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

FEBRUARY 12, 14, 26, AND 27, 2002

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

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87–708 PDF 2003

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

FEBRUARY 12, 14, 26, AND 27, 2002

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

PAUL S. SARBANES, Maryland, Chairman

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

ZELL MILLER, Georgia

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

JON S. CORZINE, New Jersey

DANIEL K. AKAKA, Hawaii

PHIL GRAMM, Texas

RICHARD C. SHELBY, Alabama

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

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)

(III)

CONTENTS

VOLUME I

TUESDAY, FEBRUARY 12, 2002

Page

Opening statement of Chairman Sarbanes ........................................................... 1

Opening statements, comments, or prepared statements of:

Senator Shelby .................................................................................................. 3

Senator Miller ................................................................................................... 4

Senator Enzi ..................................................................................................... 4

Senator Corzine ................................................................................................ 6

Senator Hagel ................................................................................................... 7

Senator Stabenow ............................................................................................. 7

Senator Bayh .................................................................................................... 8

Senator Carper ................................................................................................. 8

Senator Johnson ............................................................................................... 9

Prepared statement ................................................................................... 55

Senator Schumer .............................................................................................. 10

Senator Dodd .................................................................................................... 11

Senator Akaka .................................................................................................. 56

WITNESSES

Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, 1993

to 2000 ................................................................................................................... 14

Prepared statement .......................................................................................... 56

Richard C. Breeden, Chairman, U.S. Securities and Exchange Commission,

1989 to 1993 ......................................................................................................... 16

Prepared statement .......................................................................................... 58

Response to written questions of Senator Hagel ........................................... 94

David S. Ruder, Chairman, U.S. Securities and Exchange Commission, 1987

to 1989 ................................................................................................................... 20

Prepared statement .......................................................................................... 69

Response to written questions of Senator Hagel ........................................... 94

Harold M. Williams, Chairman, U.S. Securities and Exchange Commission,

1977 to 1981 ......................................................................................................... 23

Prepared statement .......................................................................................... 75

Response to written questions of Senator Hagel ........................................... 95

Roderick M. Hills, Chairman, U.S. Securities and Exchange Commission,

1975 to 1977 ......................................................................................................... 26

Prepared statement and exhibits .................................................................... 78

Response to written questions of Senator Hagel ........................................... 95

THURSDAY, FEBRUARY 14, 2002

Opening statement of Chairman Sarbanes ........................................................... 97

Opening statements, comments, or prepared statements of:

Senator Gramm ................................................................................................ 98

Prepared statement ................................................................................... 141

Senator Stabenow ............................................................................................. 99

Page

IV

Opening statements, comments, or prepared statements of—Continued

Senator Stabenow—Continued

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

Page

V

Lynn E. Turner, Chief Accountant, U.S. Securities and Exchange Commission, 1998 to 2001 ................................................................................................ 196

Prepared statement .......................................................................................... 243

Dennis R. Beresford, Former Chairman, Financial Accounting Standards

Board, 1987 to 1997 ............................................................................................. 201

Prepared statement .......................................................................................... 258

Response to question raised by Senator Miller .............................................. 270

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Article by Walter P. Schuetze in Abacus, a Journal of Accounting, Finance,

and Business Studies, ‘‘What Are Assets and Liabilities?’’ dated February

2001 ....................................................................................................................... 271

Article by Walter P. Schuetze, 2001 RJ Chambers Research Lecture, dated

November 27, 2001 .............................................................................................. 288

Letter from Walter P. Schuetze to Senator Charles E. Schumer, dated March

25, 2002 ................................................................................................................. 296

Letter with attachments from Lynn E. Turner, Director, College of Business,

Colorado State University, dated March 1, 2002 .............................................. 302

WEDNESDAY, FEBRUARY 27, 2002

Opening statement of Chairman Sarbanes ........................................................... 341

Opening statements, comments, or prepared statements of:

Senator Gramm ................................................................................................ 342

Senator Miller ................................................................................................... 343

Senator Corzine ................................................................................................ 362

WITNESSES

John H. Biggs, Chairman, President, and CEO, Teachers Insurance and Annuity Association–College Retirement Equities Fund (TIAA–CREF) ............. 343

Prepared statement .......................................................................................... 373

Ira M. Millstein, Co-Chairman of the Blue Ribbon Committee on Improving

the Effectiveness of Corporate Audit Committees; Senior Partner, Weil,

Gotshal & Manges, LLP ...................................................................................... 350

Prepared statement .......................................................................................... 378

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Miscellaneous exhibits submitted by Ira M. Millstein, Co-Chairman of the

Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit

Committees; Senior Partner, Weil, Gotshal & Manges, LLP ........................... 388

VOLUME II

TUESDAY, MARCH 5, 2002

Opening statement of Chairman Sarbanes ........................................................... 505

Opening statements, comments, or prepared statements of:

Senator Bunning ............................................................................................... 506

Senator Dodd .................................................................................................... 507

Senator Miller ................................................................................................... 507

Senator Crapo ................................................................................................... 508

Senator Corzine ................................................................................................ 508

Prepared statement ................................................................................... 550

Senator Stabenow ............................................................................................. 515

Prepared statement ................................................................................... 550

Senator Bennett ................................................................................................ 515

Page

VI

WITNESSES

David M. Walker, Comptroller General of the United States, U.S. General

Accounting Office; accompanied by: Thomas McCool, Managing Director,

Financial Markets and Community Investment; and Robert Gramling,

Former Director, Corporate Financial Audits .................................................... 508

Prepared statement .......................................................................................... 551

Robert R. Glauber, Chairman and Chief Executive Officer, National Association of Securities Dealers, Inc. ............................................................................ 527

Prepared statement .......................................................................................... 569

Joel Seligman, Dean and Ethan A.H. Shepley University Professor, Washington University School of Law in St. Louis; Public Member, American

Institute of Certified Public Accountants Professional Ethics Executive

Committee ............................................................................................................. 530

Prepared statement .......................................................................................... 573

John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University

School of Law ........................................................................................................ 534

Prepared statement .......................................................................................... 582

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

GAO Report, SEC Operations, Increased Workload Creates Challenges, dated

March 2002 ........................................................................................................... 594

GAO Report, Highlights of GAO’s Corporate Governance, Transparency and

Accountability Forum, dated March 2002 .......................................................... 638

Business Week article submitted by Senator Paul S. Sarbanes, dated March

11, 2002 ................................................................................................................. 653

The Wall Street Journal article submitted by Senator Robert F. Bennett,

dated February 25, 2002 ...................................................................................... 654

Letter from GAO Comptroller General of the United States David M. Walker

to Senator Paul S. Sarbanes, dated May 3, 2002 .............................................. 657

Letter from John C. Coffee, Jr., Bevis Longstreth, and Joel Seligman to

Senator Paul S. Sarbanes, dated July 1, 2002 .................................................. 670

Letter from SEC Chairman Harvey L. Pitt to Senator Phil Gramm, dated

July 3, 2002 .......................................................................................................... 674

Letter from SEC Attorney General Eliot Spitzer to Senator Paul Sarbanes,

dated June 5, 2002 ............................................................................................... 676

WEDNESDAY, MARCH 6, 2002

Opening statement of Chairman Sarbanes ........................................................... 679

Statement of Senator Gramm ................................................................................. 680

WITNESSES

Shaun F. O’Malley, Chairman, 2000 Public Oversight Board Panel on Audit

Effectiveness (O’Malley Commission); Former Chairman, Price Waterhouse;

Past President, Financial Accounting Foundation ............................................ 681

Prepared statement .......................................................................................... 716

Lee J. Seidler, Deputy Chairman of the 1978 AICPA Commission on Auditors’

Responsibilities; Managing Director Emeritus, Bear Stearns .......................... 685

Prepared statement .......................................................................................... 725

Arthur R. Wyatt, CPA, Former Chairman, American Institute of Certified

Public Accountants’ Accounting Standards Executive Committee; Former

Chairman, International Accounting Standards Committee; Former Partner, Arthur Andersen & Co.; Professor of Accountancy Emeritus, University

of Illinois ............................................................................................................... 689

Prepared statement .......................................................................................... 739

Abraham J. Briloff, Emanuel Saxe Distinguished Professor Emeritus, Bernard

M. Baruch College, CUNY ................................................................................... 692

Prepared statement .......................................................................................... 745

Bevis Longstreth, Member of the O’Malley Commission; Former Commissioner of the Securities & Exchange Commission, 1981–1984; Retired Partner, Debevoise & Plimpton .................................................................................. 696

Prepared statement .......................................................................................... 793

Page

VII

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

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

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

Page

VIII

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

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

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

Page

IX

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

VOLUME III

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

TUESDAY, JULY 9, 2002

Senate Floor Debate in Regard to the Accounting Reform and Investor Protection Act of 2002 taken from the Congressional Record ..................................... 1225

Continuation of the Senate Floor Debate in Regard to the Accounting Reform

and Investor Protection Act of 2002 taken from the Congressional Record .... 1247

WEDNESDAY, JULY 10, 2002

Senate Floor Debate in Regard to the Accounting Reform and Investor Protection Act of 2002 taken from the Congressional Record ..................................... 1261

THURDAY, JULY 11, 2002

Senate Floor Debate in Regard to the Accounting Reform and Investor Protection Act of 2002 taken from the Congressional Record ..................................... 1355

Continuation of the Senate Floor Debate in Regard to the Accounting Reform

and Investor Protection Act of 2002 taken from the Congressional Record .... 1387

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

Page

X

MONDAY, JULY 15, 2002

Senate Floor Debate in Regard to the Accounting Reform and Investor Protection Act of 2002 taken from the Congressional Record ..................................... 1463

THURSDAY, JULY 25, 2002

Senate Floor Debate in Regard to the Sarbanes-Oxley Act of 2002 Conference

Report taken from the Congressional Record .................................................... 1613

VOLUME IV

Transcript of President Bush’s remarks at the Signing Ceremony for the

Sarbanes-Oxley Act of 2002 on July 30, 2002 ................................................... 1653

The Sarbanes-Oxley Act of 2002, Public Law 107–204 signed by President

Bush on July 30, 2002. Text is identical to Conference Report on H.R. 3763

passed by the House of Representatives on July 25, 2002, by a vote of

423 Yeas to 3 Nays and by the Senate by a vote of 99 Yeas to 0 Nays .......... 1657

H.R. 5118, Corporate Fraud Accountability Act of 2002, passed by the House

of Representatives on July 16, 2002, by a vote of 391 Yeas to 28 Nays .......... 1723

S. 2673, Public Company Accounting Reform and Investor Protection Act of

2002, passed by the Senate on July 15, 2002, by a vote of 97 Yeas to

0 Nays. For procedural purposes, the bill is renamed H.R. 3763 ..................... 1737

Senate Committee on Banking, Housing, and Urban Affairs report on S. 2673,

Public Company Accounting Reform and Investor Protection Act of 2002,

filed by Chairman Sarbanes on June 26, 2002 .................................................. 1879

S. 2673, Public Company Accounting Reform and Investor Protection Act of

2002, passed by the Senate Committee on Banking, Housing, and Urban

Affairs on June 18, 2002, by a vote of 17 Yeas to 4 Nays ................................ 1953

Senate Committee on the Judiciary Report on S. 2010, Corporate and Criminal Fraud Accountability Act of 2002, filed by Chairman Leahy on May

6, 2002 ................................................................................................................... 2071

S. 2010, Corporate and Criminal Fraud Accountability Act of 2002, passed

by the Senate Judiciary Committee on April 25, 2002, by a vote of 19

Yeas to 0 Nays ...................................................................................................... 2109

H.R. 3763, Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, passed by the House of Representatives on April

24, 2002, by a vote of 334 Yeas to 90 Nays ....................................................... 2135

House Committee on Financial Services Report on H.R. 3763, Corporate and

Auditing Accountability, Responsibility, and Transparency Act of 2002,

dated April 22, 2002 ............................................................................................ 2193

H.R. 3763, Corporate and Auditing Accountability, Responsibility, and Transparency Act of 2002, passed by the House Committee on Financial Services

on April 16, 2002, by a vote of 49 Yeas to 12 Nays ........................................... 2257

(1)

ACCOUNTING REFORM AND

INVESTOR PROTECTION

VOLUME I

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 writedown 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

2

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

3

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

4

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.

5

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.

6

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.

7

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 longterm 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

8

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.

9

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

10

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.

11

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

12

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.

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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.

14

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.

15

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

16

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

17

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

18

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

19

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.

20

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 connecVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 87708V1.TXT SBANK4 PsN: SBANK4
21

tion 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 riskmanagement 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

22

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.

23

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.

24

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.

25

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-thebooks 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

26

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.

27

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

28

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 instituVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00042 Fmt 6633 Sfmt 6633 87708V1.TXT SBANK4 PsN: SBANK4
29

tion 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

30

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

31

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. Build- ing 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

32

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.

33

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.

34

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

35

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

36

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.

37

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 selfregulating 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 publicprivate body which it can use to accomplish its functions.

38

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 $21⁄2 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.

39

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.

40

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.

41

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 shorthanded, 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.

42

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

43

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

44

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

45

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.

46

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

47

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.

48

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

49

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

50

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.

51

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

52

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.

53

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.

54

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:]

55

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

56

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.

57

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

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1The Chief Financial Officer of Bennett Funding was sentenced to 30 years imprisonment

after conviction on more than 60 felony counts.

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 selfregulation.’’ 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.

—————

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

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2This company owned two ‘‘special purpose entities,’’ or (SPE’s), although our SPE’s were fully

disclosed and included in our financial statements. 3The 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.

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

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.

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

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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.

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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 ‘‘ac- crue’’ 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.

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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 finanVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00076 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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cial 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.

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4PricewaterhouseCoopers has recently announced it would add three outside directors to its

board, a definite step in the right direction.

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

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 manageVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00078 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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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.

ment 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

Prohibit consulting activities by the audit firms except where 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.

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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

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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

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6The 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.

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

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.

69

*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.

PREPARED STATEMENT OF DAVID S. RUDER*

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 sysVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00083 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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tem. 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.

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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

72

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.

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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.

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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

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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 selfregulation 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

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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.

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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

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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

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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.

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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 toplevel 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.

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The Directors of the Audit Committee

Since 1977, the investment world has looked to the audit committees of publiclytraded 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

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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.

83

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.

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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.

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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.

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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 pat- ents 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.

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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.

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1See, 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). 2The 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]).

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

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.

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3See Codification of Statements on Auditing Standards, AU § 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.

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.

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

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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

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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.

92

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.

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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

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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.

95

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 comVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00109 Fmt 6602 Sfmt 6602 87708V1.TXT SBANK4 PsN: SBANK4
96

panies 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.

(97)

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

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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, professionwide 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.

99

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

100

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.’’

101

[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.

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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

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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.

104

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.

105

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

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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

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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.]

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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 highquality standards that are globally accepted is going to be difficult.

109

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 transVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00123 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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actions, 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 rulebased 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 comVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00124 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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pany, 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

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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 sharebased 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

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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.

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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 largVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00128 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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est 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.

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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 $11⁄2 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

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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

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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.

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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

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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

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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.

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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.]

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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

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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.

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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,

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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.]

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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 daughterin-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

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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.

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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

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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 deVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00144 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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cide 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.

132

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.

133

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,

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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.

135

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 tryVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00149 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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ing 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

137

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

138

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?

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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.

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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:]

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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.

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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 selfregulation; 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.

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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

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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.

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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.

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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’eˆtre 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

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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 finanVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00161 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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1For 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) 2For 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

cial 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

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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:

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• 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 reVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00164 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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port 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 controlbased 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 dayto-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

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pany’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

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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 mixedattribute 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 highquality 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

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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 Ge ́lard (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

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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.

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• 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.

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• 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.

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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.

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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 corVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00195 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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poration’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.

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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

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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 accountVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00198 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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ing 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.

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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 wrongdoing 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

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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.

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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.

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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

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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—curVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00204 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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rent 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. PreSeptember 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

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$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 brokerdealers 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

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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

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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

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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

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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,

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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

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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-onfirm 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

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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.

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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

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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’

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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.

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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 nearterm 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

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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.

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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.

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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.

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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?

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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

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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

210

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

211

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.

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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

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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.

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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

215

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

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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.

217

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.

218

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?

219

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

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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.

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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

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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

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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.

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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.

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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?

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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?

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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

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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

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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?

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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

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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 finetune 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.

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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?

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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:]

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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.

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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

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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

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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-tomarket 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.

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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.

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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

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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.’’

that the information flowing into the markets is trustworthy and that investors

can make informed decisions and will not be misled.1

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

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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

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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 relationVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00256 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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ship 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.

—————

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 manageVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00257 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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ment, 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.

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• 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 preVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00259 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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viously 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

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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:

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• 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

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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

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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 mid1970’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

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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.

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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

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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

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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.

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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 101⁄2 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.

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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.

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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

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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

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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 firstclass 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

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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

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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.

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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

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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

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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

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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.

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• 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.

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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.

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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

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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.

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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

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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.

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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

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$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 selfVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00290 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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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.’’

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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 MINDBOGGLING 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 allinclusive, 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

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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-seis-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

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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 331⁄3 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

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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

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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.

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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 judgVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00297 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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ments 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.

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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

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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.

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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.

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1FASB 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.

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.

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

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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 heldto-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.

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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

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2For 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.

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

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.

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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.

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.

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

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4This 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. 5The 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.

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

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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.

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 mid1998 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.

—————

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

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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.

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(341)

ACCOUNTING REFORM AND

INVESTOR PROTECTION

WEDNESDAY, FEBRUARY 27, 2002

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10:30 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.

We were delayed because there was a vote, which has now been

taken care of and, hopefully, we will have a stretch of time here.

This morning, the Senate Committee on Banking, Housing, and

Urban Affairs holds its fourth hearing on accounting and investor

protection issues raised by the collapse of Enron and other public

companies. Today, the Committee will consider numerous corporate

governance issues raised by recent corporate difficulties.

Issues raised by corporate governance that have received widespread attention include the independence of directors, the independence of audit committees, selection of public firms’ external

auditors, corporate loans to executives, restrictions on option sales,

conflict of interest policies, and other matters.

A recent article in the Financial Times stated that: ‘‘Effective

corporate governance is the only way that investors can protect

themselves against executives who make mistakes and seek to

cover them up. . . . It gives meaning to the shareholders’ ownership of the company.’’ In studying these issues, we need to keep in

mind that any change to corporate governance practices should be

made with an eye toward protecting the investing public.

At our first hearing, we heard from five former Chairmen of the

SEC, who made a number of recommendations on the corporate

governance issue, and I am going to include that in the record and

I may refer to some of them in the question period.

The Chairman of the SEC, the current Chairman, Harvey Pitt,

has asked both the New York Stock Exchange and the NASD ‘‘to

review their listing agreements, to see whether new obligations for

corporate officers and directors can be articulated.’’

The Bush Administration is exploring ways to make it easier for

the Government, it so reported, to punish corporate officers and directors accused of misleading shareholders.

On February 13, the SEC announced a number of initiatives on

corporate disclosures, including requiring more prompt reporting

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by companies of transactions by company insiders and the company

securities, and improving public disclosure of trading activities by

executive officers, directors, and beneficial owners of 10 percent of

a company’s stock.

There have also been suggestions brought to our attention to require stock exchanges to toughen board and committee independence standards, to require a substantial majority of independent

directors, to require stock exchanges to toughen their definitions of

who qualifies as an independent director, and a mandate that the

SEC require additional proxy disclosures regarding the role of the

audit committee in approving both audit engagement and nonaudit

consulting agreements with the audit firm.

We are very pleased today to have two knowledgeable, able, and

committed witnesses. Both are former members of the New York

Stock Exchange and NASD’s 1998–1999 Blue Ribbon Committee on

Improving the Effectiveness of Corporate Audit Committees. The

Blue Ribbon Committee published a series of recommendations and

guiding principles for best practices by audit committees.

Our first witness is John Biggs, who is Chairman, President, and

CEO of TIAA–CREF. He serves as an at-large trustee of the Financial Accounting Foundation, a trustee of the International Accounting Standards Committee, a member of the Public Oversight

Board, and was a member of the Blue Ribbon Committee.

And our other witness today is Ira Millstein, a Senior Partner of

the law firm of Weil, Gotshal & Manges. In addition to his legal

practice, Mr. Millstein is Chairman of the Board of Advisors of the

International Institute for Corporate Governance at the Yale

School of Management. He is a former Chairman of the OECD

Business Sector Advisory Group on Corporate Governance, and was

Co-Chair of the Blue Ribbon Committee to which I made reference.

The other Co-Chair of the Blue Ribbon Committee, John Whitehead, former Deputy Secretary of State, was unable to join this

panel because of a scheduling problem, but he will be with us on

March 19. We will have the benefit of his testimony at that time.

We very much are looking forward to hearing our two witnesses

today and I want to express my appreciation and the appreciation

of the Committee for their willingness to give considerably of their

time, effort, and energy in order to be of assistance.

Before I turn to the witnesses, I will turn to my colleagues.

Senator Gramm.

STATEMENT OF SENATOR PHIL GRAMM

Senator GRAMM. Well, Mr. Chairman, let me thank you very

much for the hearings that you are holding. I thought our hearing

yesterday was outstanding and it really went a long way to focus

on the whole debate about accounting standards and independence

of standard setting boards.

I am very pleased to have an opportunity to be here today. I

would like to say to Mr. Biggs that three members of my family

are investors in TIAA–CREF. As an old college professor, I invested

in TIAA–CREF. My wife invested in TIAA–CREF. And I now force

my number-one son, who is a new economist and college professor,

to put 15 percent of his gross into TIAA–CREF.

[Laughter.]

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I told him, if he will do that religiously, that he will some day

be well off. And I want to thank you for the good job you do in

turning school teachers into capitalists.

Mr. BIGGS. Thank you.

[Laughter.]

Senator GRAMM. The American system lived out the only meaningful part of Karl Marx’s dream, and that is that workers could

own the means of production.

This is a very important subject. I would have to say that, as I

look at where we are and the whole question of corporate governance, I think someone today who had something to contribute in

corporate governance would think a long time before going on a

corporate board.

There appear to be people who think that someone meeting four

or six times a year is capable of auditing the books of a giant corporation.

My own feeling is that we have to have a good balance here in

improving system, but yet, not producing a system where no one

who has any real ability will choose to serve on a corporate board.

Since a year from now, I am going to be gainfully employed

somewhere, this is something that I have thought through myself

in terms of what are the benefits relative to the potential costs in

being involved in corporate governance? And I think, as we go

through the process, this is something we have to keep in mind.

No matter what the rules are, if you do not have good people, you

are not going to have an effective system.

So, Mr. Chairman, this is very important business we are about

here. I am glad that the jurisdiction of these areas is the jurisdiction of this Committee. I think the public and our great system of

capital accumulation will benefit from that fact.

Chairman SARBANES. Thank you very much. In the cause of full

disclosure, since my wife was a teacher, I should say that she has

also invested in TIAA–CREF and persuaded me to do the same.

Senator Miller.

COMMENTS OF SENATOR ZELL MILLER

Senator MILLER. This is important business, Mr. Chairman, and

I thank you for holding these hearings and I thank these outstanding witnesses for being with us.

I have no opening statement.

Chairman SARBANES. Thank you very much.

Mr. Biggs, why don’t we start with you? We will be happy to

hear from you. Then we will turn to Mr. Millstein.

STATEMENT OF JOHN H. BIGGS

CHAIRMAN, PRESIDENT, AND CEO

TEACHERS INSURANCE AND ANNUITY ASSOCIATION

COLLEGE RETIREMENT EQUITIES FUND (TIAA–CREF)

Mr. BIGGS. Thank you, Mr. Chairman. I am honored that you

have asked me to do this. I am also very uneasy about the obligations that my company has to the two of you.

[Laughter.]

In response to Senator Gramm, what has been extraordinary is

the wealth that has been created by people putting in 15 percent

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a year. At last count, we had 35,000 of our participants who are

millionaires, and they are beginning to call in and ask us questions

about something that they said that they did not think they would

ever be subject to the estate tax. But all of a sudden, they do have

estate tax problems and we had to create a trust company to serve

their needs. It has been a wonderful experience.

As you said, Senator, I have had a fair amount of experience

with the oversight groups, the NASD, and most recently, the POB.

The Enron collapse is still a mystery. We do not understand it

fully. It is an extraordinary event and the number of questions that

it raises is enormous.

I am happy to report, again, in my TIAA–CREF role, that our

analyst on Enron came to the conclusion last year in the spring

and summer that he simply could not understand the company

from what was reported. And he said, if we cannot understand it,

we should not buy any of the stock. Unfortunately, we did have

some of the stock because we have Index Funds and Enron had become one of the largest companies in the S&P 500, and so, we held

stock there. But the fact that so many people thought they could

understand that company through reading their financial statements and recommended it, raises real questions for all of us about

the quality of the analysis, the ability of analysts to read accounting statements.

I have three topics that I would like to focus on. First, the issue

of the environment that may have created this. A lot of people said,

well, there are all these issues as far as the accounting regulation

and the oversight of the accountants. But what were the environmental factors?

It seems to me one that was very powerful was the widespread

overuse, in my view, of stock options. Sixty percent of Enron’s employees had them. The focus on daily stock prices has become almost an epidemic, I think, in American business. And at least, I

think we ought to expense those options because there are better

ways to use stock in employee incentive plans.

The second issue is some basic common sense regarding auditor

independence. We have had some specific experience in my company which I would like to tell you about. But also, I thought a lot

about how Congress might address this and I do have a suggestion,

a recommendation to make to you.

Finally, what I believe was a major topic yesterday—the need for

a strong regulatory model for overseeing the accounting profession.

And I know that you will be talking with Chuck Bowsher soon

about the POB, but I can give you a businessman’s perspective on

that experience.

First off, the stock options. I do not want to spend too much time

on this. It is an issue that those of us in the investment world have

been fairly heated about. The investment community sees it one

way and the business community, the preparers of statements, see

it differently. And there has been a long stand-off between us.

The 1972 rules on stock options make them seem to be free. But

that is limited to a very narrow kind of stock compensation award,

the fixed-price stock option. There are many other award systems—

those that involve incentives, hurdles, requirements—in which you

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cannot get the free treatment under the 1972 rules, the rules in

APB–25.

Enron used options very extensively. Sixty percent of their employees had options. Obviously, their executives had a lot of them.

There was enormous interest in the stock price.

One of the more gross stories that came out was when the stock passed $50, there was a $100 bill put on every employee’s desk.

And it seems to me, if you want to really focus everybody on the

daily value of the stock price, that is a good way to do it. But is

that really a healthy corporate environment?

Ironically, of course, there were years when there were no taxes

paid by Enron because of the strange practice we have in this country that you can deduct the cost of the stock option when an employee exercises it, but you do not have to show it in the earnings

statement to the shareholders.

There was extraordinary lobbying, which I think is well known,

and the very existence of the private sector standard setting was

threatened, and the FASB and the SEC both capitulated finally in

1994 and didn’t adopt a requirement that we believe was a reasonable one, with reasonable provisions. It should have been adopted.

Arthur Levitt said publicly that he thought it was the greatest

mistake made by the SEC during his tenure that they did not continue to fight for that.

The FASB ruling gives a choice—you can either disclose it in a

footnote or you can put it in the earnings statement.

I am very proud of the fact that I am on the board of the one

major company in the United States that has decided to use FAS

123, the option of expensing it, and that is the Boeing Corporation.

I chair the Boeing Compensation Committee and we have a very

strong stock award plan that I think is an optimal plan in many

ways. It is a plan that we at TIAA–CREF have urged on companies

regularly as an investor. Namely, it requires hurdles to be met before a stock option or a stock award becomes valuable.

In the case of Boeing, very simply, we make a generous, restricted stock award to executives each year, and if the company

does not have at least a 10 percent growth in value, compounded

value over 5 years, the entire value is forfeited. If they have a 10

percent value, they get 25 percent of the award, and if they get up

to a 15 percent annual growth rate, they can get as much as 125

percent of the award.

Clearly, you do not pay huge amounts to executives when they

have not had excellent performance. The current fixed-price stock

option frequently ends up doing that. The kind of plan that Boeing

wanted to develop is not often used since it would not qualify as

a free option under the accounting rules.

And I can tell you that, meeting after meeting, we have talked

to companies and asked them to adopt some hurdle rates, some

performance standard before they received huge pay-offs, and they

all refuse to do it because of the accounting issues.

Again, the accounting model is a 1972 model. And I think it is

interesting that the date was 1972. It was in 1973 that the two

Nobel winners formulated the Black-Scholes model.

I can assure you that every high-tech executive in Silicon Valley

has that model on his Palm Pilot and knows how to calculate the

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value of his own options. On the other hand, he would be very unwilling to see the Black-Scholes used to value his company’s stock

plan and put that cost into his expenses.

Some of the side effects of this that I think are undesirable is

that we have had explosive growth in the use of the fixed-priced

stock option. It has distorted earnings statements. I think that

there has been a dramatic decline in dividends paid by companies

over the last decade, primarily because of this pervasive use of

stock options.

A dollar per share paid as a dividend when the stock goes ex-dividend, drops the stock price by a dollar. And if your compensation

is largely determined by a stock option, which only depends on the

price of the stock, you are not going to be in favor of paying out

that kind of cash to the shareholders.

In some companies, stock options have completely replaced pension plans. It was interesting when we challenged IBM on the way

they were abandoning their defined benefit plan, the answer of the

company was most of our competitors in the high-tech industry

have no pension plan whatsoever. They rely entirely on fixed-price

stock options, and so, why should IBM continue a very expensive

form of the defined benefit form?

I am not quite sure how Congress should deal with this issue.

I think we at TIAA–CREF have always urged that we keep that

standard setting, those technical issues, in the private sector with

the FASB or with the International Accounting Standards Committee. Some expression of support from Congress might encourage

the FASB to take up the issue.

The Levin bill has an obvious plausibility. If an employee exercises an option and earns a million bucks off of it, and the company

is allowed to deduct that from their taxable income, isn’t it plausible that they would also deduct it from their earnings? And that

bill seems to be based on that, and I find that as a pretty heavy

way to go about getting this done. One would wish that we could

do it through the accounting standards process.

Let me turn to auditor independence.

We have two practices at TIAA–CREF that we have been very

pleased with and I would be happy to answer your questions about

them. We are not sure when it started, but we think it was back

in the 1950’s, that we had a policy of rotating our auditor every 5

years. We have liberalized that to 7 years. I think 7 years is a reasonable number.

During my Chairmanship, we have had two rotations and I

would be glad to comment on what that experience has been like.

It is not nearly as bad as many would make it out to be.

The other policy was a simple, bright-line test that when we hire

an auditor, the auditor does only auditing and nothing else. We do

not use them for any other services. And it is extraordinary the

number of services that an accounting firm can offer to you, from

finding new housing for your employees when they move to another

city, to doing stuff that might plausibly be connected with the

audit. But it is a broad array.

We just said that we are not going to have our auditor do any

of those activities, including tax-planning work for the company. I

know the accountants contest this view.

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Taxes are incredibly complex in companies. In ours particularly,

where we are a combination of a life insurance company and a mutual fund complex and a trust company and so forth. The tax issues

are complex. We want to use a separate consulting firm. It happens

to be an accounting firm. We use them to do the tax work, and I

value very highly having their name on the line that they believe

our decisions are appropriate, not too aggressive, sensible tax provision for us to take because there are judgments involved and an

understanding of the background.

Then I have our auditors come in and do an independent second

review of their competitor’s work and tell me that it is okay, that

they are comfortable with it.

Frankly, I have a chance, and our chief financial officer, to probe

at both of them on those important issues. But it has been a simple, clean system that has served us well. I testified before you in

the fall of 2000 on this, on our experience.

The companies and the auditors will be very much opposed to rotation. But I can vouch from our experience that it has not been

a costly or difficult process to go through this.

The SEC, in any event, requires rotation of the partners on a

periodic basis, and when the partners rotate, it is certainly a good

time to rotate the whole firm and bring in a new group.

What we have found, very briefly, is it is an enormously energizing effect for us to have our financial people—and I get involved

myself—in interviewing the people proposing to do the audit, in

that they bring in their stars. We can get one of the best teams

that have done the work at the Prudential or the Metropolitan Life

or one of the other major financial institutions. It could be Fidelity

or whoever. And they can bring in folks who have a new point of

view, have a new understanding.

I value very highly the services of an audit firm. They are the

brightest group of people that can come in and really know all

about your company and can answer the questions of the senior

management in a way that nobody else can.

I do not rely on the State examiners in the same way. They do

not have the background. They do not have the talent of the auditors. You want the very best and brightest on your account. And

if you rotate, you will get them because the firms coming in will

compete with the quality of their people.

I think rotation every 5 to 7 years is good corporate policy. We

recommend it always to our portfolio companies that we invest in,

but not many of them have adopted it.

I was amused to see Kodak celebrating the 100th anniversary of

their relationship with their auditor. And I thought, is 100 years

with the same auditor really a good thing? Is that anything you

want to brag about? Maybe sometime in the 100 years you might

have gotten some new ideas with a different firm.

Senator GRAMM. If you are in business for 100 years, you want

to brag about it.

Mr. BIGGS. That is true.

[Laughter.]

I would agree with that, Senator Gramm.

I think about the Enron case and Arthur Andersen. Had Arthur

Andersen in 1996 known that Peat Marwick was going to come in

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in 1997, there would have been a very different kind of relationship

between them and Enron. Clearly, they would have wanted to have

their work papers in order, all of the deals documented and well

explained. They might well have challenged Enron’s management

in that early period where Enron was changing its accounting.

The new firm coming in would do an outstanding peer review, on

the spot, real time, of that previous auditor. We have been discouraged by the lack of effectiveness of the peer review mechanism that

the POB has overseen for the accounting profession.

It is not a bad system. Good people work on it. There have been

improvements in accounting because of that peer review system.

But it would not have anywhere near the bite that it would have

if you had rotation and a new audit firm coming in, real life, on

a firm.

I would think that there is a very high probability that had rotation been in place at Enron with Arthur Andersen, you would not

have had the accounting scandal that I think we now have, but instead, you would have had probably a challenged company. Maybe

even Enron might have changed its business practices if you had

had a tough questioning, challenging accounting relationship,

which they did not have.

I think that the other problems of the audit relationship are diminished enormously when you have rotation, in the sense that if

you hired one of the partners from the audit firm, by the time the

person is really in place and becomes the CFO of your company,

you have a new audit firm.

So, I do not think that you need to have as many rules and monitoring of that, which I think is very difficult and would trouble me

in limiting the employment possibilities for auditors.

We have an excellent, outstanding individual in our company

that manages all of our investment accounting functions who was

a manager at Deloitte & Touche. But we now have Ernst & Young

as our auditor. And so, I do not see any problem of his being able

to dictate to the young E&Y auditors what their views might be.

There is also a kind of simple economic analysis. I believe that

the Andersen people considered the Enron account as a perpetuity.

It wasn’t $55 million in fees in the next year. They assumed they

were going to get $55 million every year going into the future. And

if you discount that at some reasonable discount value, that relationship was somewhere between a half-billion and a billion-dollar

asset to the Arthur Andersen firm. When that kind of money is involved, the pressure on the people who might lose the account if

they stand up to management I think is just—you cannot expect

human beings to cope with that kind of money.

Rotation would just cut that whole effect off. I hope that is an

action that will be taken by Congress. I think it requires Congressional action. I do not think the SEC could impose that. I do not

think a self-regulatory organization could impose that because I

think it affects the basic working of American business.

I am very reluctant to impose more rules on American business.

But in this case, the importance to the capital markets and the

public interest in quality statements is so enormous, that I think

that those considerations would offset the intrusion, the regulatory

intrusion.

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My third point I will not spend a lot of time on. I have probably

gone on too long already. But I think we need a strong regulatory

model. I had the experience for just 9 months of working on the

POB. I was persuaded, strong-armed into doing it by people saying

it was my public duty to do so. It was very hard work. The agendas

are very long, extremely complex, fascinating in many ways. There

is nothing more interesting than studying the detail of a failed

audit and getting the evidence of who lied to whom and what were

the circumstances.

I admit that sometimes 100 page documents which we received

at each meeting went by quickly. But they were nevertheless timeconsuming and demanding.

I do not think we will ever get, putting myself aside, a better

board of people than the POB had. Two individuals that you all are

familiar with—Chuck Bowsher and Norm Augustin—were members of the committee. Mel Laird served for a number of years. I

succeeded Paul O’Neill, who went out of retirement back into an

active job. We had Don Kirk, who Chaired the FASB, and Aulana

Peters had been a member of the SEC.

I think it was a hard-working group. It was a smart group. But

it was not welcomed by the accounting profession. Every time the

POB tried to cause a change which was opposed, the opposition

was made clear, finally to the point of absurdity when they simply

said, we are not going to pay your expenses any longer, or pay for

your staff. And at that point, the SEC had to intervene and say,

you have to do it. That kept us alive.

But it was clear that we did not have the authority. When there

was a failed audit, we would ask for information and we were in

effect begging for the accounting firms to comply, and if they had

any real serious concerns, they simply wouldn’t.

Then if we did find somebody who had committed an outrageous

audit, all we could do is recommend to the executive committee of

the AICPA that they look into the matter and find out whether

there had been ethical violations. They would then delay it until

the litigation was over, which was usually about 10 years later. By

that time, we were well past any useful rule.

I think you heard vigorous testimony yesterday from people saying we need a strong oversight board. And I concur with them. I

have had discussions with a number of the former chief accountants and with former chairmen of the SEC, and I think that there

is a general consensus that we need that, and so I do not think I

need to go through and tell you about that.

I do have one point, though, and I will end.

The financing of it, I think, is very important. I served on the

Financial Accounting Foundation that raises money to finance the

FASB and appoints the members of the FASB. I am also serving

with Paul Volcker on the International Accounting Standards

Board’s foundation. In each case, we have had to go to the American business community with a tin cup asking for money to support these.

I have had I do not know how many discussions over the 5 or

6 years that I have been doing this with people, and it is a very

uneasy discussion because a key question is always there. In some

cases, they are crude enough to ask, and say, well, how much influVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00363 Fmt 6601 Sfmt 6601 87708V1.TXT SBANK4 PsN: SBANK4
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ence will we have over what the FASB decides? But in other cases,

you know the question is there, but the individual is smart enough

not to ask it.

I think if we can find some way to finance the new regulatory

agency—I would hope also the FAF and maybe even the American

share of the IASB, that you would find that it could be the stock

exchanges could pay for it. They do not want to do it, of course. Or

it could be a registration fee, some kind of fee allocated when

stocks or bonds are issued—so that the users of the statements

would actually pay.

I have been dismayed, and I have a lot of personal experience in

this, asking the investment community to pay for getting quality

finance reporting. They simply won’t do it. They free-ride on the

system. We have to go to others in the business world to do it.

There are some exceptions, I should say.

Actually, TIAA–CREF was never asked and did not until I became involved, and we have become generous supporters because

we know we are going to be in managing assets for 50 to 100 years

ahead just for the people who are signing up now. The long-run

success of the capital markets in America and worldwide are vital

to us.

I could also make a speech about the importance of the quality

international accounting standards effort because I think they will

make it much easier for TIAA–CREF and others to acquire interests in companies in other countries.

Enron notwithstanding, other countries are still so far behind the

United States, that enormous progress needs to be made. And I

think the IASB has a good chance of causing that.

Thank you for letting me go on as long as I have on these points.

Chairman SARBANES. Thank you very much. It has been very

helpful and we appreciate it.

Mr. Millstein, we would be happy to hear from you now.

STATEMENT OF IRA M. MILLSTEIN

CO-CHAIRMAN OF THE BLUE RIBBON COMMITTEE

ON IMPROVING THE EFFECTIVENESS OF

CORPORATE AUDIT COMMITTEES

SENIOR PARTNER, WEIL, GOTSHAL & MANGES, LLP

Mr. MILLSTEIN. Thank you, Mr. Chairman.

I appreciate being invited here, and having the opportunity to

think a little bit more about how to improve corporate governance.

I have been fussing with corporate governance for about 20 years,

teaching it in one way or another. And I would like to say how

much I appreciate being here with Mr. John Biggs.

TIAA–CREF is the outstanding corporate activist in the pension

field. They have taken the leadership role in pushing for governance reform for many years. They are entitled to huge credit for

leading capital market participants to focus on corporate governance. And John Biggs has helped me in a number of corporate governance reform efforts, both here in the United States and all over

the world.

I would just like to publicly thank TIAA–CREF for everything

they do in this area.

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Unfortunately, in the process of preparing for today, I thought of

a lot of things that are not in my statement and I would like to

add them today and I am happy to have the opportunity.

[Laughter.]

What we are talking about, basically, is how do we get people to

do the right thing?

Anybody who does not understand what good corporate governance is, and what they should be doing, must be living on another

planet. There are enough courses, lectures, books, good practice

rules and so on, to fill a library about what is good corporate

governance.

And you have to scratch your head after all these years and say,

why doesn’t everybody just do it? Why are we talking about new

regulations and new rules? I agree with Lynn Turner: We can have

rules and rules and rules and rules. But unless people do what

they are supposed to do, nothing is ever going to happen.

For example, even GAAP—the wonderful GAAP—has so many

gaps in it, it is a Swiss cheese. It is all about discretion. And the

question is, how do we get people to use discretion appropriately?

How do we get boards to act the way they ought to act? What do

we have to do to make people realize that the integrity of this system is critical, and that each and every player—from board member to audit committee member to analyst to auditor—has a role

to play in making the system work right?

We do not have to teach them what they have to do. They know

what they have to do. It is just ‘‘Do the right thing.’’ Everybody

knows that is the answer. So how do we get them to do it?

I had practical experience with this issue when I Co-Chaired the

Blue Ribbon Committee. I was asked by Arthur Levitt, the thenChairman of the SEC, Frank Zarb, then head of the NASD, and

Richard Grasso, head of the New York Stock Exchange, to get together a group of people and come up with some ideas about how

to improve the functioning of audit committees.

Chairman Arthur Levitt was worried about managed earnings

and cookie jar reserves and all those nice things. I know Harvey

Goldschmidt, then the SEC Counsel, was talking to you, Senator

Gramm, about these things and trying to figure out what to do?

Well, I was given the job of putting together a great group—John

Whitehead of Goldman Sachs; John Biggs of TIAA–CREF; Frank

Borelli of Marsh & McLennan; Chuck Bowsher, the former Comptroller General; Dennis Dammerman of General Electric; Dick

Grasso of the New York Stock Exchange; Frank Zarb from the

NASD; Phil Laskawy and Jim Schiro from the accounting profession; and Bill Steer, from Pfizer.

That was our very knowledgeable group. What did we do? We

came up with a report. I really urge you to read it. Perhaps if more

people read and understood it—and practiced what it preached—

we would not be here today. The vast majority of our recommendations were implemented by the SEC and the listing bodies. But I

don’t know the facts and so I can’t answer that question. What we

recommended that audit committees do however seems to me to be

capable of avoiding numerous types of problems, both for directors

and investors.

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Look at Recommendation No. 9, for example. The reason that I

mention it is that it has everything in it.

We recommended that the audit committee disclose whether or

not it had done the following things:

Did management review the audited financial statements with

the audit committee, including a discussion of the quality of accounting principles, as applied to significant judgments?

Did the outside auditors discuss with the audit committee the

outside auditor’s judgment of the quality of those numbers?

Did the members of the audit committee step aside and talk

among themselves about whether or not all of these things had

taken place?

We recommended that audit committees disclose in the proxy

statement, that it did all of these things and state that the numbers fairly present the performance of the company.

Just assume that every audit committee in the United States did

all this. Would we have these widespread problems today? I don’t

think so.

The new audit committee requirements have only been in effect

for about a year. And interestingly, we thought that a lot of these

rules were being complied with, but recent events may raise questions about this.

The issue is, how much further can we go in the world of corporate judgment and corporate governance than to tell people to report in the proxy statement whether or not they did these things.

What Mr. [Steven] Harris prompted me to think about this morning is whether there is anything legislatively that could be close to

cause audit committee members to take this even more seriously

than they do.

That is what we wanted to do—cause audit committees to study

this and say, ‘‘This is what we are really going to do. We will talk

to the auditors about quality. We will talk to the internal auditor.

We will talk to management. We will talk among ourselves and we

will pay very close attention to this process.’’ That is what we

wanted to see happen.

Now is a requirement that audit committees report in the proxy

statement whether they did it enough to encourage them to do it?

I would suggest that maybe we could take one step further and ask

the audit committee not only to disclose whether they did it, but

also disclose what they did and what conclusions they reached.

That would be big, bright sunlight.

The SEC, I think, is concerned as to whether or not it has the

authority to do that without impinging in the corporate governance

area a little further than they may have the right to.

I would urge this Committee to consider whether or not it might

be worth giving the Commission just a little more jurisdiction than

it has at the moment, at least making it clear that it could take

such a step and ask the audit committee to disclose not only

whether they discussed these matters, but also what conclusions

they reached.

I know everybody will get very nervous, Senator Gramm, and

cite this as another reason not to serve on an audit committee. I

understand.

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By the way, the audit committees were not deserted because of

our original recommendations; nor have D&O insurers refused to

insure.

But in order to encourage people on the audit committee to do

this, and in order to encourage the Commission to just put a little

more sunlight on the process and ask the audit committee to talk

about what they did or what conclusions they reached, let’s give

them a safe harbor. Let’s give them a safe harbor from litigation

so that they won’t get sued in State court proceedings.

Legislation could provide that the only people who could proceed

against an audit committee member for doing this—namely, talking about what they did—would be the SEC, and then for fraud.

But eliminate State court proceedings and strike suits and all the

rest, which is really what audit committee members worried about.

Directors should not worry about the SEC. The SEC proceeds

fairly, in my view, but directors are worried about strike suits and

they are worried about the litigation that invariably follows in the

State courts. So eliminate them.

Congress has done that before. They have eliminated strike suits

in those kinds of proceedings before. If you really want to throw

sunlight on the process and motivate audit committee members to

do their job, and talk about what they did, it seems to me that a

safe harbor might do the trick.

I would urge Congress to think about that because, as I say,

what we are trying to do is to get people to do the right thing. And

we may have to nudge them a little bit further than we have.

The whether-or-not requirement, which is what the Commission

uses now for disclosure, may not be enough. It is too easy to just

say, yes, we did it. But it doesn’t tell what the audit committee did.

It just says that the committee went through a process. That may

not be enough.

What else could we do to move things along and get boards to

upgrade the way they attack their problems?

By the way, I have confidence in boards. I believe the only way

we are going to solve this is to get boards to do what they are supposed to do in terms of monitoring their agents, the managers.

That is what they are supposed to do.

One of the problems I want to talk about, and I will deal with

that very briefly, is the issue of compensation. I think the compensation packages that are being handed out now unfortunately

motivate managers to go in the direction of pushing the numbers.

I am talking about compensation directly related to stock price.

When your compensation is directly related to stock price, and you

can exercise your options during some snapshot in time when the

price is high, you are motivated—you are only a human being—you

are motivated to see that the price goes up so that you can exercise

your option and cash out at the right time.

There is nothing illegal about that. It is just what you are going

to do. Now shouldn’t we try to cure that because that may be one

of the major pushes? But before I get to that, let’s talk about some

things which have not been done, surprisingly enough, and should

be done now.

Everyone has talked from the beginning about independent directors. Interestingly enough, there is no requirement that a board

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have a substantial majority or any majority of independent directors. There is no requirement anywhere.

My recommendation is that, through listing standards and an

SEC push, there be a requirement that every major board in the

United States have a substantial majority of independent directors.

Period.

Everybody says it is the right thing to do. And in almost every

book about good governance written, it says, ‘‘You ought to have a

majority of outside directors.’’ But there is no requirement.

Let’s make it a requirement. Let’s get a good definition of what

independence is. We do not have a standard definition of what

independence is. We have a definition that applies to audit committees, which came about as a result of the Blue Ribbon Committee

report. But it only applies to audit committees. It doesn’t apply to

the rest of the board.

We have seen in some of the current situations that, the concept

of independence is a little mushy. Is a director who presides over

a university that gets a substantial gift from the company independent? Does such a financial tie impinge on independence?

We should have a good, solid debate about what independence is,

and we should have the stock exchanges provide a listing requirement on director independence that applies, not just to audit committees, but to the majority of directors on the board, including

those on compensation and nominating committees.

Another item on the agenda which ought to be considered: Can

the CEO properly lead the board? I never have believed that it was

a possibility. In other words, can the CEO be the chairman at the

same time? Bear in mind that the board has a completely different

function than does management. Management manages and the

board oversees.

How can you oversee yourself? If you are the chairman and the

CEO, it is very hard for me to understand how you oversee yourself. So, I have always recommended, and a lot of other people have

recommended, that we move toward separating the job of CEO and

chairman and making the chairman an independent director.

Now if you do not like the idea of taking the ‘‘chairman’’ title

away from the CEO, at least every board should have a leader of

the independent directors who is an independent director; a leader

who can lead the compensation talk, lead the nomination talk, lead

the evaluation of the CEO talk.

You should have someone other than the CEO evaluating the

CEO, compensating the CEO, and recommending who the next directors will be. That ought to become a listing requirement as well.

And there ought to be, again, a requirement, and here the SEC can

step in, that every board have a conflict of interest policy and a

code of ethics. No reason not to.

Indeed, I wouldn’t be opposed to the SEC or another body indicating the kinds of things that ought to go into a code of ethics and

then have the SEC require disclosure on a comply-or-explain basis.

Namely, if a board doesn’t follow this voluntary suggestion, explain

why. It seems to me that those are all things that would improve

the performance of the board. An independent majority, a definition of independence, independent leadership, and more disclosure

about ethics and the rest.

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Now that would be a way of getting people again to do the right

thing. I believe if you have the right people on the board, properly

defined, properly independent, they will do the right thing. I believe that. And if the SEC requires them to talk about what they

did, it will help. Sunshine.

Now as far as compensation is concerned, and that is where I am

going to wind up, I think something needs to be done about the

compensation area. And I realize that that is somewhat out of your

jurisdiction. But I think, again, by regulation, or at least by SEC

disclosure provisions, we could get something done there.

One of the greatest experts in the compensation world, Fred

Cook, has recommended that really and truly, you are never going

to make long-term investors out of management as long as they are

permitted to exercise their options during their tenure.

I would like to read from a Fred Cook memo (pages) which is appended to my written statement. It says: ‘‘If executives were expected, or required, to hold a significant portion of all the company

stock they earn . . . and not diversify until after they retire, then

they will regard themselves as owners and builders of long-term

shareholder value instead of short-term value maximizers.’’

So think about it. If compensation committees really wanted to

incentivize their managers by stock, good idea, they should hold

their stock. They might even have options. There is nothing wrong

with that.

But why not require that although they vest right along, options

cannot be exercised until the executive retires. It just seems to me

that is a way of saying to the executive, we really want you to be

a long-term person.

There are other ways of doing that. People do not like to mess

with the tax laws. The other way of doing it is to create a tax incentive for executives to hold onto their stock.

In other words, you can exercise your stock options during your

tenure. But if you hold onto it for a longer period of time—if you

do not exercise it and you do not sell right away—you will get a

tax break by holding onto it 3, 4, or 5 years. We have used tax incentives before. There are ways of doing that. And it seems to me

to be useful.

Now if you do not want to change the tax laws, and I realize that

this is not in your jurisdiction, how about again having the compensation committee explain a little bit more about the type of

compensation arrangement it has adopted for its managers, and explain why they have decided not to require the executive to hold

until after he retires.

In other words, at least say to the compensation committee, if

you are going to allow short-term exercises, explain why you are

doing it. Or explain why you are not going further long-term.

I think the SEC could, if we give it a little more elbow room in

the compensation area, go to the point of having the compensation

committee explain why it was doing something that clearly did motivate the manager to go short-term.

It appears to me that those are clearly opportunities for improving corporate governance and improving the mechanisms by which

people are compensated.

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Finally, on the professional advisor’s side, again, I think there

could be a governance mechanism to use there. And this is my last

recommendation. I think there ought to be a presumption that auditing and consulting do not mix. And that presumption could be

created by the SEC.

I would not go for a bright-line rule that says, never, never,

never. Never-evers always bother me a lot. It just seems to me that

there may be occasions with a good reason to mix.

But I like a presumption against a mix. And again, I would have

the audit committee explain why it granted an exemption from that

presumption in any particular case.

So all of these suggestions are governance suggestions. They are

all suggestions that are intended to improve the board, improve the

audit committee, make it function better, put more sunlight on it,

in the hope that the sunlight will help.

Thank you very much.

Chairman SARBANES. Very good. Thank you very much, sir.

Senator Gramm has another engagement, so I am going to yield

to him to go ahead with his questioning, and then I will pick up

after that.

Senator GRAMM. Thank you, Mr. Chairman. I want to thank both

of you for presenting comprehensive testimony, and I think valuable testimony.

First of all, I do not know that we need to provide tax incentives

for people to hold stock longer. I think the problem we have today

is dual taxation of dividends makes the holding of stock to earn by

conventional means of dividends extraordinarily unattractive and

that many of the concerns that you have raised are at least in

part—I am not saying totally, but at least in part—a product of the

tax code itself. Would you agree with that?

Mr. BIGGS. Absolutely. There are situations where it probably

doesn’t matter. As a pension plan, you take cash or stock appreciation as the same thing. And there are people that still live on the

dividends and want them, but the double taxation seems extraordinarily unfair in that case. But then, that is another pressure on

reducing dividends and we do not have big enough dividend payouts I think from companies because of the tax situation.

Mr. MILLSTEIN. I agree.

Senator GRAMM. I have a little bit of concern about the dominance of outside directors. I can see that there are benefits in

terms of proctoring behavior and granting transparency. But I

think it is important as we look at this to look at cost and benefits,

not just benefits.

I think that there is something to me that at least concerns me,

a nagging concern about having people running major companies in

America that have little stake in that company.

If you had a mandate that the majority of members of the board

be outside members, so you have a company like Wal-Mart that 80

percent of it is owned by one family, and they are in essence, required to turn over the running of their company to people who are

marginal owners, at best, I think we have to look at costs and benefits. And I would have to say that concerns me.

In terms of not having the CEO in essence be the CEO in terms

of the board, I can see checks and balances coming from it, but if

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the objective of the company, if the overall objective of the economy

is to promote economic growth and let’s say that by not allowing

the CEO to be, in essence, chairman of the board, that you were

able to, at the margin, affect behavior in terms of reporting. But

in doing so, the cost is that you eliminate the kind of dynamic leadership that produces the economic growth to begin with.

I would have to say that I have real concerns about that. I would

just like, in the time I have, to give both of you an opportunity to

respond to that.

Mr. MILLSTEIN. This is a debate that has been going on a long

time, as you well know. And I respect the other side of the debate

very much because it is a very legitimate concern.

I guess my difference is that I do not look upon the board as running the company, not at all. I have always tried to make it clear

that the board has a totally different function. It does not run the

company. It does not audit the company. It is the overseer of the

company.

You might operate on the assumption, and I think it is true, that

the managers are really agents. They are agents for the shareholders. And any agent has to be supervised.

I see the board’s only role as hiring the managers, supervising

them, watching them, overseeing them, providing incentives and

making sure that they operate in the interests of the shareholders

and not themselves. That is the job of the board.

I think Wal-Mart is an exception, obviously. And the bulk of the

Fortune 500 is diversely owned by thousands and thousands of individual shareholders and funds and so on, who do not have time

to run the businesses of the companies. If Wal-Mart’s owners run

the business, that is fine. I think that is great.

Senator GRAMM. Do they want people who are not substantially

owners running it?

Mr. MILLSTEIN. They are not running it. Let me say that——

Senator GRAMM. My experience with corporate governance is

more centered around boards of regents of universities.

Mr. MILLSTEIN. That is different.

Senator GRAMM. Well, I don’t know. You have a lot more experience in this area than I do. I think board members that I have

talked to think—they certainly think they run the University of

Texas and the University of Georgia and Texas A&M.

Now, I often think they get too involved. But when you have the

power to hire and fire the CEO, when you have the power to set

compensation, maybe you are not supposed to be running it, but

you can come pretty darn close to running it, it seems to me. And

I just raise the concern.

Mr. Biggs, let me ask you, as an investor, if you have any of

those concerns?

Mr. BIGGS. First off, I am Chairman and CEO, and so, I violate

the principle. And so maybe I am not that fair, unbiased, on that

subject.

I think it is hard to tell whether there is a difference between

the American practice on that versus the British practice, which

largely separates them. I don’t have any particular feeling about

that. Frankly, I think having a single leader of an institution has

enormous value. I have actually worked in a case where I was a

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CEO and there was another person that was chairman, and I was

lucky enough to get a person who understood exactly what oversight means rather than micromanagement.

If you have a separate, independent chairman of the board and

the CEO has to do some very unpopular things, unpleasant things

in a company where he knows there is going to be opposition, you

have a real danger that people will try to end-run the CEO and go

to the chairman of the board. So, I think there is that downside.

On the minority interest, I guess I come at it as an investor with

perhaps a different point of view. If I were a member of the Walton

family, I think I might see it otherwise. But we have been burned

often enough, particularly in foreign investing, where we go in as

minority shareholders and somebody exploits their position as a

strong family ownership. Particularly governments are the worst

offenders. We have had troubles with the French government on

several investments.

The way I usually express it is, the price you pay for going public

and getting those minority shareholders in, is that you have to give

them the protections that the shareholders should have. And companies might want to think longer about going public because they

do give up enormous control when a family owns a company, if

they bring in that outside shareholder money.

Chairman SARBANES. That is important. I just want to interject

for a second. I think that we have to start thinking about corporate

governance with a sharp distinction between when you go public

and get listed on an exchange and then people can buy in and institutional investors buy you and everything else, and when that is

not the case. And the rules that apply in one arena may not be appropriate for the other arena.

Therefore, when people go public, you have to understand that

they are shifting the way they work. Now a lot of these go-go hightech companies, they pump it up and then they go public, they cash

it out, but none of the different way of operating and thinking that

I think ought to come with going public.

I am not necessarily signing off to everything that you suggested,

but I think that idea has a lot to be said for it.

Senator GRAMM. Mr. Chairman, let me say that, obviously, when

you go public, you take on a tremendous range of things you have

to do, and you should. The question is, how far should that go?

With a corporate entity, at least at the margins, theoretically,

over time, the shareholders have the power to fire the management. But if the majority of the board is made up of outside board

members, it seems to me that what we have to do, we have to have

a system where you have checks and balances. But in the end, economic growth comes from wise and effective risk-taking and from

strong leadership.

I have a concern when we are talking about, we pay corporate

executives extraordinary amounts of money—some people resent it.

I do not. People who have the skills to make decisions where honest-to-God fortunes are made and lost, and they can do it successfully, they help people like me who own part of TIAA–CREF. But

I am just concerned about this movement that takes away the entrepreneurship and resolves everything into a committee process.

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Now, I think you can certainly overdue it. Obviously, one of the

things we have to do is look at accounting, look at checks and balances and have some strengthening.

But I think when you get to the point that you are requiring that

the majority of board members be outsiders, if you got to the point

where the CEO could not be effectively chairman of the board, all

based on the assumption that board members really understand

their role, which is oversight and checks and balances, not to run

the company—if Senator Corzine were my chief executive and I

were on the board, who works for who? Or is it whom? Whatever.

[Laughter.]

Anyway, the point is, if I am an investor, I want somebody who

is responsible and who is in charge and who is talented, and I

would be very concerned about investing my money where the majority—and I think outside board members are important, critically

important. But the idea that they should be the majority, I do not

know. That makes me nervous.

Mr. MILLSTEIN. Do I have time for one more comment?

I don’t know. I think that it depends on where you come from,

Senator. I have been bouncing around 50-odd board rooms in my

career and what I have seen—maybe I have seen all the wrong

ones—but when all the power is located in one place, you have a

dangerous situation.

If you do not have somebody with real checks and balances on

the CEO, you can have a real problem. If you do not have a board

that is really looking at what is going on, you have too much power

in one place. You really have to have that agent under control.

TIAA–CREF and CalPERS and I were in Russia recently talking

to the oligarchs about their marvelous corporate governance system. They had it all right. They have a board. They have people

on it. But the money disappeared. Why did the money disappear?

Nobody was watching it. The CEO and the board were all buddies.

Everybody’s fooling around. They said, well, we have a board of directors. Look at this. Here they are. They are all sitting here.

And I said, well, where’s the money?

Senator GRAMM. Yes, but I do not think that is the issue we are

talking about here.

Mr. MILLSTEIN. The issue we are talking about is really controlling what happens when too much power is located in one place.

There is nothing more complicated about corporate governance.

Senator GRAMM. Do not forget, we are the beneficiaries and victims of our experience. But what about where not enough power is

located in one place?

Mr. MILLSTEIN. Balance.

Senator GRAMM. What about when you have bureaucracies and

people cannot make decisions? I think it cuts both ways. All I am

saying is, we have to look at not just the benefits of all the things

we do in terms of oversight, redundancy, transparency, all those

things. We have to look at the cost. I am speaking in theoretical

terms, obviously.

Mr. BIGGS. There really has to be a balance, it seems to me. You

have an engine of growth and leadership and driving and making

a company go. You have to preserve that. If you hem it in with too

much bureaucracy and limitations, you can destroy that. On the

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other hand, when something goes wrong, as does happen, then you

really look closely at that other side of this issue, which is what

were the oversight mechanisms and so forth, that were in place

there.

I would hope that we can get the balance right. But, Senator

Gramm, I hear you. On the stock options, for instance, the last

thing I want to do is eliminate stock compensation. Most people say

if you expense it, that everybody will stop giving it, using stock as

awards, and I think that is just nonsense.

I think stock compensation, if it is properly constructed—in the

case of our Boeing plan, they have at least a 5 year perspective because it does not count until the end of 5 years. They do not have

to wait till retirement, but they cannot cash out 6 months or 2

years later.

But if you can get those kinds of plans, and get the right balance

between long-term objectives and stock, I think it can work. I think

you keep the engine, the real genius of American capitalism still

fully empowered.

Senator GRAMM. Thank you, Mr. Chairman. You have been very

generous.

Chairman SARBANES. I am going to yield to Senator Miller now.

I just want to make this observation on the executive compensation

issue we have been discussing.

On February 24, the Los Angeles Times reported that, ‘‘In 1995,

41 percent of a typical chief executive’s total pay was in the form

of conventional salary or cash. The CEO collected slightly more, 42

percent, in long-term incentives, primarily stock options. By last

year, chief executives were collecting 65 percent of their pay in

long-term incentives, while salary plunged to 18 percent.’’

I just want to throw that into the mix here.

Senator Miller.

Senator MILLER. Thank you, Mr. Chairman. And thank both of

you for this very interesting and enlightening testimony.

I want to continue, as you put it, on this debate that has been

going on for a long time. I listened to you talking about the pushes

and the nudges and the sunshine. What is the role of Congress in

providing those pushes and nudges and sunshine? Should Congress

be legislating in the corporate governance area?

Mr. MILLSTEIN. No. I did not suggest that. That is the last thing

that I would suggest. I love the Congress, but stay out of corporate

governance.

[Laughter.]

Most of us in the field are not in favor of Federal chartering or

any of those things, and that is not what I am talking about.

What I was talking about was giving the Commission a little

more discretion to inch into the governance area. They are chary

about it. The Commission is chary about inching into it because

they have been slapped on the wrist several times, once in the Supreme Court, about getting into the area of corporate governance.

And they are supposedly not the corporate nanny. They are simply

a disclosure mechanism. All I am suggesting is that in the disclosure area, they be permitted to get more into what people are disclosing than just that they are disclosing it.

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In other words, at the moment, all the Commission says is, tell

us what your process is. I am suggesting that maybe the Commission be permitted to go a little further and say, why did you make

that decision? What did you decide? In order to do that, I am not

saying that Congress should do that. I said the Commission should

do that. The Commission should police it and directors ought to get

a safe harbor and not be subject to suit when they talk more about

what they do.

I suppose what I am saying is, I just think it would be a good

idea if directors talked a little bit more to the shareholders and the

markets about what they had just done. Why did they adopt this

compensation system? Did they really think that it was going to be

long-term?

And instead of having written boilerplate statements which say,

yes, I talked about it, here’s what we talked about. Not in all the

details, but these are the conclusions we reached.

Why do I think that would be good? It is more sunlight and if

they have to explain what they did to the shareholders, things I

think would be a little better. But do not put them in a position

of being sued for having done that.

I do not want directors to feel, well, we do not want to talk about

it because if we do, we are going to get sued. I would say, give

them a safe harbor and give them an exclusion. But let them talk

a little bit more about what they have done. I think it would help.

Senator MILLER. Thank you.

Mr. Biggs, do you have any thoughts on pushing and nudging?

Mr. BIGGS. I certainly agree that I do not think Congress needs

to get into the corporate governance arena in an explicit way. We

certainly need your help. Also, it seems to me, as I said, I think

that the accounting standards ought to stay in the private sector

to every extent that we can make that possible.

I think you should be encouraged by the progress that we have

made in the private sector in pushing better corporate governance.

Ira’s been at this longer than I have, but I think we have made

real progress in the last 20 years, 10 years, 5 years. I have been

thrilled with what we have accomplished with the audit committee

work. I think we really have made some improvements, and I believe the system is working. For example, the proxy method. We

file a fair number of proxy resolutions. We have effected a lot of

change.

One example—we went after a form of poison pill that seemed

extraordinarily obnoxious called the Dead Hand Poison Pill, which

meant that if someone came in and elected a new board, and threw

out the old board, the new board could not get rid of the poison pill,

which was a clever legal device for making it absolutely impossible

to force out a board.

We went after companies, and it took us about 2 years. The real

secret was finally getting to the law firms and saying, stop writing

this in, because we would go to CEO’s and say, you have this horrible provision. And they would say, I had no idea. We just stuck

that in because that was the standard form.

I think the system is working pretty well. When Enron happened, you say, well, where is your system? How good is it? But

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I think if you look across the board, we have really made progress

on corporate governance.

Senator MILLER. Another quick question and maybe you can give

me a brief answer. This is along the lines of the audit committee

and also, independent directors. Yesterday, Mr. Sutton went so far

as to recommend that the audit committee ought to be made up entirely of independent directors. What do you think about that?

Mr. MILLSTEIN. It is required. The stock exchange listing requirements today say that the audit committee has to be all independent directors. My feeling would be it would be a good idea to

have the nominating committee and the compensation committee

have the same requirements.

Mr. BIGGS. I think that it is pretty standard now among companies that really worry about good corporate governance, that they

do that.

Senator MILLER. Thank you.

Chairman SARBANES. Senator Corzine.

COMMENTS OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman. I feel like I arrived

in the last third of a movie, so I am a little out of context.

[Laughter.]

First of all, I want to compliment the witnesses on their superior

work throughout the years to try to enhance the quality of corporate governance and transparency of what goes on in corporate

America to the benefit of the quality of our financial markets and

the depth and breadth.

Their testimony, some of which I have read, and some that I am

still studying—I apologize if I am not square on and I ask for your

forbearance.

Let me ask on this independence issue, and I do not know how

much you have done on this independent director. But I do not understand and I would wonder from your own experience, why one

thinks that would compromise entrepreneurship.

Challenging questions can lead to entrepreneurship. And I would

wonder if you have tangible examples or situations, done any study

of where you have broad board independence in the success of the

underlying companies?

Mr. MILLSTEIN. I do have a few. I believe that independence promotes entrepreneurship, not destroys it, because the independent

board can remove a nonperforming manager a lot faster than if the

manager’s family is running the board.

My view has always been that the independent board members

can more easily act on behalf of the shareholders to get rid of a

nonperforming management fast and replace it with a good management. That is really their basic job in life, to hire and monitor,

compensate, and then get rid of managers. That is the job of the

board. Not to run the company, but to make sure that the board

has the single best management that it can possibly get, and then

get rid of that management if it is not working. And if that doesn’t

promote entrepreneurship, I do not know what does.

Mr. BIGGS. Two points. One answer, and I think there has been

a silly series of studies done by economists, usually young assistant

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professors, trying to show correlations between performance and

some aspect of a board structure.

I think some of those studies have shown that boards that have

independent directors do not perform as well. And I think that

those studies are just nonsense. I just do not think that is a measurable effect, for example, pick some one attribute of a board and

then try to see if it produces good or bad performance. I do not

think that is the level you were really raising the question about,

Senator Corzine.

I think a good, probing, independent board can be very effective

in prodding entrepreneurship, challenging management. I do not

see any reason why it cannot.

I think, though, that if it becomes too bureaucratic, it can certainly drag a company down. But I do not think many boards have

done that, in my experience. I think the ones that have been independent and questioning of senior management have gotten good

results by just doing that.

Senator CORZINE. With regard to the correlation of independent

boards and some of the issues we see—by the way, I think the

Enron issue if overblown relative to other fundamental problems

that we see with regard to corporate governance and accounting

and other issues. It is an important issue because there are people

who have been hurt by the process.

But the restatements that we have seen by companies leads one

to wonder whether investment decisions have been taken on proper

information historically, or whether anyone is held accountable

after the fact. We haven’t seen many corporate executives giving up

their bonuses that were formulated on earnings that were then

restated.

Is there any information that you all are aware of whether there

has been boards of great independence in those cases where you

have had performance reported and performance real, relative to

those companies that have gone through the restatement process?

Mr. BIGGS. The short answer is, I do not know of any formal

analysis of that. There is a fair amount of anecdotal information.

There may be a correlation between the aggressiveness of the SEC

at any point of time and the amount of restatements that is required. If the SEC is really pressing companies on that issue, it

could make a difference in that there is that pressure. But that

doesn’t explain the high number of restatements that we have had

in the last 5 years.

Senator CORZINE. What do you attribute this restatement to?

Mr. BIGGS. We talked earlier about the stock option mentality,

which is surprisingly short-term. People invest and there is acute

interest in where the stock price is. The market is the market, so

you cannot argue with it. But the response of missing earnings by

a penny can be brutal. Usually, the view is if it missed by a penny,

then, clearly, they did not have a cookie jar that had any cookies

in it, or they would have taken them out.

So that tells you something about the accounting. And that kind

of cynical view in the analyst community and in the controllers of

companies preparing the statements leads to the kind of thing

where you push the envelope and then you have to go back and restate when somebody finally blows the whistle on you.

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It could be the internal process of the company that can blow the

whistle. Other times, it may be the SEC finally that challenges.

I have served on the Public Oversight Board and I get the privilege of reading the investigation of the bad audits. It is usually a

CEO who lied to his auditor and forced the revenue numbers in

some way. I thought there were going to be devious, complex accounting issues involved, and it is not. It is a guy who stuffs the

product line or whatever, has side deals with companies to buy

huge amounts, and then he gets caught. And you end up either

with a restatement or the company can go under in that event.

Senator CORZINE. I presume that is why you feel strongly about

corporate governance.

Mr. BIGGS. Yes.

Senator CORZINE. If you are going to have a check and balance

on that, then you therefore need those outside questioners of CEO’s

and senior management.

Mr. BIGGS. Yes. One example—I think, somehow, somebody has

to take the rule—the external auditor shouldn’t also be the internal

auditor.

Senator CORZINE. Right.

Mr. BIGGS. That was something that they did at Andersen—well,

that Andersen condoned that I found astonishing. But there are

many people that feel that is not an inappropriate practice.

Senator CORZINE. I see my time is up.

Chairman SARBANES. Do you want to continue?

Senator CORZINE. I wonder if Mr. Millstein has any comment on

the restatements.

Mr. MILLSTEIN. I subscribe. I think he has it right.

Senator CORZINE. Thank you.

Chairman SARBANES. I want to ask some basic questions and get

your response. Why should the accounting standards be set by a

private body?

Mr. BIGGS. I think that they are very complicated issues, for one.

That does not mean that the Government could not handle a complicated issue, of course. But that there are so many economic interests that are being affected by the decisions, that if it becomes

a political issue where people are really just asserting a basic economic interest that they have, you will not get good results.

One of the important things in accounting principle setting it

seems to me is the word progress, that we need to move continuously to get better. And that progress is always bitterly opposed.

Chairman SARBANES. I am going to be a devil’s advocate here,

but I want to explore this a little bit.

Suppose you had a division of accounting standards in the SEC.

Now that division, presumably, could develop the level of competence and expertise to understand the issues because, granted,

that they are very complicated issues. That is why people come

along and they say, well, the Congress certainly shouldn’t legislate

accounting standards because the Congress cannot begin to understand the complexity of the issues.

Although we had a former chief accountant of the SEC yesterday

who said that Congress ought to set mark-to-market as a standard,

establish it by the Congress. What are the arguments against that?

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Mr. BIGGS. I would argue that—a specific issue that might be a

good one to use—I think substantial progress was made when we

required companies to put on their books the cost of benefits that

are promised employees after retirement.

If you told people that you were going to provide medical care for

their lifetime after they retire, you ought to have a liability on your

books for that and you ought to expense it in an appropriate way.

That was bitterly opposed by a number of companies that claimed

it would cause them to be in effect bankrupt. So it was very controversial. But it was proposed by the FASB as a position.

I think General Motors had a huge liability that they had to put

up at that time.

It was proposed by the FASB with a good process. There was no

reason that you could not have a good process within a division of

the SEC as well. And it was vented. There was a driving force to

get that rule implemented. We did, and I think, overall, it has been

good for the country and good for capital markets and we now have

those liabilities on the books of companies.

Would a division of the SEC have ever done that? Would they

have wanted to take on an issue that was that deep and controversial and involved so many companies? I think it is unlikely. I think

having it in the private sector with board members of the FASB

who are totally independent gave you a chance that they would do

that.

And there will be issues coming up in the future. I do not know

what they will be. The most recent one was of course derivatives

and how to account for derivatives, an incredibly complex subject,

but one on which I would think a Government agency would have

been smart to say, I am going to duck this one and not take it on.

Whereas, the FASB did feel it was important. It was an issue that

had to be dealt with.

Chairman SARBANES. Mr. Millstein, do you have a view on this?

Mr. MILLSTEIN. Yes, I do. Just formed, because I hadn’t thought

a lot about it.

Chairman SARBANES. You have had enough experience, that your

just-formed-view is better than most people’s. So please go ahead.

[Laughter.]

Mr. MILLSTEIN. The SEC approves listing requirements. The

SEC can turn to the NYSE and Nasdaq and say, ‘‘We think you

should consider some listing requirements in this area,’’ as they did

in our case with audit committee independence and chartering. The

SRO’s do it, and it comes back to the SEC for approval.

Now it seems to me you could have the same system with respect

to accounting standards. I wouldn’t be uncomfortable with that.

I would like the listing standards to be prepared by a private

body. They are the ones who know best. I do not think it is necessary to have the Government hire thousands of experts to come

up with accounting standards. But having come up with accounting

standards through, and even auditing standards, by the way, which

are just as important as accounting standards, I would find it perfectly appropriate for Congress to give the SEC the authority to approve, just as they do in listing. At least somebody in Government

would be taking a look at what just happened.

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Mr. BIGGS. The SEC has the authority to set accounting standards now, but has delegated it to the FASB. And the European

Commission is doing the same thing. They have the authority to

actually do the standards.

The SEC now, under the 1934 Act, can—— Mr. MILLSTEIN. I think they should take it back.

Chairman SARBANES. Well, it came out clearly yesterday in the

panel that the SEC actually has authority to do a number of

things. They haven’t done them.

Mr. MILLSTEIN. That is correct.

Chairman SARBANES. Now why haven’t they done them? Well,

there are a lot of pressures at work, not the least of which are pressures from the Congress. The pressures are different right now, but

the pressures were 180 degrees in the other direction not very long

ago, as a general proposition.

I take it you both feel strongly that if the standards are going

to be done by a private body, that the funding for that private body

should be in some manner automatic and assured, so that the body

setting the standards, many of which are potentially controversial,

or at least will be opposed by significant elements in industry who

see some advantageous route that they have managed to scout out

being close off to them.

So, we have to have a funding mechanism that is automatic. I

like some automatic fee arrangement or something that provides

the budget for these standard setting boards. Isn’t that the case?

Mr. BIGGS. Absolutely. I think you are absolutely right. Given

the controversial nature, we need that. The irony is that we saw

it actually happen, when the POB took an unpopular position with

the accounting profession, AICPA said, we are not going to give you

any money to pay your staff.

When you have that kind of power—— Chairman SARBANES. We had Paul Volcker here and he had the

situation where he went to Enron to get money for the International Accounting Standards Board. And then Enron internally

circulated a memo from one of their executives to another saying,

well, if we make a significant contribution here, will this give us

influence over the standards that this board is going to set? It was

a direct connection.

I am going to yield to Senator Corzine, who has a few questions.

But let me ask this, if you have just a moment, Jon.

Mr. Biggs, I want to make sure I understand what you do with

your audit firm. As I understand it, your auditor does no other

work but audit. Is that correct?

Mr. BIGGS. That is right.

Chairman SARBANES. No consulting work of any sort?

Mr. BIGGS. No.

Chairman SARBANES. Including tax consulting because they are

constantly arguing that they have to do the tax consulting.

Mr. BIGGS. We do not permit that.

Chairman SARBANES. And you change your auditor periodically?

Mr. BIGGS. Practically, it is every 7 years at this point.

Chairman SARBANES. Now is that not more expensive for you?

The argument is made that through these kinds of separations,

that it will cost the companies significantly more money.

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Mr. BIGGS. It is imperceptible to me. Theoretically, I think one

would think it would be more expensive because you are bringing

in a new firm that has to get involved with a new company—but

when we look at the fee schedule that we pay the old auditors, I

cannot see any change when we move from one to another. I mean,

the fees have gone up because our company has grown substantially. But the growth in the fees has been related to the company’s

growth and complexity, not due to rotation.

I do not believe there is any costs to the company. In our cost,

we have not been able to see it.

Now, I think a very huge, complex company, a General Electric

or Boeing, would be almost bound to incur some extra costs. But

I think those costs are offset by very significant benefits. I do not

mean just benefits to the public and the independence, but benefits

to the company in bringing in a new team.

Chairman SARBANES. What do you say to the argument that we

hear that if we just do auditing, we are not going to be able to get

the best and the brightest because the best and the brightest want

to do these innovative, imaginative work challenges that they get

if they are consulting? And so, the ability to do consulting along

with auditing means that we are going to get a higher talent person into our accounting firms. What is your view of that argument?

Mr. BIGGS. First off, the position we always had as a company

is you just did not do your consulting on your audit clients. Instead

of giving the Big 5 pretty even distribution, you had 80 percent of

the market to go do your consulting work, do it with them and not

where the independence issue was raised.

I just do not buy that argument. What seems to me remarkable

is, I think the best and brightest accountants were going into auditing back in the 1950’s and 1960’s and they are not doing it now.

And yet, this has been a period when consulting has exploded in

size—and they did not have any consulting. Nobody knew about

computers back in the 1950’s and 1960’s. They have started learning, and that is when the accountants got into that business.

But they were able to attract good people to auditing when it was

a respected, honorable field and not competing with the firms with

all the other business activities.

We have seen a real decline in people taking accounting and the

best and brightest aren’t doing it in business schools. Part of that

is the decline in the respect paid to the audit function. It is viewed

more and more as a commodity. The CEO’s do not take the senior

partner as seriously as they used to. And there has been a general

decline in the prestige of that function.

I am not an accountant or an auditor, but I was the chief accountant of a company at one time. I think accounting is a fascinating field in its own right, with enormous complexity, intellectual demand, intellectually interesting, and people will be attracted

to the profession and they do not have to have computing and a

lot of other things thrown in as actual enticement.

Chairman SARBANES. I regret that Senator Enzi, who is our only

accountant in the Senate, is not here because that would be music

to his ears, what you just said about accounting. We will make sure

that the transcript of that gets to him.

Mr. Millstein.

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Mr. MILLSTEIN. I think there is a likelihood that what John

would like to see happen will happen. The audit function is, by virtue of what we are doing here today and what you are doing in all

the hearings that are taking place, is going to get up in the eyes

of everybody.

I think a lot of the companies with whom I deal are beginning

to look at their auditors a little differently. Now that, I hope, will

lead to the point where they can charge more. If they can charge

more, they can pay more. And in today’s society, that will attract

people into the auditing profession.

It is a very respectable and important profession. The auditor

now is just as critical as the lawyer or anybody else representing

or working for the company. I think all of these hearings are extremely useful in putting the emphasis back on the significance of

that independent auditor and what he or she means to the system.

I think if we get that into our heads and are willing to pay for

it, then auditing will become an attractive profession again.

Unfortunately, many professionals were attracted to the consulting business, where they could charge anything. And many

good people moved over to consulting because it was so well paid.

Well, I think the consultants are not doing well at the moment,

at least from what I have heard around the track. Consulting is

just not doing as well. So maybe some of them are going to drift

back to auditing, where they belonged in the first place. But let’s

make it an important thing and worth paying for, and people will

go back to doing it again.

Chairman SARBANES. Senator Corzine.

Senator CORZINE. Thank you, Mr. Chairman. I am going to go a

little parochial.

There is a merger going on in and around New Jersey with

Comcast and AT&T. One of the provisions of the merger agreement, the companies are asking for a provision that would ban for

3 years the electing of new directors. I wonder if either of you have

trouble with that. What are your thoughts about those kinds of corporate governance positions?

Mr. Millstein knows this more from his legal work—is this something that is typical in mergers or is this unique to this situation?

Is it symptomatic of how the whole process has been—I do not

know about perverted—but diverted from the interests of shareholders?

Mr. MILLSTEIN. Well, let me say, I really would not like to talk

about Comcast and AT&T. But, in general, the problem I think is

sometimes people do that in order to preserve the management

structure they are putting into place. In other words, the two companies get together and they decide X is going to be the chairman

and Y is going to be the next chairman, and they want to be sure

that the succession takes place the way it should. So what you do

is you put the directors in concrete for 3 years and that makes

everything wonderful.

Do I think that is always a good idea? No, I do not. But it is one

way of guaranteeing succession in management when you have a

merger like this. People are going to do it.

Senator CORZINE. These are the kinds of things, though, that, if

we had independence with regard to boards, you could actually

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have some difference of view, or at least challenge of those kinds

of things.

Mr. MILLSTEIN. That is right. And I think that this is one of the

reasons why I promote the idea of independence on the board. It

is troublesome to me to see directors locked in by some agreement

for some period of time. Indeed, I am not sure you can do it.

Senator CORZINE. By the way, I was not looking for an opinion

about the particulars of the situation.

Mr. MILLSTEIN. I understand. Just the principle.

Senator CORZINE. You could ask also about super-voting rights

and other issues that lead to deterioration of the independence.

Mr. MILLSTEIN. Mr. Biggs and CalPERS and TIAA–CREF fight

this every day of the week, quite properly.

Mr. BIGGS. All the extreme anti-takeover protections.

Senator CORZINE. I would suggest that sometimes, some of these

things, while we would love to stay out of the Congress participating in this process, you may never get a resolution of some of

those issues if you limit it only to the regulatory structure. I am

unclear whether that can be done.

Mr. BIGGS. No.

Senator CORZINE. There are some things that go over a line of

breaking down corporate democracy.

Mr. BIGGS. It is hard to imagine what people are going to come

up with.

Senator CORZINE. Right. I have to ask one question, Mr. Biggs.

Chairman SARBANES. Sure.

Senator CORZINE. How do you feel about diversification in portfolios?

Mr. BIGGS. I have just written a very nice piece to all of our participants saying, obviously, TIAA–CREF cannot have concentrations in any company. I think that is one where we are going to

have to keep a balance because we have had a long history in our

country of encouraging stock ownership.

I am very uneasy, though, when people jam it into a 401(k) plan.

I agree with your view that that is a tax-benefited plan. There

ought to be some limitations on using that. On the other hand,

Congress has changed the Internal Revenue Code, so that companies are now encouraged to put the stock in there because then the

dividends can be changed around so that the dividends are deductible. So, we are getting different messages from Washington on

that. And the tax message is one that people really hear very loud

and clear.

I was frankly shocked when I saw how many marquee names in

American business have more than a majority of their 401(k) accumulations, in their own company stock. I think that it is a problem.

I have a hard time balancing it against, the history that goes back

to the 1950’s where we encouraged ESOP’s with tax benefits. We

encouraged stock ownership. Owning stock in your own company

became as American as homeownership.

Senator CORZINE. Well, you can be encouraging of participation

in American economic system through stock ownership and even in

your own company in certain ways. But whether you do it for retirement plans is one issue and whether you do it in compensation

is obviously a whole other issue.

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Mr. BIGGS. Right.

Senator CORZINE. And everything is an issue of degree.

Mr. BIGGS. Yes. Every company I have been involved with has

been very, very careful about having too much stock in the pension

portion. It could be the defined benefit plan funding it if the plan

was overfunded. But there are ERISA limitations.

Senator CORZINE. There is a 10 percent limit in defined benefit

programs.

Mr. BIGGS. Right.

Senator CORZINE. Thank you.

Chairman SARBANES. I want to ask some very specific questions

that arose from the testimony of others.

Former SEC Chairman Breeden, in his testimony, raised concerns about the practice of corporations making large loans to executives without the knowledge or approval of shareholders. He

recommended that corporations be required to disclose in proxies

all company loans to executives, specifying the amounts of the

loans and balances to be repaid. He also recommended requiring

that shareholders ratify any loans to executives above a certain

level. I would be interested in your views on these suggestions.

Mr. BIGGS. I very strongly agree with that view. In fact, the

whole issue of executive compensation of extraordinary amounts

being buried in contracts between the executives has been a theme

that we massed for some time. We think there is a lot of abuse in

the use of SERP’s—Supplemental Employment Retirement Plans— where there are extraordinary benefits paid.

The former Bank of America chairman before NationsBank took

over, had a contract that provided a pension that turned out to be

worth $60 million. But it was never disclosed. Shareholders could

not see that. We had no way to know that that existed.

I think transparency on executive compensation is critically important. And the SEC knows our views on that because we spent

a lot of time going to see them to say that we want all that information in the proxy.

Mr. MILLSTEIN. I agree. I would go further and say that any

transactions between the executive and the company should be a

subject of disclosure. I just think that the shareholders ought to

know everything that is going on between the executive and the

company in the way of special transaction. I also think that shareholder ratification of major compensation plans should probably be

required.

But I don’t know that I would require them to ratify every single

thing that happens. I don’t want to see the world slowed down to

that extent. It seems to me that basic compensation packages

should be subject to shareholder ratification. And any transaction

should be disclosed. That should be an open book.

Chairman SARBANES. We know that in Enron’s case and other

cases of other companies, insiders sold their shares within months

of the company’s bankruptcies.

Now leaving aside what may be available to you under the bankruptcy law to reclaim that money, some of which does not have

much punch to it, do you feel that we need stronger penalties or

remedies on insiders in this regard, including making it easier to

make them disgorge their profits?

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Mr. MILLSTEIN. I think the insider trading laws are so arcane,

that I do not think we are going to solve anything immediately. I

cannot see what new law would do that would improve anything.

I really don’t.

I think under the bankruptcy laws, there can be efforts to try to

recoup if it has been done right immediately in the zone of bankruptcy, or if it is insider trading, you go after them for insider trading. But, Senator, I do not know how to draw the line any finer.

Chairman SARBANES. Okay. Now if we are going to make systemic or structural changes on the accounting issues, the standards

and their implementation, what should that structure be?

The Public Oversight Board is all resigning. We are going to hear

from Chuck Bowsher.

Mr. BIGGS. Right.

Chairman SARBANES. What is your model that we can use here

to try to get a structure that seems to work better? First of all, I

do not think you would argue that the current structure works very

well, the tin cup analogy, in and of itself. I think that the Public

Oversight Board did not have the kind of authorities or powers

that one would assume ought to be in a body of that sort. Do you

have any view of what the structure ought to be if you were drawing a model?

Mr. BIGGS. Frankly, I think a lot of the——

Chairman SARBANES. Because that is something we may do. That

is something that the Congress could get into place and then say,

now you go do your business, instead of us trying somehow to do

the business each step of the way.

Mr. BIGGS. Well, I think the SEC has proposed a regulatory

model, which is not bad. I believe the view of Chairman Pitt was

that he could move quickly and get that done without Congressional action. And he thought the Congressional action might come

rather slowly.

But my view is that the board has to have much more authority

than we had at the POB. It has to be able to investigate and be

able to go in and get information and then have privilege of that

information so that it cannot be called up in litigation.

I think the licensing of accountants needs to be addressed in a

Federal regulatory board. We have all the State licensing of all the

accountants and yet, when they are doing an SEC-regulated audit,

it seems to me that that ought to have a strong Federal control

over the individuals permitted to do it.

Now, we have put together the most crazy quilt combination of

institutions. It took me the first 3 or 4 months on the POB just to

get straight all the initials, the acronyms, of all the different organizations from the different accounting standards groups, either

auditing standards, accounting standards, the investigative groups,

who had authority, the peer review mechanisms, and so on.

But I think that it would take Congressional authority to give

proper authority, some self-regulatory organization. I thought you

had a lot of ideas presented yesterday about the specifics of it,

which I am not really qualified to suggest.

Chairman SARBANES. Mr. Millstein, do you have anything to

add?

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Mr. MILLSTEIN. I agree. I think you need a regulatory body. I do

not think self-regulation works that well. And peer pressure I do

not think works that well.

In our business, the law business, we have the courts, who keep

a pretty good eye on us. And if there’s going to be disbarment or

something like that, we have some place to go to make it happen.

Chairman SARBANES. Right.

Mr. MILLSTEIN. I think there ought to be some equivalent of that

in the accounting profession. We are held to pretty high standards,

but we have somebody keeping an eye on us, which is the courts.

Chairman SARBANES. Well, gentlemen, thank you very much.

You have been very, very helpful and we really appreciate your testimony and the work that went into it. Hopefully, we will be able

to continue to consult with you as we move ahead in trying to

frame a response here.

Mr. MILLSTEIN. Thank you.

Mr. BIGGS. Thank you.

Mr. MILLSTEIN. We would be happy to do that.

Chairman SARBANES. Thank you very much.

The hearing is adjourned.

[Whereupon, at 12:20 p.m., the hearing was adjourned.]

[Prepared statements and additional material supplied for the

record follow:]

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PREPARED STATEMENT OF JOHN H. BIGGS

CHAIRMAN, PRESIDENT, AND CEO

TEACHERS INSURANCE AND ANNUITY ASSOCIATION

COLLEGE RETIREMENT EQUITIES FUND [TIAA–CREF]

FEBRUARY 27, 2002

Mr. Chairman and Members of the Senate Banking Committee, I am honored that

you asked me to testify today on the important issues of corporate governance raised

by the Enron collapse.

My name is John Biggs and I am Chairman, President, and CEO of TIAA–CREF,

the system providing pensions and other financial products to the education and research community. We manage about $280 billion in assets through TIAA, a New

York licensed insurance company, and CREF, the country’s first variable annuity

plan. Our company also offers to the general public life insurance products, trust

services, mutual funds, and college tuition savings plans. As the CEO of TIAA– CREF, I am proud to report that our stock analysts covering the energy business

could never understand how Enron could make enough money to cover its obligations—so our active portfolio held less than the benchmark level, resulting in relatively favorable results for our participants. We did unfortunately hold positions

in our Index Funds since Enron once held a prominent position in the S&P 500.

My other experience relevant to your deliberations is as an independent public

sector participant in financial regulation. I served for 2 years as a Governor of the

NASD and some 5 years as a Trustee of the Financial Accounting Foundation,

which funds the Financial Accounting Standards Board, or FASB, and appoints its

members. I now serve as a Trustee of the Foundation supporting in a similar way

the new International Accounting Standards Board (IASB). I was also a member of

the Blue Ribbon Committee on Improving the Effectiveness of Audit Committees.

And currently, I continue as one of the five trustees, all of us independent, of the

Public Oversight Board. As you know, this Board will go out of business on March

31 of this year. I am not an accountant but did start my career as an actuary and

earned a Ph.D. in economics along the way.

The Enron collapse and the intense interest the public and the Congress have

taken raises a number of questions. I will focus on three primary areas where

I believe America’s corporate governance must be strengthened—and I will suggest

ways in which the Congress might bring this about.

The three changes we have needed for some time and that bear directly on the

circumstances of Enron are these: (1) a means of dealing with the widespread overuse and abuse of fixed-price stock options; (2) the need for some basic common sense

regarding auditor independence; and (3) the need for a strong regulatory model to

oversee the accounting profession.

Overuse and Abuse of Stock Options

Several accounting professionals have attempted to lay the problems of Enron’s

accounting on the FASB. I believe they are seriously mistaken. In fact, during the

late 1980’s and early 1990’s the FASB was aware of the very issues that Enron

eventually faced. Among other things, the FASB addressed the absurd policy of accounting for stock options by which they appear to be ‘‘free’’ even though they form

a central feature of executive compensation plans and obviously have very substantial costs.

Enron used such options extensively, covering all their management employees

and granting large awards to their senior executives. Sixty percent of Enron’s employees had options. The cost of these options was never reported in Enron’s earnings statements although the exercise gains were so great that in several years

Enron paid no taxes.

The IRS allows as a deduction for compensation expense the difference between

the option price and the stock’s price when it is exercised (for most employee stock

options). But in reports to shareholders that difference, or any other amount, has

never been shown as an expense. Through its long, tedious, but open process the

FASB explored all theoretical aspects of stock options. It put out tentative proposals,

conducted exhaustive hearings so that all participants could comment, and heard

arguments pro and con. The process took several years.

Many critics now say that the FASB is too slow, but at other times critics have

said it was too fast, especially when the issue was an unpopular one such as stock

compensation or derivatives. The final proposal would have required a charge to expense for stock options given to employees as compensation. After extensive lobbying of Congress by companies and auditing firms, and following legislative threats

to the existence of private sector standard setting, the FASB and the SEC

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capitulated. Arthur Levitt has publicly stated that he believes this was the greatest

mistake made by the SEC during his Chairmanship.

In capitulating, the FASB published a rule in 1995, known as Financial Accounting Standard 123, that offers the choice of expense recognition or disclosure in footnotes. If disclosure is chosen, the income statement will show expense for options

only under certain circumstances required by the Accounting Principles Board (the

predecessor to the FASB) in its Opinion No. 25 (1972). The FASB said the following

in FAS 123, a statement with which I completely agree: ‘‘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.’’ (Paragraph 62) So in other words,

disclosure in footnotes is inappropriate reporting to shareholders of the costs of

operations.

As you might expect, most corporations prefer to use the obsolete accounting

model of 1972 which treats the fixed-price stock option as ‘‘free’’ and treats performance options as potentially very expensive. Significantly, most companies use virtually no other form of stock award than the fixed at-the-money option. Note that

the Black-Scholes option-pricing model was created a year later, in 1973, and forms

the basis for understanding financial transactions involving uncertainty. I can assure you that high-tech executives in Silicon Valley use the Black-Scholes model to

value their own options. Most companies also use Black-Scholes to communicate

total compensation to employees. Those same executives know that having to show

the results of that calculation to shareholders would reduce or even eliminate the

earnings of their companies.

I serve as a Director of the Boeing Company, which is the only major U.S. company to adopt the FAS 123 expense, in order to report to its shareholders the true

cost of its stock compensation plan. Boeing’s executive compensation plan is based

heavily on tough performance tests which are prohibitively expensive under the

1972 accounting model used by all other companies. For the record, Boeing adopted

its plan and FAS 123 in 1996, before I became a Director.

I might mention a further example of the strong-arm tactics of U.S. corporations.

Last year the Financial Executives International issued a press release threatening

to withdraw funding for the newly formed International Accounting Standards

Board if the Board dared to study the issue of accounting for stock-based compensation. The use of options and stock as employee compensation is a growing phenomenon overseas, with little or no accounting guidance in place. I am happy to say

that both Paul Volcker, Chairman of the Foundation supporting the IASB, and Sir

David Tweedie, Chairman of the IASB, are standing their ground, and the project

is proceeding.

The use of questionable accounting methods—for stock options has several negative results:

(1) Explosive growth in the use of stock options since 1995—huge, indeed, incredible awards to CEO’s and in some companies awards to every employee. For several

years, this practice has been a major concern addressed by TIAA–CREF’s corporate

governance program.

(2) The serious distortion of earnings statements so that some companies report

large earnings at the same time that no taxes are paid. This is because of peculiar

accounting that results in fixed-price stock options as zero ‘‘cost’’ in public income

statements while allowing the employee gain to be shown as a ‘‘cost’’ for the tax

return.

(3) Unprecedented focus on the stock price by all the employees of the company,

to the point where serious ethical dilemmas are posed for employees. When excessive stress is placed on company accountants and their auditors, malfeasance may

result. Business ethics experts wonder if potential ‘‘whistleblowers’’ are intimidated

by their colleagues’ or their own concern for their stock options.

(4) The dramatic decline in dividends is a direct result of so much recent attention to stock options. A dollar per share paid to a shareholder as a dividend reduces

the stock price by a dollar. Can anyone wonder why corporate managers find many

reasons to justify a reduction or elimination of the dividend?

(5) In many companies, stock options have replaced pension plans entirely. When

we protested the action of IBM in abandoning its defined benefit plan, the company

responded by pointing out that its competitors in the technology world had no pensions whatsoever.

(6) There has been an almost exclusive use of the fixed-price stock option in employee compensation plans. More desirable stock compensation plans could be devised that would better align management and shareholder interests. Such plans

are effectively prohibited by the 1972 rules because they require that management

show an expense for them. For example, a plan that requires performance better

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than the general market performance is not considered a ‘‘fixed-price option’’ and

results in truly onerous accounting treatment under 1972 rules. FASB Statement

123 provides sensible expense accounting for performance plans.

I have long been a strong advocate for the principle that the private sector (for

example, FASB or GASB [the Governmental Accounting Standards Board] or IASB)

should set accounting standards. Congress, through the political process, should not

enter into such technical issues, but it should demand a fair and open process. I

stand by that view. Some expression of support by your Committee, or by the full

Senate or House of Representatives—the form of which you understand better than

I—might make it possible for the IASB to study the issue, and for the FASB to reopen the question.

I believe that history would see this action as an extraordinary benefit coming out

of the many lessons to be learned from Enron.

Auditor Independence

My company has two very important provisions in its Audit Committee Charter.

(1) Our auditors may not do any work for TIAA–CREF other than what is directly

related to the audit function (this exclusionary rule also applies to our tax work);

and (2) rotation of the auditor is considered after a 5 to 10 year period. The first

rule was heatedly contested by our auditors at the time we imposed it; our current

auditors knew the rule when they began working for us in 1997 and now accept it.

We have had two auditor rotations since I have been Chairman, and each has been

not only successful but also highly energizing for our financial management work.

I testified before your Committee in the fall of 2000 in favor of the SEC proposal

to move partially to our first rule on independence. I was startled by the vehement

opposition from several accounting firms and especially from their trade association.

I thought much of their testimony was deeply suspect, especially the claims that few

companies used their auditors for other work and that, when they did, it was a

minor use. The facts revealed since the SEC required disclosure reveal the truth to

be very different.

At TIAA–CREF, we are currently considering shareholder resolutions to be filed

with several companies on auditor independence. We are particularly concerned

about the following relationships between companies and their audit firms: (1) Have

they used the same audit firm for a very long time, say 20 to 30 years? (2) Does

the audit firm have a high ratio of nonaudit fees to audit fees? and (3) Is the Chief

Financial Officer, the Chief Accounting Officer, or any other financial manager a

former employee of the audit firm?

We will ask the Audit Committee members to report on, and sign their names

to, a statement that they have considered the circumstances, including competitive

bids from other audit firms, and that they believe their audit firm is independent

and represents the shareholders and not management. We will also ask for a rationale for that belief.

I am astonished at the number of companies my colleagues have identified that

have all three relationships with their auditors. This is not to say that such companies have produced inappropriate financial reports. In reality, I believe most corporations have the right ‘‘tone at the top.’’ It is well-known in these companies that

the CEO and CFO simply will not condone inappropriate accounting. Nevertheless,

when that tone is wrong, as it appears to have been at Enron, the auditor will have

to exhibit extraordinary strength to stand up to management and say, ‘‘you cannot

do this.’’ Such auditors do exist, of course, but investors cannot count on their luck

to be represented by such an auditor.

Of course, Arthur Andersen’s relationship with Enron was ‘‘embedded’’ to say the

least. But it went even further. Enron management proposed to Arthur Andersen,

and Andersen’s senior leadership agreed, to replace Enron’s internal auditors with

Andersen personnel. Enron outsourced its internal audit function to its external

auditor, Arthur Andersen. Shouldn’t warning bells have gone off at either Andersen’s head office, or at the Enron Board, that this was an inherent conflict? In the

last couple of months, the major accounting firms and the AICPA have said that

firms should not provide internal audit services to audit clients and financial systems design services.

Finally, and perhaps most significantly, Arthur Andersen appears to have played

the role of both tax counsel and investment banker to Enron, devising the questionable tax and off balance sheet strategies that ultimately imploded, but which the

independent auditor—Arthur Andersen—was supposed to review. Again, where was

the ‘‘tone at the top’’ at Andersen? Didn’t anyone in Chicago say this was going too

far? Were the millions in additional fees for such ‘‘high value’’ services, and ‘‘high

margins,’’ too tempting to resist?

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There seems to me a widespread lack of sensitivity to conflicts for auditors that

must be addressed. And there need to be more examples of lucrative opportunities

turned down than there are.

I applaud the recent changes made by the accounting profession on limiting the

types of nonauditor work. Several of the firms saw the public need to do this in 2000

when the SEC proposed limitations. The others have grudgingly assented, arguing,

to my astonishment, that the Andersen-Enron relationships had no independence

problem.

A far more powerful antidote to this blindness to conflicts of interest would be

to require auditor rotation every 5 to 7 years. Such a requirement will be fiercely

opposed by the accountants and the companies, who will see only additional costs

of having to make such changes. But I can vouch from my experience that the costs

can be managed and that there are many positive benefits. Even if the cost-benefit

ratio were unfavorable, which I doubt, isn’t such a simple solution worthwhile, given

the importance to our capital markets of confidence in financial reports?

Consider the advantages of rotation for issues of independence that concern us.

First, rotation reduces dramatically the financial incentives for the audit firms to

placate management. If the audit firm has a kind of virtual perpetuity of millions

in fees every year (from whatever source), the present value of that relationship is

enormous: In the Enron case, probably over a half-billion dollars, given that total

fees paid to Arthur Andersen for fiscal year 2000 were $52 million. That amount

could be even higher if one considers the potential growth in ‘‘cross sold’’ services.

On the other hand, if the audit firm has a limited term, the present value is cut

by two-thirds or more. And in the final year of a 5 year term it has little value.

Economic incentives are important, especially to accountants trained to understand

them. Rotation would help contain financial incentives to manageable levels.

When overseen by the Public Oversight Board, peer reviews have been useful in

improving quality controls in audit firms. Typically, they are conducted carefully by

serious professionals, and they have been expensive. But peer reviews are a weak

self-regulatory tool, and they appear to be universally criticized as inadequate.

Consider the peer review aspects of mandatory rotation. Had rotation been in effect at Enron in 1996, and Arthur Andersen had known that a new auditor would

be appointed for 1997, and that the new auditor would do an exhaustive review of

the former audit work papers, it is likely that Arthur Andersen would have assured

that transactions and documentation were fully transparent. A thorough ‘‘real-time’’

peer review would be truly effective. A strongly constituted, independent, and authorized regulatory board to oversee the auditing profession might also ask for a

brief, signed peer review report from the new auditor. None of this would be costly

unless there were troubles, as there were at Enron.

Clearly, had Enron been required to rotate its auditors every 5 to 7 years, it is

unlikely that misleading financial reporting would have continued or that the

Board’s Audit Committee would have been kept in the dark, as they claim they

were. It is also conceivable that, if they had been confronted by a group of different

noncompliant auditors, senior management might have hesitated to engage in some

of the financial manipulation they appear to have carried out. Honest financial reporting from the beginning also would likely have resulted in more reasonable stock

valuations.

Rotation, furthermore, reduces the problem of cross-selling other services and is

likely to eliminate the revolving door that allows former auditors to become the top

financial officers of the audited company. For example, by the time the former

KPMG partner becomes CFO, the new auditor might be PricewaterhouseCoopers,

Deloitte & Touche, and so on.

I believe rotation of auditors will not become a practice without explicit action by

Congress. I strongly urge this Committee to consider the benefits such a change

would make in the U.S. financial world.

A Strong Regulatory Model

The Public Oversight Board (POB) on which I have served for the past several

months, attempted to oversee a bewildering array of monitoring groups. One was

the Quality Control Inquiry Committee (QCIC) that reviews auditor performance in

contested audits (for example, where a lawsuit had been filed). A second was the

Peer Review Board that participates in inter-firm peer reviews.

There were others as well. The POB oversaw the Professional Ethics Executive

Committee (PEEC) that reviews members’ actions in all types of ethical issues. It

oversaw the Auditing Standard Board (ASB) and the SEC Practice Section (SECPS).

Finally, the POB had the opportunity to raise questions with the FASB if accounting standards seemed in need of repair.

377

Being a nonaccountant and an independent director, I found the POB very hard

work, especially for a sitting CEO. The other four members were retired, and I succeeded Paul O’Neill who, as you know, moved from retirement to a very active position. What was often most frustrating was our lack of authority if we found something that we thought should be changed. While the major firms and the AICPA

were outwardly cooperative when the SEC demanded action, they were unwilling to

change in response to any significant POB initiative. At one point, the AICPA

threatened to withhold funding from the POB, but was finally forced by the SEC

into an unwilling marriage, documented by a new charter that gave us assurance

of being able to pay our staff. No one will really miss us after March 31.

In short, we need something better for a regulatory body. Elements of Chairman

Harvey Pitt’s proposal certainly move in the right direction, but I believe the proposed entity needs more authority. And that authority can come only from Congress.

The investigative authority of a new accounting regulatory body needs to be clearcut and not simply a derivative of the SEC. Accounting firms must know that they

cannot refuse to open their books or prevent their staff from cooperating with this

new agency. Of course, it must have the ability to keep the information gathered

out of the hands of the litigating lawyers. And it must have the authority to discipline firms and individuals without the delays of an AICPA investigating process.

The new agency must have licensing authority, beyond that of the States, for

individuals who will practice at the SEC bar. It should have authority, I believe,

to approve or to disapprove business affiliations of licensed practitioners—for example, is it appropriate for American Express or for H&R Block to become major

players in providing audit services? Should accounting firms with an SEC audit

practice be allowed to go into all the major financial businesses that the Big 5 have

now entered?

The new agency should also have a reliable funding source that does not come

from the accounting profession on a voluntary basis. Nor should it come from the

business community through the ‘‘tin-cup’’ process now used by the Financial Accounting Foundation and the Foundation for the International Accounting Standards Board.

Concerning this point, I have served on fund-raising committees for both the

FASB and the IASB. I can assure you that voluntary giving to support the regulation of the auditing profession will not work. Raising money for a much more benign

purpose—for instance, establishing accounting principles in the private sector—has

been a very tough sell. Those of us asking for the money feel compromised. The

unspoken question is this: ‘‘If I give, will I have more influence on FASB decisions?’’

The investment community has largely refused to support either the FASB or the

IASB, with a very few exceptions to that rule. The usual contributors are those with

a strong sense of community interest—the major banks, investment banking concerns, and several large global businesses.

We should devise instead a fee on stock market transactions, or registrations, or

some other financial activity that will be devoted to paying for auditing oversight,

the work of the Financial Accounting Foundation, and perhaps even the American

share of the IASB’s needs.

Given the welcome demise of the POB, the ball is squarely in the court of Congress and the SEC to define a strong regulatory body. It should have real teeth, adequate funding (without membership fees from the very institutions the new body

will regulate), and a fair chance of bringing a new ethic and culture to a profession

that needs to change.

It is my hope that we will succeed in these three areas: First, that we can make

companies provide transparent accounting for stock options; second, that we can assure greater independence of auditing through auditor rotation; and third, that a

strong regulatory body can be created. If these goals are reached, I believe we may

look back on Enron as being a short-term financial tragedy for its employees and

the holders of its securities, but a major long-run benefit for U.S. capital markets.

Thank you for giving me time to express my views on these important matters.

378

PREPARED STATEMENT OF IRA M. MILLSTEIN

CO-CHAIRMAN OF THE BLUE RIBBON COMMITTEE ON IMPROVING THE

EFFECTIVENESS OF CORPORATE AUDIT COMMITTEES

SENIOR PARTNER, WEIL, GOTSHAL & MANGES, LLP

FEBRUARY 27, 2002

Chairman Sarbanes, Ranking Member Gramm, and Members of the Committee:

I am pleased to appear before you in my capacity as the Co-Chairman of the Blue

Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees

(Committee on Audit Committee Effectiveness). This Committee was convened in

1998 by the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) at the request of Securities and Exchange Commission

Chairman Arthur Levitt. The Report that we issued in 1999 addressed concerns

that are closely related to the concerns about the integrity of financial reporting,

the audit and accounting profession and corporate governance that are at the heart

of this hearing.

At the outset, be advised that I am a Senior Partner in the international law firm

of Weil, Gotshal & Manges, LLP. Several months ago, in the fall of 2001, my firm

was hired to counsel Enron in its bankruptcy restructuring. The firm was not regular counsel to Enron previously. I am not actively engaged on the Enron matter,

although my partners have consulted with me from time to time on certain corporate governance issues relating to the bankruptcy. I have no knowledge of the

events leading up to the bankruptcy filing other than what has appeared in the

media. In addition, over the years my firm has represented Arthur Andersen in litigation and other matters unrelated to Enron. I have no knowledge of Andersen’s

relationship to Enron, other than what has appeared in the media.

My testimony today as the Co-Chairman of the Committee on Audit Committee

Effectiveness does not necessarily reflect the views of Weil, Gotshal & Manges, LLP

or any of my partners. I have not consulted any client in regard to this testimony,

and therefore it does not reflect the views of Enron, Andersen, or any other client

of my firm.

You have asked that I provide recommendations for legislative and for regulatory

responses to what appears to be an increasing incidence of high-profile financial reporting and governance failures in recent years. Throughout my career I have counselled corporate boards, managers and investors on various corporate governance

and regulatory matters and have studied closely our system of corporate governance

regulation. (In addition, I have taught graduate business school courses on corporate

governance at Yale, Harvard, and Columbia.) Over this period, one element has

remained constant: Our market system is not static; it is dynamic—constantly

changing. Our corporate governance system continuously adjusts and improves in

response to failures, whether through voluntary adjustment of board practice, new

listing rule requirements, amendments to SEC disclosure rules, or various related

pieces of legislation, for example, in the area of tax incentives. These high-profile

corporate governance failures should not be interpreted, therefore, as failures of capitalism or capital markets. Rather, these failures should be viewed as cause for further adjustments and corrections to our corporate governance system. Such adjustments should focus on the factors that are key to the problems emerging in today’s

corporate environment: Management incentives, true independence and diligence on

the part of corporate directors—who are charged with monitoring managers—and

the professionalism of those upon whose advice directors need to rely in carrying

out their role. These events present a challenge for all of us to avoid overreacting,

and to limit our interventions to fine-tuning a system that usually works well.

The Current Problem

I will focus today on what I consider the core of the current problem: The incentives and disincentives that can drive managers and boards and those who advise

them to push to the limit, and sometimes beyond, the numbers that are meant to

reflect the company’s financial performance and health. We should seek incentives

and disincentives that are more carefully attuned to the pressures in the current

environment.

I wish we could solve today’s problems by urging all participants in our market

system, and particularly in our corporate governance system, to act moderately and

prudently, fairly and ethically. If all did so, corrective action would not be necessary.

As Oliver Wendell Holmes recognized, however, humans cannot be expected to act

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1Oliver Wendell Holmes, ‘‘The Path of the Law,’’ in The Path of the Law and its Influence:

The Legacy of Oliver Wendell Holmes, Jr., 333, at 335 (Steven J. Burton, ed., 2000). 2Frederick W. Cook & Co., Inc. Memorandum re: The Implications of ‘‘Enron’’ for Executive

and Director Compensation at 2 (February 6, 2002) (‘‘Frederick W. Cook Memorandum’’). (A copy

is attached as Exhibit A.) 3 Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Vol. II at 264– 65 (E. Canaan edition, 1776); Adolph Berle & Gardiner Means, The Modern Corporation and

Private Property, at 123 (1932). 4See National Association of Corporate Director (NACD), Report of the NACD Commission on

Director Professionalism (1996, reissued 2001); The Business Roundtable, Statement on Corporrate Governance (1997); American Federation of Labor and Congress of Industrial Organizations

(AFL-CIO), Investing in Our Future: AFL-CIO Proxy Voting Guidelines (1997); California Public

Employees; Retirement System (CalPERS), U.S. Corporate Governance—Core Principles &

Guidelines (April 13, 1998); Teachers Insurance and Annuity Association–College Retirement

Equities Fund (TIAA–CREF), TIAA–CREF Policy Statement on Corporate Governance (2000);

Counsel of Institutional Investors, Core Policies, General Principles, Positions & Explanatory

Notes (2001). See also Organisation for Economic Cooperation and Development (OECD) Ad Hoc

Task Force on Corporate Governance, OECD Principles of Corporate Governance (May 1999),

Continued

moderately, prudently, morally and ethically at all times.1 He noted that law and

regulation generally, therefore, must address, by providing countervailing incentives

and disincentives, the prospect that self-interest may lead persons to act ‘‘badly.’’

This applies to the corporate governance regulation as well. Self-interest—which a

market system relies heavily upon—can interfere with the moral, ethical, and legal

obligations of directors and managers to protect and enhance the assets of the corporation that are committed to their care by, and for the benefit of, others.

An effective system of corporate governance must strive to channel the self-interest of managers, directors, and the advisors upon whom they rely into alignment

with the corporate, shareholder, and public interest.

In just the last decade, management has faced increased market pressures for

short-term stock price performance and corresponding pressures to satisfy market

expectations on a quarterly basis. This, coupled with increasing grants to senior executives of stock options and other incentives that are focused on short-term stock

appreciation, may have created incentives that tipped the balance toward the promotion of self-interest rather than the protection and promotion of long-term shareholder value. As one of the country’s leading compensation experts noted recently:

It is . . . possible that stock option grants have become so large at top

management levels that they encourage high risks to reap high rewards.

Perhaps the power of incentives to motivate is not linear. If stock options

are good, are more stock options better? Once stock option grants have become sufficient in amount to provide the right balance between operational

and market incentives, whatever that amount is, what is the purpose in

granting more? Is it merely wasteful, or is it possible that it goes beyond

waste to create perverse incentives that destabilize a company? 2

These concerns are magnified when the integrity of the independent auditors, financial and investment advisors and analysts, and lawyers upon whom directors,

managers, and the public rely for a fair picture of the company’s performance and

prospects, may also be skewed by self-interest.

In a general sense, these are not new concerns. The key issue in corporate governance regulation throughout the history of the joint-stock corporation, as recognized

by Adam Smith in 1776, reiterated by Adolph Berle and Gardiner Means in 1932,3

and repeated by numerous observers since, has focused on the ‘‘agency problem’’: It

is a given that directors and managers are fallible human beings (like all of us).

Therefore, they may not always subordinate their self-interests to the interests of

those on whose behalf they are acting. And this is true of auditors, analysts, and

lawyers as well. This ‘‘agency problem’’ should be periodically reassessed to account

for the circumstances of each era.

Over the past decade and a half, these issues have gained considerable attention

as they relate to publicly-traded corporations. In particular, added emphasis was

given to the importance of board composition, as well as to increased transparency

about corporate governance processes and structures. With respect to board composition, the theory is that a board of directors comprised of a majority of knowledgeable individuals who are not members of management and who lack business

or family ties to management will be more likely to provide effective oversight of

the managers, and circumscribe the ‘‘agency problem.’’

A number of recommended corporate governance best practice guidelines have

issued from various sources.4 In addition, the tax code now provides tax incentives

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available at www.oecd.org/daf/governance/principles.htm (setting forth international principles

of corporate governance). 5 I.R.C. § 162(m). 6See Order Approving Proposed Rule Change by the NYSE, Exchange Act Release No. 42233,

File No. SR–NYSE–99–39; Order Approving Proposed Rule Change by the AMEX, Exchange Act

Release No. 42232, File No. SR–Amex–99–38; Order Approving Proposed Rule Change by the

NASD, Exchange Act Release No. 42331, File No. SR–NASD–99–48. 7Pearl Meyer & Partners Memorandum re: Executive Pay Trends: Looking Forward and Back

at 2 (February 2002) (Pearl Meyer Memorandum) (A copy is attached as Exhibit B). 8See e.g., DEL. GEN. CORP. LAW § 141 (CSC 2002).

for certain performance-based compensation decisions when made by a committee

of outside directors.5 Notably, within the past 2 years, listing rules of the NYSE,

AMEX, and Nasdaq were amended to require that every listed company have an

audit committee comprised of at least three independent members.6 At the same

time, SEC disclosure requirements were amended to require a significant amount

of disclosure by audit committees, including disclosures about audit committee consideration of auditor independence.

We have had only 1 year of experience under the new listing and SEC rules, so

it may be premature to determine whether these improvements have had the intended impact. Nonetheless, we should now dig down and address root causes of the

problems that have arisen.

One matter that requires attention is, as noted above, the possible over-reliance

on compensation devices for managers and directors that are unduly linked to shortterm stock market price performance. This link may cause managers and directors

to focus too heavily on their own self-interest in short-term stock appreciation. As

long as the investing public focuses on short-term stock price performance rather

than long-term growth—and this is not something that will readily change (and analysts and bankers play a role here)—we cannot expect corporate managers to be

fully resistant to market pressures. This pressure is exacerbated when managers receive compensation that permits, and even induces, taking advantage of short-term

rises in stock price.

The markets tend to pressure managers to ‘‘make the numbers,’’ and self-interest

compounds the problem. The boards and regulators need to keep this in mind. They

can and should focus on creating countervailing incentives. This same concern

extends to those advisors whom directors must rely on to carry out their crucial

oversight role.

Another leading compensation expert predicts that boards are learning that heavily concentrating compensation on short-term market priced incentives, rather than

on ‘‘real’’ economic performance, is not good for the business—and that boards will

self-correct:

Re-balancing executive pay will be a major theme, as companies seek to

reduce their reliance on the stock market and realign their compensation

programs to pay for ‘‘real’’ strategic and financial performance. There will

be a new appreciation that successfully growing and running a business are

of greatest value to shareholders in the long run, even if those efforts are

not reflected in short-term stock price movement. This realization will result in some shift of compensation dollars from options to long-term incentives and to full-value stock grants earned on a performance basis.7

Even if this prediction about the developing trend in management compensation

is accurate, in today’s environment many may question whether this change will be

broadly enough felt to deter future corporate governance failures without a push

from regulators and/or legislators.

The Central Role of the Board in Controlling the ‘‘Agency Problem’’

The board is the focal point of our corporate governance system. Pursuant to State

statutes, it is elected by and accountable to the shareholders, and is charged generally with directing the affairs of the corporation.8 The board fulfills its role by delegating managerial authority to the managers, which it hires, monitors incentivizes

(compensates) and replaces when necessary. The board also is charged with oversight of the company’s financial reporting and legal compliance. To do all this, it

can—and must—reasonably rely on advice from professionals. Under our system,

while management is responsible for maintaining the corporation’s financial records

and completing its financial reports, it is the outside auditors who provide assurance

that the financial reports comply with generally accepted standards. The board selects the outside auditors and is charged with ensuring auditor independence necVerDate 11-MAY-2000 10:35 Jul 17, 2003 Jkt 000000 PO 00000 Frm 00394 Fmt 6621 Sfmt 6621 87708V1.TXT SBANK4 PsN: SBANK4
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9See American Law Institute, Principles of Corporate Governance: Analysis and Recommendations § 3.02 (1994).

essary for attaining that assurance. The board also has available the advice of legal

counsel to help assess the company’s disclosure and other compliance obligations.

The board is not positioned to (and hence does not) manage, audit, practice law

or render advice on the short- and long-term reactions of the market. Rather, it delegates to management, and then monitors the management and performance of the

company, all on behalf of shareholders and the company.9 In so doing, the board

is entitled to reasonably rely on information and advice provided by managers, auditors, lawyers, bankers, and others.

However, the board faces constraints in its monitoring ability that it must take

into account related to pragmatics, capacity and context:

• Managers need flexibility to take the reasonable risks that are at the heart of

entrepreneurialism; directors who constantly second-guess management’s reasonable business judgments risk stifling management performance.

• Boards are comprised, increasingly, of directors who are not members of management, with good reason. However, this means that, as stated above, boards must

place considerable reliance on managers for information about company affairs

and performance and, therefore, there will always be some risk of both intentional

malfeasance and unintentional failure going undetected at the board level for

some period. This highlights the legal and practical importance of the reports that

management (and professional advisors) make to boards. In the investigations

now going on, sufficient attention should be given to this and to the consequences

of inaccurate or misleading reports to directors.

• Much of what impacts company performance and can effect manager incentives

may be outside the board’s control, including the market’s short-term focus and

occasional ‘‘irrational exuberance.’’

The Committee on Audit Committee Effectiveness and Ensuing Reforms

Throughout the mid to late 1990’s, the SEC expressed increasing concern about

the integrity of financial reporting by publicly-traded corporations, fueled by a perception that corporate managers faced ever increasing pressures to match or exceed

market analysts’ expectations. The expressed concern was that this pressure would

lead to increased corporate efforts to ‘‘manage’’ earnings—to push the boundaries of

the Generally Accepted Accounting Principles in preparing the company’s financial

reports, and thereby obscure the true condition of the company. In 1998, the SEC

encouraged the NYSE and NASD to convene a private-sector Committee on Audit

Committee Effectiveness to study the issues and make recommendations for encouraging greater financial reporting oversight by audit committees. I had the honor of

Co-Chairing the committee with John Whitehead. (A copy of our Report and Recommendations [the Report], which includes a full list of committee members, is attached as Exhibit C.) Our Report contained 10 recommendations, focusing on:

• Strengthening the independence of the audit committee.

• Improving audit committee operations.

• Improving mechanisms for discussion and for accountability among the audit committee, the outside auditors and management.

Our premise was that if boards and their auditors accepted a clear delineation

of responsibilities for financial reports and the reporting process, and then acted

diligently, the problem would self-correct. Our recommendations aimed to support

a culture of integrity and independence. Soon after the Report was released, the

vast majority of our recommendations were adopted. (They are attached hereto as

Exhibit D.)

Audit committees of large publicly-traded corporations appear to be abiding by the

new rules. To the extent that corporate culture has been resistant to change at some

companies, the current widespread concerns about auditor independence and the

quality of financial reporting combined with media attention and the fear of shareholder litigation and reputational effect, are likely to shock audit committees into

action. It may be premature to determine whether these improvements have yet

had the intended impact. Nonetheless, it is appropriate to take a hard look at

whether additional legislation, SEC regulation or listing rules could strengthen

independence, provide more appropriate incentives and thereby help to restore investor confidence.

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10 A complete list of proposed legislation is available from the Enron-bills database found at

http://www.westlaw.com, searching the terms ‘‘House’’ or ‘‘Senate.’’ 11See Press Release, Securities and Exchange Commission, Pitt Seeks Review of Corporate

Governance, Conduct Codes (February 13, 2002), available at http://www.sec.gov/news/press/

2002-23.txt. 12See supra note 4. 13 I.R.C. § 162(m). 14The SEC has asked the listing bodies to review corporate governance requirements. Press

Release, Securities and Exchange Commission, Pitt Seeks Review of Corporate Governance,

Conduct Codes (February 13, 2002), available at http://www.sec.gov/news/press/2002-23.txt.

See also The Fall of Enron: How Could It Have Happened? Hearing Before the Senate Committee on Governmental Affairs, 107th Congress (2002) [hereinafter Governmental Affairs Hearings] (Statement of Arthur Levitt, Jr., former Chairman of the Securities and Exchange

Commission (1993–2000) ), available at http://www.senate.gov/∼govlaffairs/012402levitt.htm

(‘‘[S]tock exchanges, as a listing condition, should require at least a majority of the directors

on company boards to meet a strict definition of independence.) The current independence definitions applicable to the audit committees of listed companies can be found in the sources listed

in Note 6.

Significant legislative initiatives are already underway—at last count, Westlaw

listed over fifty pieces of Enron-related legislation.10 In addition, the SEC has proposed certain disclosure-related reforms and is considering others. Recently, it asked

the NYSE and NASD to review corporate governance listing requirements.11 The

suggestions that follow incorporate and build upon a number of suggestions advanced by others that I believe bear consideration.

Board Independence

Further and more serious consideration needs to be given to the issue of board

independence, including the issue of independent board leadership. Providing objective judgment as to managerial performance, compensation, incentives, and all other

oversight matters is at the heart of what boards are supposed to do. Best practice

recommends that, to ensure objective judgment in assessing management, boards of

listed companies be comprised primarily of outside directors who in form and substance—relationships, attitude, and perspective—are independent of management.12

Attitude and perspective cannot be regulated, but conditions can be set to reduce

the possibility that certain relationships between managers and directors will taint

objectivity, and other conditions can be set to create an environment in which the

right attitude and perspective is promoted. Other than the listing rules pertaining

to audit committees (and certain tax incentives applicable to compensation committee decisions 13), there is today no mandate regarding board independence and

no widely applied definition of independence.

As to the issue of board leadership, we need to reconsider whether a corporate

executive can adequately serve the board leadership function while heading up the

management team that the board is charged with monitoring and incentivizing.

Generally, managers disfavor separating the Chairman and CEO titles. In the

United States, the expectation among CEO’s is that the culmination of a successful

career includes the title of ‘‘Chairman and CEO.’’ (Note, however, that this was the

expectation in the U.K. as well, until the Cadbury Code—and now the Combined

Code—recommended that two individuals hold the positions. Disclosure of the degree of compliance with these Codes was mandated by the listing rules of the London Stock Exchange. In the past decade, the practice of combining the titles—and

related expectations—have changed significantly in the U.K., due solely to the pressure of this disclosure requirement.) Leading the board and leading the company are

two very distinct and important jobs. Certain aspects of the board’s leadership

role—those concerned with leading the review of management performance, including compensation, and potential management transactions with the corporation—

present a conflict of interest that makes it difficult, if not impossible, for a company

executive to fulfill that role. Therefore:

• Boards of publicly-traded corporations should be required (through listing standards) to include a majority—I would call for a substantial majority—of the ‘‘independent’’ directors under a strict definition of independence (ideally the same

definition that applies to the audit committee, albeit with some refinement as described below).14

• The definition of director independence provided in the listing rules (for audit

committee purposes) should be reviewed to determine whether it adequately addresses all the relationships that may reasonably be expected to reduce independence. In particular, this review should consider relationships between directors

and charities and educational institutions that receive significant grants from the

corporation, and any consulting or other fee arrangements (other than regular

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15 Id. 16See London Stock Exchange Committee on Corporate Governance, The Combined Code:

Principles of Good Governance and Code of Best Practice (July 1998), available at www.ecgn.org;

Toronto Stock Exchange Committee on Corporate Governance in Canada, ‘‘Where Were The Directors?’’: Guidelines For Improved Corporate Governance in Canada (Dey Report) (December

1994), available at www.ecgn.org.

compensation, within a usual range, for serving as a director) between directors

and the corporation.15

• Boards of publicly-traded corporations should be required (through listing standards) to constitute a compensation committee (much as they are currently required to have an audit committee) with entirely independent directors, using the

strict definition of independence.

• Boards of publicly-traded corporations should be encouraged through SEC disclosure requirements (or even required through listing requirements) to separate the

position of CEO from that of board leadership. Board leadership should be provided by a nonexecutive director; one who is independent in all aspects. I would

urge that this independent leadership be formalized in the position of Chairman,

but title can be left to each board to decide.

• As a matter of best practice, independent directors and independent board committees—including the audit committee and ideally the compensation and nominating/governance committees—should play a larger role in setting the ‘‘tone at

the top.’’ They should bear responsibility for company culture vis-a`-vis financial

reporting and ‘‘making the numbers,’’ compensation and incentive decisions, management stockholding and trading policies, and policies concerning management

transactions involving conflicts of interest.

• Although, the tone at the top cannot be mandated, the boards of listed companies

should be required or encouraged (through SEC disclosure and listing requirements) to adopt, regularly review and disclose a corporate code of conduct that

addresses conflicts of interest and management and director stockholding and

trading policies. Clearly, the board should be responsible for overseeing its implementation and its actions taken by boards to implement these policies should

be disclosed, including any exceptions granted under the policies and the reasons

therefore.

• It may be time to consider whether boards should be encouraged to rely on a

small full time staff or regularly use outside advisors for support. Board work, for

larger corporations, requires significant information, time and attention. For the

board as a collective group of individuals who convene on a part-time basis to

fulfill all that we expect may require more support than traditionally has been

available. It may be fruitful for some staff resources to be explicitly devoted to

supporting the work of the board. We should consider ways to encourage boards,

or the independent directors as a group, to have available some staff and counsel

resources of their own, distinct from staff and counsel hired by management, especially where potential conflicts with the interests of management are apparent (for

example, audit and compensation).

Changes along the lines outlined above would encourage boards to be more vigilant and diligent in protecting shareholder value and in devising the best means to

deal with the risk that self-interest will diverge from the corporate, shareholder and

public interest.

In considering these and similar measures, one should keep in mind the variety

within the universe of publicly-held companies in the United States, not to mention

the tremendous variety among companies in the rest of the world who compete in

what is rapidly becoming one global capital market. In a market economy, variety

and diversity can be a source of strength. We should be careful that any norms that

are established be flexible enough to accommodate this diversity. Experience with

corporate governance listing standards in the United Kingdom and Canada, suggest

that often a ‘‘comply or explain’’ regimen is sufficient to induce widespread adoption

of recommended practices without undue restriction on diversity.16 Specifically,

under such a system, a company is required to publicly disclose whether it follows

the normative, yet voluntary, standard and to explain the reasons for any noncompliance. This allows flexibility while still asserting reasonable pressure for

compliance. It also provides investors significant amounts of information about the

governance of companies, which can be used for investment and voting decisions.

It may be time to consider what should be embedded in mandatory listing requirements and what should be encouraged through flexible ‘‘comply or explain’’ disclosure requirements. But more yet may be needed.

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17Paul W. MacAvoy & Ira M. Millstein, ‘‘The Board of Directors in the American Corporate

Form as the Instrument for More Effective Governance,’’ in The David Hume Institute: The First

Decade (1996). 18 Id at 7. 19 Holding restrictions could apply to all stock received, or just apply to a high percentage (80

to 90 percent). See Cook, supra note 2, at 4 (discussing retention ratios in the context of company ownership guidelines or policies).

Compensation Issues—The Core

The growing practice of compensating managers with stock and stock option

grants, which managers are then allowed to sell or exercise within a relatively short

period of time—and during their tenure at the company—can, as noted above, create inappropriately short-term and stock-price focused incentives, and thereby exacerbate the agency problem in the context of a short-term oriented market. Performance compensation based on a snapshot of stock market performance at a single

point in time chosen by the manager may not provide incentives for the kind of

management activity that is ‘‘good’’ for the company and shareholders as a whole

in the long run.

Over the past decade, companies have turned increasingly to stock-based compensation both as a form of pay-for-performance and as a means of aligning the selfinterests of managers with the interests of shareholders. Indeed, I was among those

who urged stock compensation as a method of aligning the interests of management

(and directors) with shareholder interests. However, when managers are compensated with significant stock awards or stock options and are allowed to trade in

that stock in the short-term (subject only to insider trading restrictions), their selfinterest in relatively short-term stock market fluctuations may conflict with their

need to focus on both the long-term viability of the company and improvements in

its long-term profitability. In particular, the focus on stock-based compensation,

without conditions linking stock awards to realization by managers of long-term performance goals, may have put in place incentives that promote managerial selfinterest to diverge from the corporate, shareholder and public interest. In some

cases, such compensation may have crowded out other more traditional means of

compensation that supported a longer term view, thereby producing an imbalance

in incentive compensation that is especially counterproductive.

In 1996, Yale economist Paul W. MacAvoy and I co-authored a paper entitled ‘‘The

Board of Directors in the American Corporate Form as the Instrument for More

Effective Governance.’’ 17 (A copy is attached as Exhibit E.) In it, we discussed the

use of stock in pay-for-performance schemes and, in particular, the inappropriate incentives that linking such schemes solely to short-term movements in stock price

might create. We said:

Stock [based compensation] plans should be further refined to motivate

the managers to achieve longer term growth and to sharpen their concern

for the value added from improved strategies. Stock grants can be programmatic, but with sales restrictions, or even postponement of sales until

retirement, so as to focus incentives on the long term.18

Directors should seriously rethink stock-based compensation that creates shortterm incentives to raise stock price rather than long-term incentives to improve performance and enhance value appreciation. It is with these concerns in mind that

I recommend the following for consideration:

• Pay-for-performance programs should be linked to measures of profitability or economic value added rather than short-term changes in stock market valuation. In

any event, they should be designed to consider company performance relative to

peer group performance, and not simply generalized stock market performance.

Although I have some reservations about the use of the tax laws to further corporate governance policy, consideration could be given to creating a stricter definition of what constitutes ‘‘performance based’’ compensation for purposes of Section

162(m) of the Internal Revenue Code.

• Mechanisms should be developed to encourage executives and directors to hold

stock they receive, whether in the form of stock grants or stock options, for a significant period of time. Ideally, companies should restrict or discourage sale of

company stock during a director’s tenure and require or encourage significant

holding periods for executives.19 (Of course, some flexibility may be required for

special circumstances, for example, for start-ups that lack sufficient cash to pay

executives what they are worth.) Again, while tax solutions pose concerns, consideration could be given to creating tax incentives designed to encourage executives

to hold stock. Such incentives could include, for example, gradually reducing over

some period of years the tax rate for grants of stock or exercise of options from

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20See Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight Hearing Before the Senate Committee on Banking, Housing, and Urban Affairs,

107th Congress (2002) [hereinafter Banking, Housing, and Urban Affairs Hearings] (statement

of Richard C. Breeden, former Chairman, Securities and Exchange Commission (1989–1993) ),

available at http://banking.senate.gov/02l02hrg/021202/breeden.htm (suggesting that disclosure of all stock transactions by senior corporate executives be sped up); see also Legislative

Solutions to Problems Raised by Events Relating to Enron Corporation Hearing Before the

House Subcommittee on Capital Markets, Ins. and Gov’t Sponsored Enter., 107th Congress

(2002) (Statement of Harvey L. Pitt, Chairman, Securities and Exchange Commission), available

at http://www.sec.gov/news/testimony/020402tshlp.htm (‘‘One area of possible legislation already identified is the need to require corporate insiders to make public their trading activities

more quickly than current law requires.’’). 21 Cook, supra note 2, at 6. 22See Press Release, Securities and Exchange Commission, SEC To Propose New Corporate

Disclosure Rules (February 13, 2002), available at http://www/sec/gov/news/press/2002.22.txt

(announcing that the SEC will propose rules that will ‘‘provide accelerated reporting by companies of transactions by company insiders in company securities including transactions with the

company’’).

the rate applicable to ordinary income to the most favorable rate for long-term

capital gains. Alternatively, tax incentives could be created to encourage companies to contractually restrict the ability to transfer stock in grants of stock and

stock options.

• Prompt disclosure of all transactions in the company’s stock by corporate executives and directors should be required.20 At the very minimum, the current rules

that allow for once-a-year disclosure of sales of stock back to the company should

be eliminated.

• The directors should be compensated fairly for the time necessary to fulfill their

responsibilities. As a matter of best practice, however, stock options should be

avoided altogether—especially those exercisable within a short period. ‘‘The motivation of directors are and should be different from those of management. Directors are not strategic partners with management in creating value for shareholders; they are guardians of shareholders’ interests.’’ 21 And directors should be

discouraged from selling stock in the company during their tenure.

These recommendations may seem a bit draconian, given what became the widely

accepted compensation trend in the 1990’s. However, before the widespread use of

such compensation devices, U.S. corporations and the economy succeeded—and with

considerable might—by compensating high-performing managers with salaries,

bonuses, and some long-term stock opportunities.

Conflicts of Interest

Transactions between the corporation and its managers, directors or large shareholders are rife with potential conflicts of interest. Most large publicly-traded corporations have codes of conduct for addressing such conflicts that recognize that

some conflicts are inevitable. While that may be so, the corporate culture should

view transactions that involve conflicts—especially with members of senior management or directors—as highly suspect, and to be avoided if at all possible. Therefore,

as alluded to above:

• The boards of publicly-traded companies should be required or be encouraged to

adopt, regularly review and disclose a corporate code of conduct that addresses

conflicts of interest, and management and director stockholding and trading policies. The actions taken by boards in implementing these policies should also be

reported on, including disclosure of any exceptions granted under these policies

and the reasons for the exceptions.

• SEC’s rules should be amended to mandate prompt disclosure of transactions

between the corporation (or its affiliates) and members of senior management, directors, or controlling shareholders.22

Professional Advisors

To obtain a fair picture of corporate performance and prospects, the shareholding

public relies on managers and directors, as well as on auditors, analysts, and those

who advise the company, all of who are susceptible to self-interest. Appropriate incentives and disincentives are required to protect against self-interest from overcoming the professional responsibilities of auditors, analysts, and lawyers.

Obtaining the appropriate balance in the relationship between the board, the

auditor and management is key to audit integrity and both the auditors’ and the

board’s ability to perform the role expected. Significant efforts to improve auditor

independence were recently undertaken by the SEC, and it is not yet clear whether

the intended outcome is being fully realized. In particular, as noted above, it is only

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23See Banking, Housing, and Urban Affairs Hearings, supra note 20 (Statement of Richard

C. Breeden) (‘‘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 5–7 years.’’); Governmental Affairs Hearings, supra note 14 (Statement of

Arthur Levitt, Jr.) (‘‘I also propose that serious consideration be given to requiring companies

to change their audit firm—not just the partners—every 5–7 years to ensure that fresh and

skeptical eyes are always looking at the numbers.’’); Banking, Housing, and Urban Affairs Hearings, supra note 20 (Statement of Harold M. Williams, former Chairman, Securities and Exchange Commission (1977–1981) ), available at http://banking.senate.gov/02l02hrg/021202/

williams.htm (‘‘I would urge the [Securities Exchange] Commission to consider a requirement

that a public company retain its auditor for a fixed term . . .’’); Harrison J. Goldin, Editorial,

Auditor Term Limits, N.Y. TIMES, February 1, 2002, at A25; Banking, Housing, and Urban

Affairs Hearings, supra note 20 (Statement of Roderick M. Hills, former Chairman, Securities

and Exchange Commission (1975–1977) ), available at http://banking.senate.gov/02l02hrg/

021202/hills.htm (stating that the ‘‘ultimate weakness’’ of the financial reporting system is that

it ‘‘suffers from too many rules’’ and should instead allow auditors to make their own judgments

‘‘drawn from a conceptual framework’’). 24 National Ass’n Sec. Dealers, Inc., Proposed Rule Regarding Research Analyst Conflicts of Interest, File No. SR–NASD–2002–21, filed with Securities and Exchange Commission, February

7, 2002, available at www.nasdr.com/analystlguide.htm; see also S. 1895, 107th Congress

(2002). 25Public Statement by SEC Chairman Harvey L. Pitt at the SEC Speakers Conference, Washington, DC, February 22, 2002.

within the last year that audit committees have been required to both determine

and report on auditor independence. Nonetheless, numerous recommendations for

additional reforms have already been floated. They range from bright line prohibitions, for example, absolute limitations on the provision of nonaudit services to audit

clients and requirements for auditor rotation, to more judgment based approaches.23

While the bright line approaches are attractive because of the certainty they create,

careful consideration needs to be given to the potential for unintended consequences.

• Consider whether instead of asking the audit committee simply to review the possibility of conflicting relationships after the fact, it might be preferable to ask the

audit committee to start with the decided presumption that audit and consulting

do not mix. (The industry is already considering eliminating the mix, voluntarily.)

Then leave it to the audit committee to decide on creating an exception when it

deems an exception necessary and desirable for the company and its shareholders.

Analysts and investment bankers also have potential conflicts of interest. The

NASD has proposed changes to the rules for addressing conflicts of interest that

arise when analysts are employees of investment banking or other firms having

business relationships with, or who themselves own securities of, the company involved. Among other things, the proposal would mandate increased disclosure of

conflicts in analyst reports and prohibit the investment banking arm from supervising or controlling research analysts or approving analyst reports. It would also

prohibit approval of analyst reports by the subject company, prohibit a link between

analyst compensation and specific investment banking transactions, and require disclosure in analyst reports if analyst compensation is based in part on investment

banking revenues.24 Some observers may prefer bright line prohibitions against analyst coverage of any stock in which the analyst has an ownership interest or in

which the analysts’ firm is engaged in a transaction.

I would be remiss if I did not discuss lawyers and their self-interests. Lawyers

play a critical role in both supporting the governance efforts of boards and assisting

managers to structure transactions while abiding by legal requirements. A classic

dilemma is posed, however. Lawyers often identify with the management team and

view themselves as strategic partners in achieving the client’s business goals. And

they may well perceive that the more effective they are in helping to achieve management’s goals, the more likely it is that they will receive additional business. Yet

lawyers also are expected to provide professional judgment and to counsel management about the legal boundaries and, in particular, to view their clients as more

than just management, and to include the corporation and its shareholders. I would

urge the American Bar Association to review the ethical conduct rules and, in

particular:

• Consider whether ethical conduct rules give lawyers sufficient guidance in balancing these roles. • Consider encouraging a set line of reporting for in-house counsel to bring to the

board concerns not otherwise acted on by management.

I support SEC Chairman Pitt’s recent call for both lawyers and accountants to ‘‘move away from wooden, rigid, literalism,’’ and ‘‘adopt a bias in favor of the needs

of the investing public.’’ 25

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26 ‘‘Reforms to Restore Confidence in Business,’’ Financial Times, February 19, 2002, at 14.

Conclusion

My suggestions can be boiled down simply to this: Diligent independent directors,

properly led, informed and assisted, can circumscribe the agency problems. If managers are not overly motivated by options to seek short-term market price appreciation, they should be less likely to—consciously or unconsciously—push the numbers,

push their auditor, and push the analysts. (Other compensation means are available

to handsomely reward managers for true performance successes.) If auditors, analysts, and lawyers remove the conflicts that stand in the way of the true professionalism the public expects, they are more likely to resist.

As I said at the outset, the great strength of our system is its ability to correct—

sometimes by self-correction, sometimes with assistance from the SRO’s, the SEC,

the legislative bodies both State and Federal, and the courts. If self-correction by

the private sector will not suffice (and in many respects it does not appear likely

to fully address the current concerns), then look to the listing bodies and their

contractual power to bind listed companies, together with greater SEC disclosure requirements. When that won’t suffice, look to legislative solutions. We must remember, however, as recently well-put by the Financial Times, that ‘‘no set of regulations, no matter how detailed, can outmanoeuvre a really determined manipulator.

...’’ 26 The great conundrum is that notwithstanding all our efforts for corrections,

ultimately, to considerable degree, we are left to rely on the integrity of individuals.

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