securities and Exchange Commission, in testimony by its Chairman before
the U.S. Senate's Committee on Banking, Housing, and Urban Affairs,
described how faulty accounting and the consequent improper measurement
of regulatory capital contributed to lax regulatory oversight of the
S&L's, which ultimately led to the bailout. The Commission in that
testimony took the position that banks and thrifts should mark-to-
market their bond portfolios. At that time, Richard Breeden was
Chairman of the SEC. Chairman Breeden is a lawyer, not an accountant.
But he strongly believed that thrifts and banks were presenting false
pictures of their financial position and results of operations, and
importantly the amounts of their regulatory capital, through the use of
historical cost accounting for their bond portfolios and through
selective timing of sales of bonds so as to trigger gains but not
losses, a practice called ``gains trading.''
When I interviewed with Chairman Breeden for the position of Chief
Accountant in December 1991, it turned out that his and my thoughts on
market value accounting were in sync. At least as far as bond
portfolios were concerned. Chairman Breeden did not want to go further
than the bond portfolio. I wanted to mark all assets to market, but in
the early 1990's, I was glad to start with the bond portfolios of
thrifts and banks. So in January 1992, I started as Chief Accountant to
the SEC. As it turns out, I was the Commission's foot soldier getting
thrifts and banks to mark-to-market their bond portfolios. Of course,
there was no stopping with depository institutions. Insurance companies
and other ``float'' companies also had bond portfolios, and they also
had to mark-to-market their bonds. I was Chief Accountant from January
1992 to April 1995. I spent a considerable portion of 1992 and 1993
promoting the Commission's view that banks, thrifts, and insurance
companies should mark-to-market their bond portfolios.
In May 1993, the FASB, in Statement 115, required that all
marketable equity securities be marked-to-market. Statement 115 went
part of the way on bonds and requires that trading and held-for-sale
bond portfolios be marked-to-market, but allows the held-to-maturity
bond portfolio to be reported at cost. (Determining which bond is in
which portfolio is a metaphysical, serendipitous determination that has
always eluded my understanding.) Since 1993, the accounting for bonds,
mortgages, mortgage-backed securities, derivative instruments, and
hedging has become more incredibly complex than I can or want to
describe, but gains trading out of the held-to-maturity portfolio still
is possible. However, the FASB is moving forward to require mark-to-
market on all financial assets and liabilities.
Few people know that to the extent that we have mark-to-market
accounting today, the credit for that belongs to the Securities and
Exchange Commission, and primarily to Chairman Breeden. Incidentally,
none of those Commissioners in 1990 was an accountant. (To my
knowledge, only one accountant, Mr. James Needham, has served as a
Commissioner since the Commission was established in 1934. Most, but
not all, of the Commissioners have been lawyers. An exception is Arthur
Levitt, the Immediate Past Chairman, who is not an attorney. Chairman
Levitt, prior to his appointment to the SEC, was head of the American
Stock Exchange.)
When the SEC endorsed mark-to-market on bonds in 1990, the banking,
thrift, and insurance companies community had to be dragged, kicking
and screaming, into the world of relevant, mark-to-market accounting.
In a sense, the FASB was also dragged along by the SEC because none of
the FASB's constituencies was in favor of mark-to-market, and the FASB
itself was not out in front leading the charge for mark-to-market. But
come around it did, and now the FASB is moving forward on mark-to-
market for all financial assets and liabilities.
I think that it is now time for the SEC, the FASB, and the
reconstituted International Accounting Standards Board, to extend mark-
to-market to the rest of the balance sheet--to all assets and
liabilities. Why do I say that? Well, to begin with, there is no
question that mark-to-market produces relevant information that
investors and creditors can use to make investment decisions. Not only
is the information relevant, its quality is undisputed. The two ideas--
relevance of information and quality--go hand in glove. There is no
relevance to a datum called cost or cost minus amortization--it is just
a number, a number having no information content. The ``quality'' of
the datum called cost or cost minus amortization for assets such as
inventory, factories, mines, oil and gas reserves, salmon farms,
machinery and equipment, copyrights, and patents is indisputably awful;
worse, it can be and often is misleading. We have seen many situations
in the USA, and I am sure you have seen them in Australia as well,
where corporations have been reporting earnings and an excess of assets
over liabilities using our current Generally Accepted Accounting
Principles just before going bust. We now have the case where after the
tragic events of September 11 some U.S. airlines are teetering on the
brink of bankruptcy and the market prices of their aircraft have fallen
into the cellar. Yet the historical cost of those aircraft continues on
the airlines' balance sheets because, under the FASB's rule in
Statement 121 and now Statement 144 of looking to the undiscounted
future cash flows from the aircraft, the carrying amount of the
aircraft is not impaired. What an awful rule. Historical cost of assets
and representations as assets of FASB-approved junk such as goodwill,
deferred income taxes and tax benefits of operating loss carry-
forwards, and capitalized direct-response advertising costs have misled
investors for years. I will have more on quality later.
The second reason to adopt mark-to-market for all assets and
liabilities is to go back to basics--to go back to first principles--
and to simplify the accounting. First, we need a definition of assets
that we can all understand. The FASB's definition of assets in
paragraph 25 of its Concepts Statement 6 is as follows: ``Assets are
probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.'' That is
followed by six paragraphs of about six hundred words explaining the
definition. There are 330,000 members of the American Institute of
Certified Public Accountants. It is my experience that a very large
majority of those CPA's does not understand the FASB's definition of an
asset. I have seen litigation involving alleged fraudulent financial
statements because of improper asset and income recognition where both
parties to the litigation and both of their expert witnesses, in their
briefs and at trial, quoted the very same words from the FASB's
Concepts Statements saying that a debit balance on the balance sheet
was, or was not, a fit and proper asset under the FASB's definition.
The judge has not yet decided the case even though 3 years have gone
by.
Not only do most practicing accountants not understand the FASB's
language about assets, ordinary folk are mystified by that babble. The
financial statements that are produced as a result of all of the FASB's
rules, which now is a veritable mountain of rules, are impenetrable. Go
to the Internet and look at the financial statements and related notes
to the financial statements of U.S. companies in their annual reports.
There are pages and pages of jargon, understandable to a few highly
indoctrinated accountants but not most investors and other ordinary
folk. This is not just my opinion. The new Chairman of the SEC, Mr.
Harvey Pitt, is quoted in the November 5, 2001 issue of Business Week,
at page 92, as saying that quarterly and annual reports are ``. . . not
always capable of being deciphered by sophisticated experts, much less
ordinary investors.''
Using the FASB's definition of an asset, a thing that most of us
call a truck is not that which is the asset. The asset is the economic
benefit, whatever that is, that will arise from using the truck to haul
lumber or coal or bread. Using the FASB's definition, the truck is an
abstraction. I think that we should define assets by reference to real
things, not abstractions. I think that we should define assets as
follows: Cash, claims to cash, for example, accounts and notes
receivable, and things that can be sold for cash, for example, a truck.
I will bet this audience understands my definition of an asset.
The FASB's definition of a liability in paragraph 35 of Concepts
Statement 6 is as murky as its definition of an asset, to wit:
``Liabilities are probable future sacrifices of economic benefits
arising from present obligations of a particular entity to transfer
assets or provide services to other entities in the future as a result
of past transactions or events.'' That paragraph is followed by five
paragraphs of more than seven hundred words that explain the
definition. Included in those five paragraphs is a sentence that says
liabilities include, in addition to legal obligations, ``equitable or
constructive obligations,'' but does not define what those are. Most
accountants do not understand, at the margin, what the FASB's
definition of a liability means, leading to great diversity in
practice. In practice, if the management of a corporation says that it
has a liability under a so-called restructuring plan, a liability may
be, but need not be, booked. In practice, year-end bonuses to employees
are sometimes, but not always, booked as liabilities as the year
progresses even though there is no contractual obligation to pay the
bonuses. We are seeing in 2001 that many U.S. corporations are not
going to pay bonuses or are going to pay reduced amounts of bonuses.
(See The Wall Street Journal, October 2, 2001, p. B1.) (I doubt that
there is much disclosure in financial statements about those liability
reversals.) In corporate acquisitions, liabilities are booked if the
acquiring corporation declares that it will pay out cash for this or
that even though there is no contractual requirement to pay cash; no
liability is booked if the corporation makes no declaration.
Consequently, liability recognition, and the amount thereof, is subject
to great management discretion and abuse.
I think that liabilities should be defined as follows: Cash
outflows required by negotiable instruments, by contracts, by law or
regulation, and by court-entered judgments and agreements with
claimants. I will bet this audience understands my definition of
liabilities. Nothing murky about it.
The third reason to adopt mark-to-market for all balance sheet
items is to stop--to stop dead in its tracks--earnings management.
Earnings management is a scourge in the USA. The disease called
earnings management is pandemic. I am not being shrill or alarmist when
I say that I think that it threatens the very soul of financial
reporting. What we get under our present reporting system is earnings
as determined by management, not as determined by transactions and
economic events and conditions that actually happened and that exist.
Many people, indeed many accountants, are fond of saying that financial
statements should portray economic reality. But, in fact, except for
the financial statements of investment companies (mutual funds) and
broker-dealers where all assets are marked-to-market every evening at
the close of business, today's financial statements come nowhere close
to achieving that goal because, except for stocks, and bonds in some
cases, noncash assets are not marked-to-market.
In the spring of 1998, a national business magazine in the USA--
Forbes--had the following banner on its cover: ``Pick a Number, Any
Number.'' That was followed by articles in the national press, such as
USA Today, about ``Abracadabra Accounting,'' ``Hocus Pocus
Accounting,'' and the like. The gist of these articles was that the
accounting numbers were being managed or manipulated by corporations
and certified as being okay by their external auditors. This national
outrage moved Chairman Levitt of the SEC into action. On September 28,
1998, Chairman Levitt gave a speech entitled ``The Numbers Game.''
(That speech is available at www.sec.gov.) In that speech, he gave
examples of ways that corporations are managing their earnings--big
bath restructuring charges, creative acquisition accounting, cookie jar
reserves, improper revenue recognition, and abuse of materiality. (I
would point out that under our current accounting rules there are
dozens of ways to manage earnings. Chairman Levitt gave only a few
examples.) Chairman Levitt made numerous suggestions for improvement.
The upshot of that speech was (1) the SEC's staff produced Staff
Accounting Bulletins on restructuring charges, revenue recognition,
materiality, and banks' loan loss allowances; (2) the New York Stock
Exchange and the Nasdaq charged a blue-ribbon panel chaired by two
prominent business leaders, Mr. Ira Millstein and Mr. John Whitehead,
with making recommendations about corporate audit committees; and (3)
the Public Oversight Board of the American Institute of CPA's charged
the Panel on Audit Effectiveness chaired by Mr. Shaun O'Malley,
formerly the CEO of PricewaterhouseCoopers, with making recommendations
about improving the effectiveness of external audits.
The Millstein and Whitehead Blue Ribbon Committee issued its report
on February 8, 1999. (The report is available at www.nyse.com.) Among
the Committee's recommendations are that: (1) there be a discussion
between the audit committee and the external auditor about the quality
of the company's accounting; and (2) that the audit committee represent
in the company's annual report that, based on discussion with
management and the external auditor, the company's financial statements
are fairly presented in conformity with Generally Accepted Accounting
Principles. The second recommendation attracted massive, negative
comment from the corporate and legal communities. Commentators stated
that audit committee members are not accountants and do not have the
expertise to determine whether the company's financial statements
conform to Generally Accepted Accounting Principles. When the SEC
adopted its revised rules on audit committees on December 22, 1999 (See
SEC Release No. 34.42266 at www.sec.gov.), the SEC did not adopt that
recommendation. Instead, the SEC merely required that the audit
committee state, in the annual report, that, after discussion with the
external auditor, the audit committee ``. . . recommended to the Board
of Directors that the audited financial statements be included in the
Annual Report . . .,'' thereby implicitly acknowledging that members of
audit committees do not know whether the financial statements comply
with Generally Accepted Accounting Principles.
The recommendation that the audit committee discuss with the
external auditor the quality of the company's accounting has been acted
on by the auditing profession in the USA. In December 1999, the AICPA's
Auditing Standards Board issued Statement on Auditing Standards No. 90,
``Audit Committee Communications,'' which requires, as to public
companies, that the auditor ``. . . discuss with the audit committee
the auditor's judgments about the quality, not just the acceptability,
of the company's accounting principles as applied in its financial
reporting.'' I would like to be a fly on the wall when such discussions
take place in the corporate boardroom. I can just imagine the auditor
saying to his/her client, ``My firm has audited your financial
statements. My firm is prepared to report without qualification that
your financial statements have been prepared in conformity with
Generally Accepted Accounting Principles, but my grade on the quality
of your financial statements is C-.'' In my opinion, this requirement
by the Auditing Standards Board is worse than a joke. It is farcical.
The large auditing firms have hundreds, some thousands, of partners in
the USA and still more worldwide. There are no objective standards by
which the individual partner in San Francisco, Sydney, Seoul,
Singapore, or Southhampton can make a judgment about the quality of a
client's accounting. Following the Auditing Standards Board's rule,
opinions about the quality of clients' accounting would be based on the
idiosyncratic judgments of hundreds or thousands of individual
partners. The practical upshot will be that every client's grade on
quality will be an A. There are two reasons for that. First, given the
highly competitive nature of the public accounting business, few if any
audit partners are going to jeopardize a client relationship by telling
the client that its accounting is not of high quality. The second
reason is that the accounting rules under which financial statements
are prepared allow the management to use its judgment in preparing
those financial statements, and the auditor has no basis on which to
make a different judgment except personal preference.\2\
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\2\ For an excellent discussion and analysis of why the presence of
audit committees cannot and will not improve the quality and
reliability of today's financial statements, see ``Are Audit Committees
Red Herrings?'' by P. W. Wolnizer, Abacus, Vol. 31, No. 1, March 1995,
pp. 45-66.
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The O'Malley Panel issued its 255 page report on August 31, 2000.
(That report may be viewed at www.pobauditpanel.org.) The Panel's major
recommendations are as follows:
Auditors should perform some ``forensic-type'' procedures on
every audit to enhance the prospects of detecting material
financial statement fraud.
The Auditing Standards Board should make auditing and quality
control standards more specific and definitive . . .
Audit firms should put more emphasis on the performance of
high quality audits in communications from top management,
performance evaluations, training, and compensation and
promotion decisions.
The Public Oversight Board (POB) of the AICPA, the AICPA, the
SEC Practice Section (SECPS) of the AICPA, and the SEC should
agree on a unified system of governance for the [auditing]
profession under a strengthened Public Oversight Board that
would oversee standard setting (for auditing, independence, and
quality control), monitoring, discipline, and special reviews.
The SECPS should strengthen the peer review process,
including requiring annual reviews for the largest firms, and
the POB should increase its oversight of those reviews.
The SECPS should strengthen its disciplinary process.
The audit committees should pre-approve nonaudit services
that exceed a threshold amount . . .
The International Federation of Accountants should establish
an international self-regulatory system for the international
auditing profession.
As I understand it, the Auditing Standards Board and other AICPA
entities are working on the Panel's recommendations. And I have no
doubt that the SEC's staff is watching over their shoulders to make
sure that all of the details are implemented to the SEC's staff 's
satisfaction. Maybe the number of financial statement frauds that the
SEC periodically has to investigate and address through enforcement
actions will be reduced if more ``forensic-type'' audit work is done by
external auditors as recommended by the Panel. But the earnings
management game won't stop even if every one of the Panel's
recommendations is implemented immediately. And the dismaying, surprise
corporate collapses--such as HIH Insurance here in Australia--that
happens about once a month won't stop even if every one of the Panel's
recommendations is implemented immediately.
There have been similar panels, committees, and even Royal
Commissions in the past, all with more or less similar recommendations.
We now have O'Malley. We had the Kirk Panel in the 1990's. We had
Treadway about 15 years ago. We had the Cohen Commission in the late
1970's. We had Metcalf. Canada had MacDonald. Great Britain had
Cadbury. Australia has had similar committees, I am sure. In the
1970's, we in the USA introduced peer reviews of audit firms.
Concurring audit partner reviews also now are a requirement in the USA.
We have the AICPA's Quality Control Inquiry Committee looking into
external auditor performance when financial statements are restated. We
have the AICPA's Public Oversight Board, breathing hard, looking over
everyone's shoulder. All for naught. What we have is layers on top of
layers on top of layers of regulation. After O'Malley, we no doubt will
have another layer of regulation.
We had the AICPA's Committee on Accounting Procedure writing the
accounting rules from 1939 to 1959. That did not work and that
committee was replaced by the AICPA's Accounting Principles Board,
which wrote the accounting rules until 1973. In 1973, the Accounting
Principles Board was replaced, with great hope and fanfare, by the
Financial Accounting Standards Board.\3\ Things were supposed to get
better. But nothing has changed. Earnings management continues to
flower.
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\3\ I know. I was a Charter Member of the FASB. My wife and I were
present at the FASB's inauguration dinner in the spring of 1973. Mr.
Reginald Jones, the Chairman of General Electric, delivered the
inaugural address. He held out great hope for the FASB.
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Corporations today continue to manipulate their earnings without
objection from their external auditors. SEC Commissioner Hunt in a
speech on October 26, 2001 discussed earnings management. (See
www.sec.gov.) Business Week, in the July 23, 2001 issue on page 71
reports, ``In today's financial climate, auditor's reports have about
as much credibility as buy recommendations from Wall Street analysts.''
The June 2001 issue of the Harvard Business Review has a 12 page
article entitled ``The Earnings Game: Everyone Plays, Nobody Wins.'' On
Friday night, October 19, 2001, on a TV program called ``Wall Street
Week,'' I heard and saw a prominent Wall Street investment manager say
something along the following lines: ``Corporations are writing off
assets right and left in the quarter ended September 30, 2001.
Comparative earnings statements in 2002 will be wonderful.'' His
implication was that the write downs are arbitrary. The Levy Institute
Forecasting Center, in a Special Research Report dated September 2001,
describes in 23 pages of detail ``Two Decades of Overstated Corporate
Earnings,'' which its Chairman, Mr. David Levy, previewed on TV on CNBC
on October 24, 2001. Business Week, in the October 15, 2001 issue on
pages 46 and 47, says: ``Brace yourself for what may be the ugliest
quarter ever for corporate earnings. For years, companies used every
trick in the book to make their results look better than they really
were. Now many will be taking the opposite tack: Loading costs and
charges onto their income statements in an all-out effort to make an
already horrid year look even worse. To make next year's results look
stronger companies may load losses into 2001 by: Slashing values of
physical assets, which will cut depreciation charges in the future;
overestimating likely bad debts, thus boosting future profits when
customers pay up; and by charging impending restructuring costs
immediately, so as to benefit if they are less than expected.''
It is not just in Business Week and the Harvard Business Review. I
see it in Forbes. I see it in Barron's. I read the earnings reports of
corporations on their websites and in The Wall Street Journal, and I
see the earnings management. It is going on in bright daylight, and not
behind closed doors. Everyone on Wall Street knows it is going on. The
Stock Exchanges know it is going on. The SEC knows it is going on.
Every sell-side security analyst knows it is going on. Every
institutional investor knows it is going on. But the individual
investor who is not part of the Wall Street in-the-know crowd doesn't
know it is going on. John and Jane Q. Public do not know it is going
on. Maybe Members of Congress do not know it is going on. The external
auditors cannot stop it. Even if the external auditors were U.S.
Federal Government auditors, whose independence would be unquestionably
pure, they could not stop it because the accounting rules allow for
earnings management. External auditors have no ground on which to stand
to stop it because of the way the accounting rules are constructed. The
Stock Exchanges cannot stop it. Because the accounting rules allow for
earnings management, the SEC cannot stop it through its Division of
Corporation Finance, which reviews and clears registration statements
and other filings by issuers of securities. The SEC's Office of Chief
Accountant and Division of Enforcement cannot stop it because the
accounting rules allow it. I could not stop it when I was Chief
Accountant at the SEC.
I have been in this business since August 1, 1957. I think that I
have seen every side and dimension of this problem. In my opinion, the
only way that earnings management will be stopped is as follows: The
SEC, or the SEC and FASB, or the SEC and FASB and IASB, must change the
accounting rules. The SEC must make deep and fundamental changes to the
system. Unless and until the SEC requires that assets be reported at
estimated selling prices, which of course means that only things that
have a market price could be represented as assets, nothing will
change. Unless and until the SEC requires that liabilities be reported
at estimated settlement prices, nothing will change. Unless and until
the SEC requires that reported asset and liability amounts be based on
estimated selling and settlement prices and that external auditors get
evidence about those selling and settlement prices from persons or
entities outside the reporting enterprise, nothing will change.
So long as management controls the numbers, nothing will change.
For example, so long as management decides on the amount of inventory
obsolescence, the amount of bad debts, or the amount of the warranty
liability, nothing will change. So long as management decides on the
assumed rate of return on pension plan assets, nothing will change. So
long as management decides on the estimated useful lives and salvage
values of capital assets without regard to the selling prices of those
assets as determined by the marketplace, nothing will change. So long
as management decides on what will be future, undiscounted cash flows
from capital assets, and can change those numbers at will in
determining whether the carrying amounts of capital assets are
impaired, nothing will change. So long as management is allowed to
recognize liabilities for restructuring the business whenever
management wants to, and in an amount determined solely by management,
nothing will change.
The reported numbers for assets and liabilities must be such that
they can be verified by external auditors (and by regulators and
courts) by reference to sources outside the enterprise. By reference to
competent evidence.\4\ The SEC must make deep and fundamental change to
the system. Only by requiring that assets and liabilities have a
reference point in the marketplace and that the amounts representing
those assets and liabilities be verifiable by reference to sources,
competent sources,\5\ outside the enterprise, will we be able to
produce financial statements that include reliable numbers. As a
practical matter, neither the FASB nor the IASB can accomplish such
deep and fundamental change on its own. Or even together. Only the SEC
can accomplish such change. And only if such change is made will the
financial statements be of high quality.
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\4\ This style of auditing--obtaining competent evidence--is
exactly what P. W. Wolnizer describes and recommends in his book
Auditing as Independent Authentication, Sydney University Press, 1987.
\5\ The SEC should require (a) disclosure, either by the reporting
enterprise or the external auditor, of the names of the persons or
entities that furnished the selling and settlement prices and (b) the
consent of those persons or entities to the use and disclosure of their
names.
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This idea that financial statements be of high quality, or that
accounting standards be of high quality, has attracted a lot of
attention recently. The term, ``high quality,'' is on everyone's lips.
It is high sounding. The IASB's website says that the IASB, ``. . . is
committed to developing, in the public interest, a single set of high
quality, understandable and enforceable accounting standards that
require transparent and comparable information in general purpose
financial statements.'' The U.S. House of Representatives' Subcommittee
on Capital Markets, Insurance and Government Sponsored Enterprises, on
June 7, 2001, held a hearing on ``Promotion of International Capital
Flows through Accounting Standards.'' Representatives Baker, Oxley,
LaFalce, Kanjorski, and Mascara made ``Opening Statements.'' Mr. Paul
Volcker, Chairman of the Trustees of the IASB, Mr. Philip Ameen, VP &
Comptroller of General Electric, representing Financial Executives
International, and Mr. Robert Elliott, a KPMG partner representing the
AICPA, testified before the Subcommittee about international accounting
standards. By my count, the U.S. Representatives, Mr. Volcker, Mr.
Ameen, and Mr. Elliott, in their prepared remarks, used the term ``high
quality'' no fewer than twenty-three times. Sometimes high quality
standards, sometimes high quality financial statements, and sometimes
high quality information. Mr. Lynn Turner, the SEC's Chief Accountant
from mid-1998 to mid-2001, used the term frequently in his speeches
when describing financial statements prepared under FASB standards and
when he described what he hopes will result under IASB standards. But I
cannot tell what it is that these people are describing. These people
obviously are not describing what Chairman Levitt described in his
September 1998 speech, what Commissioner Hunt described in his speech
on October 26, 2001, and what Chairman Pitt meant when he said
quarterly and annual reports are indecipherable by ordinary investors.
These people obviously are not describing what I see in the Harvard
Business Review, Business Week, Forbes, and Barron's about earnings
management. To me, these people sound like my 7-year-old granddaughter
who is wishing that Santa Claus will bring her a pony on Christmas
morning.
What is it that we want for investors when we say ``high quality
financial statements'' or ``high quality information?'' I will tell you
what I want. I want financial statement amounts (numbers) that are
relevant and reliable. Historical costs of assets and historical
proceeds of liabilities are not relevant to an investor for purpose of
making an investment decision--or to any business person wanting to
make a decision about an asset or a liability. Only current selling
prices for assets and current settlement prices for liabilities are
relevant. The only reliable measures of those prices are those that
come from the marketplace, from persons or entities unrelated to the
reporting enterprise. Selling prices of assets and settlement prices of
liabilities can be verified by external auditors by reference to
marketplace sources. If the SEC requires that assets and liabilities be
measured, and be verified by external auditors, by reference to selling
and settlement prices that exist in the marketplace, and requires
disclosure of the names of persons or entities that furnished those
prices, the resulting financial statements will be of high quality. And
that standard, unlike what we have today, will be enforceable by
external auditors, regulators, and ultimately the courts.
There is a new Chairman, Mr. Harvey Pitt, and a new Chief
Accountant, Mr. Robert Herdman, at the SEC. Mr. Pitt made a speech on
October 22, 2001 (see www.sec.gov) before the governing council of the
AICPA, wherein he spoke of ``. . . simplifying financial disclosures to
make accounting statements useful to, and utilizable by, ordinary
investors'' and that ``we [SEC] may need to reconsider whether our
accounting principles provide a realistic picture of corporate
performance.'' The SEC's press release on September 19, 2001 (see
www.sec.gov) announcing Mr. Herdman's appointment as Chief Accountant
says, ``Mr. Herdman will lead us [SEC] in revising and modernizing our
accounting and financial disclosure system.'' Those words are
promising. Maybe Mr. Pitt and Mr. Herdman will surprise investors with
the equivalent of a pony on Christmas morning--that is, high quality
financial statements.
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Postscript on December 9, 2001: After I presented this lecture, I
received in the mail a brochure advertising a two-day course entitled
``How to Manage Earnings in Conformance with GAAP.'' ``This Intensive
Two-day, Skill-based Workshop Features over 50 Illustrations,
Applications and Case Studies to Make GAAP Work for Your Company or
Client.'' ``Earn 16 Hours of A&A CPE Credit and CLE Credit.'' This
course is sponsored by the National Center for Continuing Education,
967 Briarcliff Drive, Tallahassee, Florida 32308, and costs $995. I
rest my case about earnings management being a disease.
* * *
Walter P. Schuetze, now retired, was Chief Accountant to the
Securities and Exchange Commission and Chief Accountant of the
Commission's Division of Enforcement, a charter member of the Financial
Accounting Standards Board, a member and chair of the Accounting
Standards Executive Committee of the American Institute of Certified
Public Accountants, and a practitioner of public accountancy with the
firm of KPMG LLP.