United States General Accounting Office 

Before the Committee on Banking, Housing, and Urban GAO Affairs, U.S. Senate 

For Release on Delivery 

Expected at 10 a.m. EST 

Tuesday, March 5, 2002 

PROTECTING THE 


PUBLIC INTEREST


Selected Governance, 

Regulatory Oversight, 

Auditing, Accounting, and 

Financial Reporting Issues 

Statement of David M. Walker 

Comptroller General of the United States 

a

GAO-02-483T


Mr. Chairman and Members of the Committee: 

I appreciate the opportunity to discuss with the committee my perspectives 

on some of the issues that are now receiving extensive national interest 

following the rapid and unexpected decline of Enron Corporation (Enron) 

and the resulting huge losses suffered by Enron’s shareholders and 

employees. The rapid failure and bankruptcy of Enron has led to severe 

criticism of virtually all areas of the nation’s financial reporting and 

auditing systems, which are fundamental to maintaining investor 

confidence in our capital markets. At last count, 12 congressional 

committees, the Department of Justice, the Securities and Exchange 

Commission (SEC), and the Department of Labor’s Pension and Welfare 

Administration all have ongoing investigations of Enron. The individuals 

responsible for the Enron debacle should be held accountable for any 

misdeeds. At GAO, accountability is one of our core values and must be a 

critical component of any system in order for it to function effectively. 

The facts regarding Enron’s failure are still being gathered to determine the 

underlying problems and whether any civil and/or criminal laws have been 

violated. Therefore, I will not comment on the specifics of the Enron 

situation and who is at fault. At the same time, the Enron situation raises a 

number of systemic issues for congressional consideration to better 

protect the public interest. It is fair to say that other business failures or 

restatements of financial statements have also sent signals that all is not 

well with the current system of financial reporting and auditing. As the 

largest corporation failure in U.S. history, Enron, however, provides a loud 

alarm that the current system may be broken and in need of an overhaul. 

I will focus on four overarching areas—corporate governance, the 

independent audit of financial statements, oversight of the accounting 

profession, and accounting and financial reporting issues—where the 

Enron failure has already demonstrated that serious, deeply rooted 

problems may exist. It should be recognized that these areas are the 

keystones to protecting the public’s interest and are interrelated. Failure in 

any of these areas places a strain on the entire system. The overall focus of 

these areas should be guided by the fundamental principles of having the 

right incentives for the key parties to do the right thing, adequate 

transparency to provide reasonable assurance that the right thing will be 

done, and full accountability if the right thing is not done. These three 

overarching principles represent a system of controls that should operate 

with a policy of placing special attention on those areas of greatest risk. In 

addition, an established code of ethics should set the “tone at the top” for 

Page 1 GAO-02-483T 
expected ethical behavior in performance of all key responsibilities. The 

1980s savings and loan crisis, for which this committee was instrumental in 

shaping the reforms to protect deposit insurance and the public interest, is 

a prime example of the serious consequences that can result when one or 

more components of an interrelated system breaks down. 

My comments today are intended to frame the broad accountability issues 

and provide our views on some of the questions and options that must be 

addressed to better safeguard the public interest going forward. There will 

no doubt be many views on what needs to be fixed and how to do it. We 

look forward to working with the Congress to provide assistance in 

defining the issues, exploring various options, and identifying their pros 

and cons in order to repair any weaknesses that threaten confidence in our 

capital markets and that inhibit improvements in the current system and 

appropriate actions by the key players. In considering changes to the 

current system that gave rise to Enron and other earlier financial reporting 

failures, it will be important that the Congress consider a holistic approach 

to addressing the range of interrelated issues. From all that has been heard 

from the inquiries to date, it is clear that there is no single silver bullet to fix 

the problems. It is also clear that many parties are focusing on various 

elements of the issues but do not seem to be taking a comprehensive 

approach to addressing the many interrelated issues. This is what we are 

trying to do for the Congress. 

On February 25, 2002, GAO held a forum on various governance, 

transparency, and accountability issues that was attended by experts in 

each of these areas. A summary of the results of the forum is being 

released today and is available at our web site.

1 Also, we have completed 

the study of the SEC’s resources that you requested and the report is being 

released today.

2 I will discuss the results of that work today as well. 

Before discussing these matters, I would like to quickly provide an 

overview of the current corporate governance system, the independent 

audit function, regulatory oversight, and the accounting and financial 

reporting framework. An attachment to my testimony graphically 

illustrates the interrelation and complexity of these systems. 

1

Highlights of GAO’s Forum on Corporate Governance, Transparency, and Accountability 

(GAO-02-494SP, March 5, 2002). 

2

SEC Operations: Increased Workload Creates Challenges, (GAO-02-302, March 5, 2002). 

Page 2 GAO-02-483T 
Overview of the 

Current Governance, 

Auditing, Oversight 

Systems, and Financial 

Reporting 

Public and investor confidence in the fairness of financial reporting is 

critical to the effective functioning of our capital markets. The SEC, 

established in the 1930s following the stock market crash of 1929 and the 

Great Depression, protects investors by administering and enforcing 

federal securities laws, and its involvement with requirements for financial 

disclosures and audits of financial statements for publicly traded 

companies. In this respect, the public accounting profession, through its 

independent audit function, has received a franchise to audit and attest to 

the fair presentation of financial statements of publicly traded companies. 

However, such a franchise brings with it not only the important role of 

attesting to the reliability of financial statements and related data, but also 

the concomitant responsibility of protecting the public interest and 

ensuring public confidence through appropriate independence, 

professional competence, and high ethical standards for auditors. 

The SEC, the primary federal agency involved in accounting and auditing 

requirements for publicly traded companies, has traditionally relied on the 

private sector for setting standards for financial reporting and independent 

audits, retaining a largely oversight role. Accordingly, the SEC has 

accepted rules set by the Financial Accounting Standards Board (FASB)3

— 

generally accepted accounting principles (GAAP)—as the primary standard 

for preparation of financial statements in the private sector. The SEC has 

accepted rules set by the American Institute of Certified Public 

Accountants’ (AICPA) Auditing Standards Board—generally accepted 

auditing standards(GAAS)—as the standard for conducting independent 

audits of financial statements for private sector entities. The SEC monitors 

the performance of the standard-setting bodies and also monitors the 

accounting profession’s system of peer review, which checks compliance 

with applicable professional standards. 

The SEC also oversees the activities of a variety of key market participants. 

It does this using the principle of self-regulation. According to this 

principle, the industry regulates itself through various self-regulatory 

organizations (SROs) overseen by the SEC. SROs are groups of industry 

professionals with quasi-governmental powers to adopt and enforce 

standards of conduct for their members. They include the nine securities 

3

FASB, as part of the Financial Accounting Foundation (FAF), is a not-for-profit organization 

supported by contributions from accounting firms, corporations, and other entities that are 

interested in accounting issues. FASB consists of seven full-time members who are selected 

and approved by the FAF. 

Page 3 GAO-02-483T 
exchanges, such as the New York Stock Exchange (NYSE), which regulate 

their marketplaces and the National Association of Securities Dealers 

(NASD) which regulates the over-the-counter market. In addition to 

regulating member broker dealers, the SROs establish listing standards for 

those firms that list on their market. 

The AICPA administers a self-regulatory system for the accounting 

profession that includes setting auditing and independence standards, 

monitoring compliance, and disciplining members for violations of ethic 

rules and standards. The Public Oversight Board, administratively created 

by the AICPA in consultation with the SEC in 1977, monitors public 

accounting firms’ compliance with professional standards and oversees the 

Auditing Standards Board. State boards of accountancy license public 

accounting firms and individuals to practice public accounting within each 

state’s jurisdiction. 

The audit is a critical element of the financial reporting structure because it 

subjects information in the financial statements to independent and 

objective scrutiny, increasing the reliability and assurance that can be 

placed on those financial statements for efficient allocation of resources in 

a capital market where investors are dependent on timely and reliable 

information. Management of a public company is responsible for the 

preparation and content of the financial statements, which are intended to 

disclose information that accurately depicts the financial condition and 

results of company activities. In addition, public companies registered 

with the SEC must maintain an adequate system of internal accounting 

control. The independent auditor is responsible for auditing the financial 

statements in accordance with generally accepted auditing standards to 

provide reasonable assurance that the financial statements are fairly 

presented in accordance with GAAP. The auditor’s opinion on the financial 

statements is like an expert’s stamp of approval to the public and the 

capital markets. 

U.S. stock exchanges require listed companies to meet certain corporate 

governance standards, including that boards of directors have independent 

audit committees to oversee the accounting and financial controls of a 

company and the financial reporting process. Audit committees can help 

protect shareholder interests by providing sound leadership and oversight 

of the financial reporting process by working with management and both 

internal and external auditors. 

Page 4 GAO-02-483T 
The interrelation and complexity of the systems of corporate governance, 

auditing, oversight, and accounting and financial reporting, which 

cumulatively are the foundation for maintaining investor confidence in our 

capital markets, is graphically illustrated in the charts attached to this 

statement. The many links within and between the systems further 

illustrate the strain that can be placed on the overall system when 

weaknesses occur within any part of the system. 

I would now like to focus on each of the four overarching areas I 

mentioned earlier, starting with corporate governance. 

Corporate Governance	 I want to acknowledge immediately that serving on the Board of Directors 

of a public corporation is an important, difficult, and challenging 

responsibility. That responsibility is especially challenging in the current 

environment with increased globalization and rapidly evolving 

technologies having to be addressed while at the same time meeting 

quarterly earnings projections in order to maintain or raise the market 

value of the corporation’s stock. These pressures, and related executive 

compensation arrangements, unfortunately often translate to a focus on 

short-term business results. This can create the perverse incentives, such 

as managing earnings to inappropriately report favorable financial results, 

and/or failing to provide adequate transparency in financial reporting that 

disguises risks, uncertainties, and/or commitments of the reporting entity. 

On balance though, the difficulty of serving on a public corporation’s board 

of directors is not a valid reason for not doing the job right, which means 

being knowledgeable of the corporation’s business, asking the right 

questions, and doing the right thing to protect the shareholders and the 

public interest. A board member needs to have a clear understanding of 

who is the client being served. Namely, their client should be the 

shareholders of the company, and all their actions should be geared 

accordingly. Audit committees have a particularly important role to play in 

assuring fair presentation and appropriate accountability in connection 

with financial reporting, internal control, compliance, and related matters. 

Enron’s failure has raised many questions about how its Board of Directors 

and audit committee were performing their duties and responsibilities. 

These questions include the following: 

Page 5 GAO-02-483T 
•	 Did the board of directors fulfill its fiduciary responsibility to 

shareholders and protect the public interest in overseeing Enron’s 

management? 

•	 Did the board operate in a proactive manner and raise the appropriate 

questions designed to identify key problems and mitigate related risks? 

•	 Did the board have the appropriate industry, financial, or other 

appropriate expertise? 

•	 Did board members have personal or business relationships that may 

have either in fact or in appearance affected their independence? 

•	 Did the board, especially its audit committee, have an active interface 

and appropriate working relationship with Enron’s internal and external 

auditors? 

•	 Did the board and its audit committee have appropriate resources to do 

the job including staff and independent advisors? 

•	 Did the board and its audit committee report meaningfully on their 

activities? 

These are fundamental questions that as I previously mentioned are being 

addressed by various investigations and, therefore, I will not comment on 

those issues. However, these issues are instructive and, as a minimum, call 

for a review of the applicable rules and regulations that govern boards of 

directors. In that respect, the Administration recently formed a group of 

top financial policymakers and regulators to consider corporate 

governance and disclosure reforms. The SEC has asked the NYSE and 

Nasdaq to review corporate governance and listing standards, of public 

companies, including the important issues of officer and director 

qualifications and the formal codes of conduct. The SEC Chairman 

recently announced that the NYSE has established a Special Committee on 

Corporate Accountability and Listing Standards to examine corporate 

governance issues, including the possibility of requiring continuing 

education programs for officers and directors, and the Nasdaq also is 

taking similar steps. The corporate chief executives who make up the 

Business Roundtable have stated that they are reviewing their voluntary 

standards for corporate governance. The AFL-CIO has petitioned the SEC 

to amend its proxy disclosure requirements regarding conflicts of interest 

reportable by Board members. The California Public Employees’ 

Retirement System (CalPERS) is also reviewing definitions and standards 

for independent corporate directors. 

These examples are not intended to be a complete listing of reviews 

underway on corporate governance requirements. We applaud these 

initiatives. Hopefully, they will provide the opportunity for a thorough 

Page 6 GAO-02-483T 
review of corporate governance requirements. These efforts will help to 

identify and frame the issues and to serve as a basis for determining 

whether the fundamental underpinnings for effective performance of 

boards of directors and audit committees are in place along with controls 

to monitor performance. Some basic factors to consider in reviewing the 

various requirements that govern membership and responsibilities of 

boards of directors of public companies include the following: 

•	 Is there a clear understanding of whom the board is serving and its 

fiduciary responsibility to shareholders and related impact on the 

capital markets? 

•	 What type of relationship should the board have with management (for 

example, constructive engagement)? 

•	 What, if any, selection process changes are necessary in order to assure 

the proper identification of qualified and independent board members? 

•	 Is the nominating process for board membership designed to ensure 

that the board is getting the right mix of talent to do the job? 

•	 Do board membership rules address who other than management would 

nominate Board members? 

•	 Are the independence rules for outside directors and audit committee 

members sufficient to ensure the objectivity of the members? 

•	 Do board membership rules address whether the corporation’s CEO 

should be allowed to be the board chairman? 

•	 Do board membership rules address whether independent board 

members should nominate the chairman of the board? 

•	 Do board membership rules address whether members of corporation 

management, including the CEO, should be allowed to be board 

members, and if so, what percentage of total board membership? 

•	 Do board membership rules address whether corporation service 

providers, such as major customers or other related parties, should be 

allowed to be board members? 

•	 Do requirements ensure that the board will have access to the resources 

and staff necessary to do the job, including its own staff and access to 

independent legal counsel and other experts? 

•	 Do requirements ensure that the responsibilities of board members, 

including the members who serve on audit committees and other 

committees, such as the nominating, finance, and compensation 

committees, are required to be committed to a charter that governs their 

operation? 

•	 Do requirements address the appropriate working relationship between 

the audit committee and the internal and external auditors? 

Page 7 GAO-02-483T 
•	 Do requirements provide for the board of directors to establish a formal 

code of conduct to set the tone for expected personal and business 

ethical behavior within the corporation? 

•	 Do requirements provide that waivers of the code of conduct are not 

expected and should such circumstances arise, which should be 

extremely rare, that any exceptions must be approved by the board of 

directors and publicly reported? 

•	 Do requirements provide for public reporting on the effectiveness of 

internal control by management and independent assurances on the 

effectiveness of internal control by the corporation’s independent 

auditors? 

•	 Do requirements provide for public reporting by the board of directors, 

the audit committee, and other committees of the board on their 

membership, responsibilities, and activities to fulfill those 

responsibilities? 

•	 Do the stock exchanges and the SEC have sufficient authority to enforce 

requirements governing boards of directors and audit committees and to 

take meaningful enforcement actions, including imposing effective 

sanctions when requirements are violated? 

•	 Does the SEC have sufficient resources and authority to fulfill its 

responsibilities under the federal securities laws and regulations to 

operate proactively in monitoring SEC registrants for compliance and to 

take timely and effective actions when noncompliance may exist? 

•	 Is the SEC efficiently and effectively using technology to manage its 

regulatory responsibilities under the federal securities laws by assessing 

risks, screening financial reports and other required filings, and 

accordingly prioritizing the use of its available resources? 

Boards of directors and their audit committees are a critical link to fair and 

reliable financial reporting. A weak board of directors will also likely 

translate into an ineffective audit committee. That combination makes the 

difficult job of auditing the financial statements of large corporations, 

which usually have vast, complex and diversified operations, much more 

challenging. 

Regulation and The model for regulation and oversight of the accounting profession 

involves federal and state regulators and a complex system of self- Oversight of the regulation by the accounting profession. The functions of the model are 

Accounting Profession interrelated and their effectiveness is ultimately dependent upon each 

component working well. Basically, the model includes the functions of 

Page 8 GAO-02-483T 
•	 licensing members of the accounting profession to practice within the 

jurisdiction of a state, as well as issuing rules and regulations governing 

member conduct, which is done by the state boards of accountancy; 

•	 setting accounting and auditing standards, which is done by the 

Financial Accounting Standards Board and the Auditing Standards 

Board, respectively, through acceptance of the standards by the SEC; 

• setting auditor independence rules, which within their various areas of 

responsibility, have been issued by the AIPCA, the SEC, and GAO; and 

• oversight and discipline, which is done through systems of selfregulation by the accounting profession and the public regulators (the 

SEC and state boards of accountancy). 

The Enron failure has brought a direct focus on how well the systems of 

regulation and oversight of the accounting profession are working in 

achieving their ultimate objective that the opinions of independent auditors 

on the fair presentation of financial statements can be relied upon by 

investors, creditors, and the various other users of financial reports. 

The issues currently being raised about the effectiveness of the accounting 

profession’s self-regulatory system are not unique to the collapse of Enron. 

Other business failures or restatements of financial statements over the 

past several years have called into question the effectiveness of the system. 

A continuing message is that the current self-regulatory system is 

fragmented, is not well coordinated, and has a discipline function that is 

not timely nor does it contain effective sanctions, all of which create a 

public image of ineffectiveness. Reviews of the system should consider 

whether overall the system creates the right incentives, transparency, and 

accountability, and operates proactively to protect the public interest. 

Also, the links within the self-regulatory system and with the SEC and the 

state boards of accountancy (the public regulatory systems) should be 

considered as these systems are interrelated and weaknesses in one 

component can put strain on the other components of the overall system. 

I would now like to address some of the more specific areas of the 

accounting profession’s self-regulatory system that should be considered in 

forming and evaluating proposals to reshape or overhaul the current 

system. 

Accounting Profession’s The accounting profession’s current self-regulatory system is largely 

Self-Regulatory System	 operated by the AICPA through a system, largely composed of volunteers 

from the accounting profession. This system is used to set auditing 

Page 9 GAO-02-483T 
standards and auditor independence rules, monitor member public 

accounting firms for compliance with professional standards, and 

discipline members who violate auditing standards or independence rules. 

AICPA staff support the volunteers in conducting their responsibilities. 

The Public Oversight Board oversees the peer review system established to 

monitor member public accounting firms for compliance with professional 

standards. In 2001, the oversight authority of the Public Oversight Board 

was expanded to include oversight of the Auditing Standards Board. The 

Public Oversight Board has five public members and professional staff, and 

receives its funding from the AICPA. 

On January 17, 2002, the SEC Chairman outlined a proposed new selfregulatory structure to oversee the accounting profession. On January 20, 

2002, the Public Oversight Board passed a resolution of intent to terminate 

its existence no later than March 31, 2002. The Public Oversight Board’s 

Chairman was critical of the SEC’s proposal and expressed concern that 

the Board was not consulted about the proposal. The SEC’s proposal 

provided for creating an oversight body that would include monitoring and 

discipline functions, have a majority of public members, and be funded 

through private sources. No further details have been announced. 

The authority for the oversight body is a basic but critical factor that can 

influence its operating philosophy, its independence, and, ultimately, its 

effectiveness. Related factors to consider include 

•	 determining whether the body should be created by statute or 

administratively, such as is the case for the current Public Oversight 

Board; 

•	 deciding the basic scope of the body’s enabling authority, such as 

whether oversight authority should be limited to coverage of the public 

accounting firms that audit SEC registrants, which is the authority of the 

current Public Oversight Board, or whether it should be expanded to 

other public accounting firms that also provide audit services to a 

broader range of entities; and 

•	 determining mission objectives clearly to ensure that protecting the 

public interest is paramount. 

Membership of the oversight body and its funding may also influence the 

body’s operating philosophy (proactive as opposed to reactive), 

independence, and resolve to actively assess and minimize risks within the 

system that affect protecting the public interest. Factors to consider 

include 

Page 10 GAO-02-483T 
•	 whether the membership should be limited to public members (exclude 

practicing members of the accounting profession), such as is the case 

for current Public Oversight Board, or whether membership should 

allow some practicing members of the accounting profession to sit on 

the board; 

•	 how the members will be selected, including the chair, their term limits, 

and compensation; and 

•	 how the amount and source of funding will be established since a 

problem with either may present potential conflicts or limit the 

oversight body’s ability to effectively protect the public interest. 

The responsibilities of the oversight body and its powers to perform those 

responsibilities will largely define whether the oversight body is set up with 

a sufficient span of responsibility to oversee the activities of the accounting 

profession and to take appropriate actions when problems are identified. 

Related factors to consider include 

•	 whether the current system of peer review should be continued in its 

present form and monitored by the oversight body, such as was done by 

the Public Oversight Board, with oversight by the SEC; 

•	 whether the oversight body should have more control over the peer 

review function, such as selecting and hiring peer reviewers, managing 

the peer review, and being the client for the peer review report; 

•	 whether the oversight body’s authority should extend to all standardsetting bodies within the accounting profession so that accounting, 

auditing, quality control and assurance, and independence standards are 

subject to oversight (currently the Public Oversight Board does not 

oversee the setting of accounting standards or auditor independence 

rules); 

•	 whether the oversight body’s authority related to standard setting 

should be expanded to direct standard-setting bodies to address any 

problems with standards and approve the adequacy of revised standards 

(currently the Public Oversight Board does not have such direct 

authority); 

•	 whether the oversight body’s authority should extend to the discipline 

function (currently the Public Oversight Board does not oversee the 

discipline function); 

•	 whether the oversight body should have investigative authority over 

disciplinary matters (currently this function is housed within another 

component of the AICPA) or authority to request investigations; and 

•	 whether the body within the self-regulatory system responsible for 

investigations of disciplinary matters should have power to protect 

Page 11 GAO-02-483T 
investigative files from discovery during litigation to facilitate 

cooperation and timeliness in resolving cases. 

Accountability requirements can provide for stewardship of resources, 

help to set the operating philosophy of the oversight body, and provide a 

means of monitoring the oversight body’s performance. The current Public 

Oversight Board issues an annual report and its financial statements are 

audited. Related factors to consider include 

•	 whether the oversight body should prepare strategic and annual 

performance plans; 

•	 whether the oversight body should have an annual public reporting 

requirement and what information should be included in the report, 

such as whether the report should be limited to the oversight body’s 

activities or whether the report should provide more comprehensive 

information about the activities of the entire self-regulatory system, and 

whether the oversight body should have audited financial statements; 

and 

•	 whether and, if so, how the Congress should exercise periodic oversight 

of the performance of the self-regulatory system and the performance of 

the oversight body. 

At this time, the outcome of the SEC’s proposal to establish a body for 

overseeing the accounting profession that would include monitoring and 

discipline functions is uncertain. There is considerable overlap in the 

functions of the current self-regulatory system and the functions of the SEC 

related to the accounting profession. For example, the AICPA sets auditor 

independence rules applicable to its membership, and the SEC sets auditor 

independence rules for those auditors who audit SEC registrants. Also, the 

AICPA disciplines its members for noncompliance with independence rules 

or auditing standards. The SEC, through its enforcement actions, 

disciplines auditors of SEC registrants who violate its laws and regulations, 

which include noncompliance with independence rules and auditing 

standards. In addition, the SEC also conducts various activities to oversee 

the peer review function of the self-regulatory system. 

As proposals are considered for reshaping or overhauling the selfregulatory system, the overlap of functions with the SEC’s responsibilities 

should be considered to provide for oversight of the accounting profession 

that is both efficient and effective. Related factors to consider include the 

following: 

Page 12 GAO-02-483T 
•	 whether current independence rules are adequate to protect the public 

interest; 

•	 whether independence rules for auditors should be consistent and set 

by the government or private sector, or whether the status quo is 

acceptable; 

•	 whether the current system of peer review is acceptable or whether the 

SEC should play a role that exercises more direct control or oversight of 

the accounting profession’s compliance with standards; and 

•	 how the investigative/enforcement functions of the self-regulatory 

system and the SEC can be jointly used to efficiently and effectively 

achieve their common objectives to resolve allegations of audit failure. 

Similarly, the discipline functions of the SEC and the self-regulatory system 

overlap with the state boards of accountancy, which are the only 

authorities that can issue or revoke a license to practice within their 

jurisdictions. The communication and working relationship opportunities 

for efficiency and effectiveness that exist between the SEC and the selfregulatory system also exist for their relationship with the state boards of 

accountancy in resolving allegations of audit failure. 

The Independent Audit 

Function 

For over 70 years, the public accounting profession, through its 

independent audit function, has played a critical role in enhancing a 

financial reporting process that facilitates the effective functioning of our 

domestic capital markets as well as international markets. The public 

confidence in the reliability of issuers’ financial statements that is provided 

by the performance of independent audits encourages investment in 

securities issued by public companies. This sense of confidence depends 

on reasonable investors perceiving auditors as independent expert 

professionals who have neither mutual nor conflicts of interests in 

connection with the entities they are auditing. Accordingly, investors and 

other users expect auditors to bring to the financial reporting process 

integrity, independence, objectivity, and technical competence, and to 

prevent the issuance of misleading financial statements. 

The Enron failure has raised questions concerning whether auditors are 

living up to the expectations of the investing public; however, similar 

questions have been repeatedly raised over the past three decades by 

significant restatements of financial statements and unexpected costly 

business failures. Issues debated over the years continue to focus on 

auditor independence concerns and the auditor’s role and responsibilities, 

Page 13 GAO-02-483T 
particularly in detecting and reporting fraud and assessing the 

effectiveness of and reporting on internal control. 

Auditor Independence 

Concerns 

The independence of public accountants—both in fact and in appearance— 

is crucial to the credibility of financial reporting and, in turn, the capital 

formation process. Auditor independence standards require that the audit 

organization and the auditor be independent in fact and in appearance. 

These standards place responsibility on the auditor and the audit 

organization to maintain independence so that opinions, conclusions, 

judgments, and recommendations will be impartial and will be viewed as 

being impartial by knowledgeable third parties. 

Since the mid-1970s, many observers of the auditing profession have 

expressed concern about the expanding scope of professional services 

provided by the public accounting profession. Specifically, questions have 

been raised by the media, the Congress, and others concerning the 

propriety of performing both audit and certain nonaudit services for the 

same client. While these services and their perceived impact on accounting 

firms’ independence have been the subject of many studies and while 

actions have been taken to strengthen auditor independence, the Enron 

failure has brought this issue once again to the forefront and has sparked 

new proposals to prohibit or limit auditors from providing nonaudit 

services to audit clients. A common concern is that when auditor fees for 

consulting services are a substantial part of total auditor fees, this situation 

can create pressures to keep the client happy and can threaten auditor 

independence. 

Auditors have the capability of performing a range of valuable services for 

their clients, and providing certain nonaudit services can ultimately be 

beneficial to investors and other interested parties. However, in some 

circumstances, it is not appropriate for auditors to perform both audit and 

certain nonaudit services for the same client. In these circumstances, the 

auditor, the client, or both will have to make a choice as to which of these 

services the auditor will provide. These concepts, which I strongly believe 

are in the public interest, are reflected in the revisions to auditor 

independence requirements for government audits,4

 which GAO recently 

4

Government Auditing Standards, Amendment No. 3, Independence (GAO/A-GAGAS-3, 

January 2002). 

Page 14 GAO-02-483T 
issued as part of Government Auditing Standards. 

5 The new 

independence standard has gone through an extensive deliberative process 

over several years, including extensive public comments and input from my 

Advisory Council on Government Auditing Standards.6 The standard, 

among other things, toughens the rules associated with providing nonaudit 

services and includes a principle-based approach to addressing this issue, 

supplemented with certain safeguards. The two overarching principles in 

the standard for nonaudit services are that 

•	 auditors should not perform management functions or make 

management decisions, and 

•	 auditors should not audit their own work or provide nonaudit services 

in situations where the amounts or services involved are significant or 

material to the subject matter of the audit. 

Both of the above principles should be applied using a substance over form 

determination. Under the revised standard, auditors are allowed to 

perform certain nonaudit services provided the services do not violate the 

above principles; however, in most circumstances certain additional 

safeguards would have to be met. For example: (1) personnel who perform 

allowable nonaudit services would be precluded from performing any 

related audit work, (2) the auditor’s work could not be reduced beyond the 

level that would be appropriate if the nonaudit work were performed by 

another unrelated party; and (3) certain documentation and quality 

assurance requirements must be met. The new standard includes an 

express prohibition regarding auditors providing certain bookkeeping or 

record keeping services and limits payroll processing and certain other 

services, all of which are presently permitted under current independence 

rules of the AICPA. 

The focus of these changes to the government auditing standards is to 

better serve the public interest and to maintain a high degree of integrity, 

objectivity, and independence for audits of government entities and entities 

5

Government Auditing Standards were first published in 1972 and are commonly referred 

to as the “Yellow Book,” and cover federal entities and those organizations receiving federal 

funds. Various laws require compliance with the standards in connection with audits of 

federal entities and funds. Furthermore, many states and local governments and other 

entities, both domestically and internationally, have voluntarily adopted these standards. 

6

The Advisory Council includes 20 experts in financial and performance auditing and 

reporting drawn from all levels of government, academia, private enterprise, and public 

accounting, who advise the Comptroller General on Government Auditing Standards. 

Page 15 GAO-02-483T 
that receive federal funding. However, these standards apply only to audits 

of federal entities and those organizations receiving federal funds, and not 

to audits of public companies. In the transmittal letter issuing the new 

independence standard, we expressed our hope that the AICPA will raise 

its independence standards to those contained in this new standard in 

order to eliminate any inconsistency between this standard and their 

current standards. The AICPA’s recent statement before another 

congressional committee that the AICPA will not oppose prohibitions on 

auditors providing certain nonaudit services seems to be a step in the right 

direction.7 In 2000, the SEC considered a principle-based approach for 

auditor independence rules applicable to auditors of SEC registrants, but 

decided in the end to set specific rules by types of nonaudit services. We 

believe a principle-based approach is more effective given the wide variety 

of nonaudit services provided by auditors and the continuing evolution of 

the market. 

The new independence standard is the first of several steps GAO has 

planned in connection with nonaudit services covered by government 

auditing standards. In May 2002, we plan to issue a question and answer 

document concerning our independence standard, and I will ask my 

Advisory Council on Government Auditing Standards to review and 

monitor this area to determine what, if any, additional steps may be 

appropriate. In addition, the Principals of the Joint Financial Management 

Improvement Program, who are the Comptroller General, the Secretary of 

the Treasury, and the Director, Office of Management and Budget, have 

agreed that the 24 major federal departments and agencies covered by the 

Chief Financial Officers Act should have audit committees. The scope, 

structure, and timing of this new requirement will be determined over the 

next several months. This will include determining what role these audit 

committees might play in connection with nonaudit services. 

Another auditor independence issue, which also existed with Enron, 

concerns the employment by the client of its former auditor. The revolving 

door between auditors and the companies they audit has existed for years. 

This is due in part to the mandatory retirement of partners from public 

accounting firms, often before the partners are ready to leave the 

profession. Another contributing factor that entices auditors to work for 

audit clients is the lucrative compensation for executives in public 

7

Testimony of AICPA Chairman before the House Energy and Commerce Committee 

(Subcommittee on Communications, Trade and Consumer Protection), February 14, 2002. 

Page 16 GAO-02-483T 
companies. Employment by the client of its former auditor can have a 

clear implication on the quality of audits and has been cited as a factor in 

the savings and loan scandal of the late 1980s. The AICPA asked the SEC in 

1993 to prohibit public companies from hiring their audit partner for a year 

after an audit. The SEC rejected the proposal as too difficult to enforce. 

However, Enron has resurfaced the issue. One congressional proposal 

would prohibit an accounting firm from providing audit services to a 

company whose controller or chief financial officer had worked for that 

public accounting firm. This issue again raises the auditor independence 

perception problem and provides another opportunity to further enhance 

auditor independence. A factor to consider in this debate includes 

mandating a “cooling off period” in which a partner or senior auditor from a 

firm cannot go to work for a former audit client for a period of time after 

separating from their firm. 

A related issue is whether an audit firm should be allowed to serve as the 

client’s auditor of record without a limit on the period of time. Currently, 

there are no time limits for rotation of audit firms, although the AICPA 

requirements for member firms that audit SEC registrants require partner 

rotation every 7 years. The concerns are that the auditor may become too 

close to management over a period of years and, therefore, threaten the 

auditor’s objectivity. Also, the auditor’s familiarity with the business 

operations of the client may result in a less than thorough audit. Opposing 

arguments against auditor rotation include that there is a significant 

learning curve for a new auditor and, during that time, there is a greater 

risk of the auditor overlooking transactions that may result in misleading 

financial statements. Also, auditor rotations can increase audit costs for 

the client.8 Building on the current AICPA requirement for rotating the 

audit engagement partner every 7 years, rotating addition key members of 

the audit team is another alternative to consider. Rotating addition key 

members of the audit team should have less of an impact of the auditor’s 

learning curve and not increase audit costs, although this option would still 

leave open the appearance of an independence issue for the firm. 

8

Federal, state, and local government auditors generally have their responsibilities defined 

by law or regulation. Therefore, rotation of government auditors raises different 

considerations than in the private sector. However, the rationale behind rotation of 

auditors (enhancing auditor independence) is addressed in Government Auditing 

Standards. The standards add organizational criteria that consider factors in the 

appointment, removal, and reporting responsibilities of the head of the audit organization to 

ensure independence. The organizational criteria for determining auditor independence are 

in addition to personal and external requirements that are considered in judging the 

independence of government auditors. 

Page 17 GAO-02-483T 
Study groups over the years have recognized that corporate boards and 

their audit committees could and should play a more significant role in 

strengthening the independence of audits. The situation with Enron and its 

auditors is another event that highlights the necessity to reexamine 

relationships of boards of directors, audit committees, and management 

with the independent auditor in order to strengthen the objectivity and 

professionalism of the independent auditor and to enhance the 

independent audit. Factors to consider in making changes include the 

following: 

• Who should be the client for the audit? 

•	 Should the audit committee be actively responsible for hiring, 

determining fees, and terminating the auditor? 

•	 Should there be more required communication and interaction between 

the auditor and the audit committee? 

•	 Should the audit committee preapprove the provision of certain 

nonaudit services by audit firms? 

•	 Should the audit committee be required to review and approve the 

staffing of audit firm personnel? 

Auditor’s Roles and 

Responsibilities for Fraud 

and Internal Control 

Under current auditing standards, auditors are responsible for planning 

and performing the audit to obtain reasonable, but not absolute, assurance 

about whether the financial statements are free of material misstatement, 

whether caused by error, illegal acts, or fraud. As stated over the years by 

many who have studied the profession, no major aspect of the independent 

auditor’s role has caused more difficulty than the auditor’s responsibility 

for detecting fraud. In August 2000, the Panel on Audit Effectiveness 

concluded that the auditing profession needs to address vigorously the 

issue of fraudulent financial reporting, including fraud in the form of 

illegitimate earnings management.9 The study expressed concern that 

auditors may not be requiring enough evidence, that is, they have reduced 

the scope of their audits and level of testing, to achieve reasonable 

assurance about the reliability of financial information that the capital 

markets need for their proper functioning. The study recommended that 

auditing standards be strengthened to effect a substantial change in 

auditors’ performance and thereby improve the likelihood that auditors will 

9

The Panel on Audit Effectiveness Report and Recommendations (August 31, 2000). The 

Panel was formed by the Public Oversight Board at the request of the SEC to study the 

effectiveness of the audit model and other issues affecting the accounting profession. 

Page 18 GAO-02-483T 
detect fraudulent financial reporting. The AICPA is working on a new 

auditing standard to improve auditor performance in this area, which it 

expects to issue by the end of this year. 

We have long believed that expanding auditors’ responsibilities to report on 

the effectiveness of internal control over financial reporting would assist 

auditors in assessing risks for the opportunity of fraudulent financial 

reporting or misappropriation of business assets. Currently, the auditor’s 

report on a public company’s financial statements does not address internal 

control or purport to give any assurance about it, and auditors are not 

required to assess the overall effectiveness of internal control or search for 

control deficiencies. The important issues of the auditor’s responsibility 

for detecting and reporting fraud and for reporting on internal control 

overlap since effective internal control is the major line of defense in 

preventing and detecting fraud. Taken together, these issues raise the 

broader question of determining the proper scope of the auditor’s work in 

auditing financial statements of publicly owned companies. The auditor 

would be more successful in preventing and detecting fraud if auditors 

were required to accept more responsibility for reporting on the 

effectiveness of internal control. The Congress recognized the link 

between past failures of financial institutions and weak internal control 

when it enacted the Federal Deposit Insurance Corporation Improvement 

Act of 1991 that grew out of the savings and loan crisis. The act requires an 

independent public auditor to report on the effectiveness of internal 

control for large financial institutions. 

For all of the financial statements audits that we conduct, which include 

the consolidated financial statements of the federal government, and the 

financial statements of the Internal Revenue Service, the Bureau of Public 

Debt, the Federal Deposit Insurance Corporation, and numerous smaller 

entities’ operations and funds, we issue separate opinions on the 

effectiveness of internal control over financial reporting and compliance 

with applicable laws and regulations. We require extensive testing of 

controls and compliance in our audits. We have done this for years 

because of the importance of internal control to protecting the public 

interest. Our reports have engendered major improvements in internal 

control. As you might expect, as part of the annual audit of our own 

financial statements, we practice what we recommend to others and 

contract with a CPA firm for both an opinion on our financial statements 

and an opinion on the effectiveness of our internal control over financial 

reporting and compliance with applicable laws and regulations. We believe 

strongly that the AICPA should follow suit and work with the SEC to 

Page 19 GAO-02-483T 
require expanded auditor involvement with internal control of public 

companies. 

The AICPA Chairman recently expressed the accounting profession’s 

support for auditor reporting on the effectiveness of internal control.

10 

Auditors can better serve their business clients and other financial 

statements users and protect the public interest by having a greater role in 

providing assurances of the effectiveness of internal control in deterring 

fraudulent financial reporting, protecting assets, and providing an early 

warning of internal control weaknesses that could lead to business failures. 

The SEC, the AICPA, and corporate boards of directors are major 

stakeholders in achieving realistic auditing standards for fraud and internal 

control. However, as we stated in our 1996 report on the accounting 

profession,11 the SEC is the key player in providing the leadership and in 

bringing these parties together to enhance auditor reporting requirements 

on the effectiveness of internal control. We believe it would be difficult for 

the AICPA to unilaterally expand audit requirements without SEC support. 

Accounting and 

Financial Reporting 

Model 

Business financial reporting is critical in promoting an effective allocation 

of capital among companies. Financial statements, which are at the center 

of present-day business reporting, must be relevant and reliable to be 

useful for decision-making. In our 1996 report on the accounting 

profession,12 we reported that the current financial reporting model does 

not fully meet users’ needs. 

We found that despite the continuing efforts of standard setters and the 

SEC to enhance financial reporting, changes in the business environment, 

such as the growth in information technology, new types of relationships 

between companies, and the increasing use of complex business 

transactions and financial instruments, constantly threaten the relevance 

of financial statements and pose a formidable challenge for standard 

setters. A basic limitation of the model is that financial statements present 

the business entity’s financial position and results of its operations largely 

10See footnote 7. 

11The Accounting Profession Major Issues: Progress and Concerns (GAO/AIMD-96-98, 

September 24, 1996). 

12See footnote 11. 

Page 20 GAO-02-483T 
on the basis of historical costs, which do not fully meet the broad range of 

user needs for financial information.13 

In 1994, the AICPA’s Special Committee on Financial Reporting, after 

studying the concerns over the relevance and usefulness of financial 

reporting and the information needs of professional investors and 

creditors, concluded that the current model is useful as a reliable 

information basis for analysts, but concluded that a more comprehensive 

model is needed that includes both financial information and nonfinancial 

information. In addition to financial statements and related disclosures, 

the model recommended by the study would include 

•	 high-level operating data and performance measures that management 

uses to manage the business; 

• management’s analysis of changes in financial and nonfinancial data; 

•	 forward-looking information about opportunities, risks, and 

management’s plans, including discussions about critical success 

factors, as well as information about management and shareholders; 

and 

•	 background about the company, including a description of the business, 

its industry, and its objectives and strategies. 

The Committee acknowledged that many business entities do report 

nonfinancial information, but it stressed the need to develop a 

comprehensive reporting package that would promote consistent reporting 

and the need to have auditors involved in providing some level of assurance 

for each of the model’s elements. Opposing views generally cite liability 

concerns as a risk to reporting forward-looking and other related 

nonfinancial information, concerns over cost of preparing the information, 

and concerns whether more specific disclosures would put business 

entities at a competitive disadvantage. Although standard setters have 

addressed certain issues to improve the financial reporting model, a project 

13The accounting and reporting model under generally accepted accounting principles is 

actually a mixed-attribute model. Although most transactions and balances are measured 

on the basis of historical cost, which is the amount of cash or its equivalent originally paid to 

acquire an asset, certain assets and liabilities are reported at current values either in the 

financial statements or related notes. For example, certain investments in debt and equity 

securities are currently reported at fair value, receivables are reported at net realizable 

value, and inventories are reported at the lower of cost or market value. Further, certain 

industries such as brokerage houses and mutual funds prepare financial statements on a fair 

value basis. 

Page 21 GAO-02-483T 
to develop a more comprehensive reporting model has not been 

undertaken. 

Enron’s failure and the inquiries that have followed have raised many of the 

same issues about the adequacy of the financial reporting model, such the 

need for transparency, clarity, and risk-oriented financial reporting, 

addressed by the AICPA’s Special Committee on Financial Reporting. The 

limitations of the historical cost-based model were made more severe in 

the case of the Enron failure by accounting rules and reports designed for a 

pipeline operator that transitioned into a company using numerous 

offshore, off balance sheet, quasi-affiliated, tax shelter entities to operate, 

invest in, trade or make a market for contracts involving water, electricity, 

natural gas, and broadband capacity. However, criticism of the financial 

reporting model should also consider the criticisms of the corporate 

governance system, the auditing profession, and the regulatory and selfregulatory oversight models which may impact the quality of financial 

reporting. Also, human failure to effectively perform responsibilities in any 

one or all four of these areas has been raised by the many inquiries 

following Enron’s sudden failure. Also, Enron’s November 8, 2001, 

reporting to the SEC (Form 8-K filing), which restated its financial 

statements for the years ended December 31, 1997 through 2002, and the 

quarters ended March 31 and June 30, 2001, acknowledges that the 

financial reports did not follow generally accepted accounting principles 

and, therefore, should not be relied upon. 

Among other actions to address the Enron-specific accounting issues, the 

SEC has requested that the FASB address the specific accounting rules 

related to Enron’s special purpose entities and related party disclosures. 

The SEC is expecting the FASB to revise and finalize the special purpose 

accounting rules by the end of this year. The FASB has stated its is 

committed to proceed expeditiously to address any financial accounting 

and reporting issues that may arise as a result of Enron’s bankruptcy. In 

that respect, the FASB at a recent board meeting set a goal of publishing an 

exposure draft by the end of April 2002 and a final statement by the end of 

August 2002 that would revise the accounting rules for special purpose 

entities. The SEC has also announced specific areas for improving 

disclosures, including 

•	 more current disclosure, including “real-time” disclosure of 

unquestionable material information; 

• disclosure of significant trend data and more “evaluative” data; 

• financial statements that are clearer and more informative for investors; 

Page 22 GAO-02-483T 
•	 disclosure of the accounting principles that are most critical to the 

company’s financial status and that involve complex or subjective 

decisions by management; and 

•	 private-sector standards setting that is more responsive to the current 

and immediate needs of investors. 

In addition, the SEC has announced plans to propose new corporate 

disclosure rules that will 

•	 provide accelerated reporting by companies of transactions by company 

insiders in company securities, including transactions with the 

company; 

• accelerate filing by companies of their quarterly and annual reports; 

•	 expand the list of significant events requiring current disclosure on 

existing Form 8-K filings (such events could include changes in rating 

agency decisions, obligations that are not currently disclosed, and lockout periods affecting certain employee plans with employer stock); 

•	 add a requirement that public companies post their Exchange Act 

reports on their Web sites at the same time they are filed with the SEC; 

and 

•	 require disclosure of critical accounting policies in Management’s 

Discussion and Analysis of Financial Condition and Results of 

Operations contained in annual reports. 

The SEC Chief Accountant has also raised concerns that the current 

standard-setting process is too cumbersome and slow and that much of the 

FASB’s guidance is rule-based and too complex. He believes that (1) 

principle-based standards will yield a less complex financial reporting 

paradigm that is more responsive to emerging issues, (2) the FASB needs to 

be more responsive to accounting standards problems identified by the 

SEC, and (3) the SEC needs to give the FASB freedom to address the 

problems, but the SEC needs to monitor projects and, if they are 

languishing, determine why. 

We support the SEC’s stated plans to specifically address the accounting 

issues raised by the Enron failure and the broader-based planned initiatives 

that begin to address some of the overarching issues with the current 

financial reporting model. It will be important that these initiatives be 

aimed at the end result of having a financial reporting model that is more 

comprehensive while, at the same time, more understandable and timely in 

providing current value financial information and nonfinancial information 

that will provide users with data on the reporting entity’s business risks, 

Page 23 GAO-02-483T 
uncertainties, and outlook, including significant assumptions underlying 

the nonfinancial information. We also support a more direct partnering 

between the SEC and the FASB to facilitate a mutual understanding of 

priorities for standard-setting and realistic goals for achieving 

expectations. 

On balance, standard setting is inherently difficult and subject to pressures 

by those parties most affected by proposed changes. Today’s business 

environment that includes increased globalization, rapid technological 

advances, real-time communication, and extremely sophisticated financial 

engineering is a difficult challenge for accounting standard-setters as our 

commercial world moves from an industrial base to an information base. 

Further more, creative use of financial reports, such as the recent 

phenomenon of using “pro forma” financial statements to present a “rosier 

picture” than GAAP may otherwise allow, adds another challenge for 

standard-setters and regulators. On December 4, 2001, the SEC issued FRR 

No. 59, Cautionary Advice Regarding the Use of “Pro Forma” Financial 

Information in Earnings Releases. One of the key points in the 

cautionary advice release was that the antifraud provisions of the federal 

securities laws apply to a company issuing “pro forma” financial 

information. 

With that said, we believe that the underlying principles of accounting and 

financial reporting are still valid, namely, that financial reporting must 

reflect the economic substance of transactions, be consistently applied, 

and provide fair representation in accordance with generally accepted 

accounting principles. In applying these underlying principles, it is 

important to recognize the variety of users of financial information and 

their financial acumen. One size will not likely fit all, and targeted 

audiences for reported financial information may need to be identified, 

such as sophisticated investors, analysts, and creditors versus the general 

public. We also believe that the auditors need to be active players in 

developing a more comprehensive model with the objective of adding value 

to the information through independent assurances. Finally, effective 

corporate governance, independent auditors, and regulatory oversight 

must accompany accounting standards and financial reporting. For 

meaningful and reliable financial reporting, it is not enough to say the rules 

were followed, which is the minimum expectation. Those with 

responsibilities for financial reporting and their auditor must ensure that 

the economic substance of business transactions is, in fact, fairly reported. 

Page 24 GAO-02-483T 
I would now like to turn to the results of the work that you requested in 

asking us to look at the resource issues at the SEC. 

The SEC’s Ability to 

Fulfill Its Mission 

Over the last decade, securities markets have experienced unprecedented 

growth and change. Moreover, technology has fundamentally changed the 

way markets operate and how investors access markets. These changes 

have made the markets more complex. In addition, the markets have 

become more international, and legislative changes have resulted in a 

regulatory framework that requires increased coordination among financial 

regulators and requires that the SEC regulate a greater range of products. 

Moreover, as I discussed earlier, the recent, sudden collapse of Enron and 

other corporate failures have stimulated an intense debate on the need for 

broad-based reform in such areas as financial reporting and accounting 

standards, oversight of the accounting profession, and corporate 

governance, all of which could have significant repercussions on the SEC’s 

role and oversight challenges. At the same time, the SEC has been faced 

with an ever-increasing workload and ongoing human capital challenges, 

most notably high staff turnover and numerous vacancies. 

In our work requested by this Committee, for which our report is being 

released at this hearing, we found that the SEC’s ability to fulfill its mission 

has become increasingly strained due in part to imbalances between the 

SEC’s workload (such as filings, complaints, inquiries, investigations, 

examinations, and inspections) and staff resources.14 Although industry 

officials complimented the SEC’s regulation of the industry given its staff 

size and budget, both the SEC and industry officials identified several 

challenges that the SEC faces. First, resource constraints have contributed 

to substantial delays in the turnaround time for many SEC regulatory and 

oversight activities, such as approvals for rule filings and exemptive 

applications.

15 Second, resource constraints have contributed to 

bottlenecks in the examination and inspection area as the SEC’s workload 

has grown. Third, limited resources have forced the SEC to be selective in 

its enforcement activities and have lengthened the time required to 

14Staff resources are measured in this report in terms of full-time equivalent staff years. 

15A company files an exemptive application when it seeks an SEC decision to exempt a new 

activity from existing rules and laws. 

Page 25 GAO-02-483T 
complete certain enforcement investigations.16 Fourth, certain filings were 

subject to less frequent and less complete reviews as workloads increased. 

Fifth, today’s technology-driven markets have created ongoing budgetary 

and staff challenges. Finally, the SEC and industry officials said that the 

SEC has been increasingly challenged in addressing emerging issues, such 

as the ongoing internationalization of securities markets and technologydriven innovations like Alternative Trading Systems17 (ATSs), and 

exchange-traded funds. 

The SEC routinely prioritizes and allocates resources to meet workload 

demands, but faces increasing pressure in managing its mounting workload 

and staffing imbalances that resulted from its workload growing much 

faster than its staff. Critical regulatory activities, such as reviewing rule 

filings and exemptive applications and issuing guidance, have suffered 

from delays due to limited staffing. According to industry officials, these 

delays have resulted in forgone revenue and have hampered market 

innovation. Oversight and supervisory functions have also been affected. 

For example, staffing limitations and increased workload have resulted in 

the SEC reviewing a smaller percentage of corporate filings, an important 

investor protection function. In 2001, the SEC reviewed about 16 percent 

of the annual corporate filings, or about half of its annual goal of 30 to 35 

percent. Although the SEC is revamping its review process to make it more 

risk-based, recent financial disclosure and accounting scandals illustrate 

how important it is that the SEC rise to the challenge of providing effective 

market oversight to help maintain investor confidence in securities 

markets. 

SEC Staff Turnover	 In addition to the staff and workload imbalances, other factors also 

contribute to the challenges the SEC currently faces. SEC officials said 

that although additional resources could help the SEC do more, additional 

16The SEC Chairman has recently announced an initiative called real-time enforcement, 

which is intended to protect investors by (1) obtaining emergency relief in federal court to 

stop illegal conduct expeditiously, (2) filing enforcement actions more quickly, thereby 

compelling disclosure of questionable conduct so that the public can make informed 

investment decisions, and (3) deterring future misconduct through imposing swift and stiff 

sanctions on those who commit egregious frauds, repeatedly abuse investor trust, or 

attempt to impede the SEC’s investigatory processes. According to the SEC, insufficient 

resources may inhibit the effectiveness of this initiative, which depends upon prompt action 

by enforcement staff. 

17An ATS is an entity that performs functions commonly performed by a stock exchange. 

Page 26 GAO-02-483T 
resources alone would not help the SEC address its high staff turnover, 

which continues to be a problem. Furthermore, in recent years the staff 

turnover and large differentials in pay between the SEC and other financial 

regulators and industry employers resulted in many staff positions 

remaining vacant as staff left at a faster rate than the SEC could hire new 

staff. Although the SEC now has the authority to provide pay parity, its 

success will depend upon the SEC designing an effective implementation 

approach and the agency receiving sufficient budgetary resources. We also 

found that the SEC’s budget and strategic planning processes could be 

improved to better enable the SEC to determine the resources needed to 

fulfill its mission. For example, unlike recognized high performing 

organizations, the SEC has not systematically utilized its strategic planning 

process to ensure that (1) resources are best used to accomplish its basic 

statutorily mandated duties and (2) workforce development addresses the 

resource needs that are necessary to fulfill the full scope of its mission, 

including activities to address emerging issues. 

18 

As we noted in our 2001 report on the SEC’s human capital practices, about 

one-third of the SEC’s staff left the agency from 1998 to 2000.19 The SEC’s 

turnover rate for attorneys, accountants, and examiners averaged 15 

percent in 2000, more than twice the rate for comparable positions 

government-wide. Although the rate had decreased to 9 percent in 2001, 

turnover at the SEC was still almost twice as high as the rate 

governmentwide. Further, as a result of this turnover and inability to hire 

qualified staff quickly enough, about 250 positions remained unfilled in 

September 2001, which represents about 8.5 percent of the SEC’s 

authorized positions. SEC officials said that they could do more if they had 

more staff, but all cited the SEC’s high turnover rate as a major challenge in 

managing its workload. Likewise industry officials agreed that many of the 

challenges that the SEC faces today are exacerbated by its high turnover 

rate, which results in more inexperienced staff and slower, often less 

efficient, regulatory processes. 

Although the SEC and industry officials said that the SEC would always 

have a certain amount of turnover because staff can significantly increase 

18High performing organizations are organizations that have been recognized in the current 

literature or by GAO as being innovative or effective in strategically managing their human 

capital. 

19Securities and Exchange Commission: Human Capital Challenges Require 

Management Oversight (GAO-01-947, September 17, 2001). 

Page 27 GAO-02-483T 
their salaries in the private sector and some staff only plan to stay at the 

SEC for a period of time, many said pay parity with other financial 

regulators could enable the SEC to attract and retain staff for a few 

additional years. The SEC estimated that a new employee generally takes 

about 2 years to become fully productive and that pay parity could help 

them keep staff a year or two beyond the initial 2 years. Although industry 

officials said they were generally impressed by the caliber of staff that the 

SEC hires and the amount of work they do, they said that staff inexperience 

often requires senior SEC officials to become more involved in basic 

activities. Industry officials also said that certain divisions, such as Market 

Regulation, could benefit from staff with a fundamental understanding of 

how markets work and market experience. They said that such experience 

could help speed rulemaking and review processes. However, SEC officials 

said that they have a difficult time attracting staff with market experience, 

given the government’s pay structure. 

Some officials said that the SEC’s turnover rate should decrease after pay 

parity is implemented. Presently, the SEC professional staff are paid 

according to federal general pay rates. On January 16, 2002, the President 

signed legislation that exempted the SEC from federal pay restrictions and 

provided it with the authority necessary to bring salaries in line with those 

of other federal financial regulators. That legislation also mandated that we 

conduct a study to look at the feasibility of the SEC becoming a fully selffunded agency. Although the SEC now has the authority to implement pay 

parity, as of March 1, 2002, the SEC has not received an additional 

appropriation to fund its implementation. In addition, the SEC has to take 

a number of steps to effectively implement this new authority. 

Although the SEC’s workload and staffing imbalances have challenged the 

SEC’s ability to protect investors and maintain the integrity of securities 

markets, the SEC has generally managed the gap between workload and 

staff by determining what basic statutorily mandated duties it could 

accomplish with existing resource levels. This approach, while practical, 

under the circumstances, has forced the SEC’s activities to be largely 

reactive rather than proactive. For instance, the SEC has not put 

mechanisms in place to identify what it must do to address emerging and 

evolving issues. Although the SEC has a strategic plan and has periodically 

adjusted staffing or program priorities to fulfill basic obligations, the SEC 

has not engaged in a much needed, systematic reevaluation of its programs 

and activities in light of current and emerging challenges. Given the 

regulatory pressures facing the SEC and its ongoing human capital 

challenges, it is clear that the SEC could benefit from an infusion of funding 

Page 28 GAO-02-483T 
and possibly additional resources. However, a comprehensive, agency 

wide planning effort, including planning for use of technology to leverage 

available resources, could help the SEC better determine the optimum 

human capital and funding needed to fulfill its mission. 

Closing Comments	 A number of witnesses who have recently appeared before this Committee 

and other congressional committees to discuss Enron’s failure have stated 

that our nation’s system of capital markets is recognized around the world 

as the best. I share that view. Our capital markets enjoy a reputation of 

integrity that promotes investor confidence that is critical to our economy 

and the economies of other nations given the globalization of commerce. 

This reputation is now being challenged. The effectiveness of our systems 

of corporate governance, independent audits, regulatory oversight, and 

accounting and financial reporting, which are the underpinnings of our 

capital markets, to protect the public interest has been called into question 

by the failure of Enron. Many of the issues that are being raised have 

previously surfaced from other business failures and/or restatements of 

financial statements that significantly reduced previously reported 

earnings or equity. Although the human element factor, and the basic 

failure to always do what is right, are factors that can override systems of 

controls, it is clear that there are a range of actions that are critical to the 

effective functioning of the system underlying our capital markets that 

need attention. In addition, a strong enforcement function with 

appropriate civil and criminal sanctions is also needed to deal with 

noncompliance. 

The results of the forum that we held last week on governance, 

transparency, and accountability identified major issues in each of the 

areas, which I have addressed in my remarks today, that endanger their 

effective functioning to protect the public interest. As is usually the case in 

issues of this magnitude and importance, there is no single silver bullet to 

quickly make the repairs needed to the systems supporting our capital 

markets. The fundamental principles of having the right incentives, 

adequate transparency, and full accountability provide a good sounding 

board to evaluate proposals that are advanced. A holistic approach is also 

important as the systems are interrelated and weak links can severely 

strain their effective functioning. I have framed a number of the key issues 

today for congressional consideration. As always, we look forward to 

working with you to further refine the issues, and develop and analyze 

options and take other steps designed to repair the system weaknesses that 

today pose a threat to investor confidence in our capital markets. 

Page 29 GAO-02-483T 
In summary, Enron’s recent decline and fall coupled with other recent 

business failures pose a range of serious systemic issues that must be 

addressed. Effectively addressing these issues should be a shared 

responsibility involving a number of parties including top management, 

boards of directors, various board committees, stock exchanges, the 

accounting profession, standard setters, regulatory/oversight agencies, 

analysts, investors, and the Congress. In the end, no matter what system 

exists, bad actors will do bad things with bad results. We must strive to 

take steps to minimize the number of such situations and to hold any 

violators of the system fully accountable for their actions. 

Mr. Chairman, this concludes my statement. I would be please to answer 

any questions you or other members of the committee may have at this 

time. 

Contacts and	 For further information regarding this testimony, please contact Robert W. 

Gramling, Financial Management and Assurance, at (202) 512-6535. Acknowledgments	 Individuals making key contributions to this testimony include Cheryl E. 

Clark, Michael C. Hrapsky, Thomas J. McCool, Jeffrey C. Steinhoff, and 

Orice M. Williams. 

Page 30 GAO-02-483T 
Attachment I: Overview of Regulatory and 

Private Sector Structure 

Rating Agencies 

Banks and Lenders 

(creditors) 

Institutional Investors 

Public Interest -- Effective Financial 

and Capital Markets 

• Individual Investors 

See

next

page

Page 31 GAO-02-483T 
Attachment I: Overview of Regulatory and 

Private Sector Structure 

Public 

regulation 

Financial reporting 

Enforcement 

• Boards of directors 

• Audit committees 

• Management 

responsibilities for 

- Financial reporting 

- Internal controls 

- Compliance with 

laws and regulations 

- Code of ethics 

Corporate governance and 

listing standards 

Investment banking and 

securities analysis 

Corporate governance and 

listing standards Publicly traded 

companies 

Private sector 

regulation 

Certification, licensing, discipline 

Financial audits and 

consulting services 

SECPS 

(Peer 

review) Compliance monitoring 

Quality control and audit standards 

Ethics, independence rules, discipline 

Broker 

dealers 

NASDAQ 

Independence standards for auditors of SEC registrants 

Delegated 

responsibility Accounting rules 

FASB 

State 

boards 

of 

accountancy 

ASB 

Corporate 

governance 

PEEC 

FAF 

AICPA 

Self-regulatory 

organizations 

e.g. 

NYSE 

NASD 

SEC 

POB 

Public 

accounting 

firms 

NYSE 

exchange 

Direct Responsibility 

Delegated Responsibility 

Oversight 

(194109) Page 32 GAO-02-483T 
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