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77–990CC 2002

ARE CURRENT FINANCIAL ACCOUNTING

STANDARDS PROTECTING INVESTORS?

HEARING

BEFORE THE

SUBCOMMITTEE ON

COMMERCE, TRADE, AND CONSUMER PROTECTION

OF THE

COMMITTEE ON ENERGY AND

COMMERCE

HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

SECOND SESSION

FEBRUARY 14, 2002

Serial No. 107–84

Printed for the use of the Committee on Energy and Commerce

(

Available via the World Wide Web: http://www.access.gpo.gov/congress/house

COMMITTEE ON ENERGY AND COMMERCE

W.J. ‘‘BILLY’’ TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida

JOE BARTON, Texas

FRED UPTON, Michigan

CLIFF STEARNS, Florida

PAUL E. GILLMOR, Ohio

JAMES C. GREENWOOD, Pennsylvania

CHRISTOPHER COX, California

NATHAN DEAL, Georgia

STEVE LARGENT, Oklahoma

RICHARD BURR, North Carolina

ED WHITFIELD, Kentucky

GREG GANSKE, Iowa

CHARLIE NORWOOD, Georgia

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

HEATHER WILSON, New Mexico

JOHN B. SHADEGG, Arizona

CHARLES ‘‘CHIP’’ PICKERING, Mississippi

VITO FOSSELLA, New York

ROY BLUNT, Missouri

TOM DAVIS, Virginia

ED BRYANT, Tennessee

ROBERT L. EHRLICH, Jr., Maryland

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

MARY BONO, California

GREG WALDEN, Oregon

LEE TERRY, Nebraska

JOHN D. DINGELL, Michigan

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

RALPH M. HALL, Texas

RICK BOUCHER, Virginia

EDOLPHUS TOWNS, New York

FRANK PALLONE, Jr., New Jersey

SHERROD BROWN, Ohio

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

BART STUPAK, Michigan

ELIOT L. ENGEL, New York

TOM SAWYER, Ohio

ALBERT R. WYNN, Maryland

GENE GREEN, Texas

KAREN MCCARTHY, Missouri

TED STRICKLAND, Ohio

DIANA DEGETTE, Colorado

THOMAS M. BARRETT, Wisconsin

BILL LUTHER, Minnesota

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

JANE HARMAN, California

DAVID V. MARVENTANO, Staff Director

JAMES D. BARNETTE, General Counsel

REID P.F. STUNTZ, Minority Staff Director and Chief Counsel

SUBCOMMITTEE ON COMMERCE, TRADE, AND CONSUMER PROTECTION

CLIFF STEARNS, Florida, Chairman

NATHAN DEAL, Georgia

Vice Chairman

ED WHITFIELD, Kentucky

BARBARA CUBIN, Wyoming

JOHN SHIMKUS, Illinois

JOHN B. SHADEGG, Arizona

ED BRYANT, Tennessee

STEVE BUYER, Indiana

GEORGE RADANOVICH, California

CHARLES F. BASS, New Hampshire

JOSEPH R. PITTS, Pennsylvania

GREG WALDEN, Oregon

LEE TERRY, Nebraska

W.J. ‘‘BILLY’’ TAUZIN, Louisiana

(Ex Officio)

EDOLPHUS TOWNS, New York

DIANA DEGETTE, Colorado

LOIS CAPPS, California

MICHAEL F. DOYLE, Pennsylvania

CHRISTOPHER JOHN, Louisiana

JANE HARMAN, California

HENRY A. WAXMAN, California

EDWARD J. MARKEY, Massachusetts

BART GORDON, Tennessee

PETER DEUTSCH, Florida

BOBBY L. RUSH, Illinois

ANNA G. ESHOO, California

JOHN D. DINGELL, Michigan,

(Ex Officio)

(II)

C O N T E N T S

Page

Testimony of:

Castellano, James G., Chairman of the Board, American Institute of

Certified Public Accountants ........................................................................ 27

Herdman, Robert K., Chief Accountant, U.S. Securities and Exchange

Commission ................................................................................................... 11

Hinchman, Grace L., Senior Vice President for Public Affairs, Financial

Executives International .............................................................................. 60

Jenkins, Edmund L., Chairman, Financial Accounting Standards Board ... 16

Linsmeier, Thomas J., Associate Professor of Accounting and Information

Systems, Eli Broad College of Business, Michigan State University ....... 62

Material submitted for the record by:

Markey, Hon. Edward J., a Representative in Congress from the State

of Massachusetts, letter dated March 7, 2002, to Robert K. Herdman .... 71

(III)

(1)

ARE CURRENT FINANCIAL ACCOUNTING

STANDARDS PROTECTING INVESTORS?

THURSDAY, FEBRUARY 14, 2002

HOUSE OF REPRESENTATIVES, COMMITTEE ON ENERGY AND COMMERCE, SUBCOMMITTEE ON COMMERCE, TRADE, AND CONSUMER PROTECTION, Washington, DC.

The subcommittee met, pursuant to notice, at 9 a.m., in room

2212, Rayburn House Office Building, Hon. Cliff Stearns (chairman) presiding.

Members present: Representatives Stearns, Shimkus, Bryant,

Buyer, Terry, Bass, Towns, DeGette, Harman, Markey, Rush, and

Eshoo.

Staff present: Ramsen Betfarhad, majority counsel; David

Cavicke, majority counsel; Brian McCullough, majority professional

Staff; Brendan Williams, legislative clerk; Consuela Washington,

minority counsel; David Nelson, minority investigator.

Mr. STEARNS. Good morning, everybody. I think what we will do,

while members might be trickling in, I think I will start with my

opening statement and even start with some of the witnesses and

we can, as members come in, although it is not the normal procedure, we can break after the witnesses, to have some of the members’ opening statements, but I would like to continue on, since we

were supposed to start at 9 o’clock.

Introspection abounds in many sectors of business following the

collapse of Enron. Boards of Directors are rethinking their duties

of loyalty and duties of care, auditing firms are reviewing their client relationships with an eye toward independence, and Wall

Street is contemplating more diligent company review rather than

relying on market momentum.

Congress, too, is asking whether current accounting and disclosure standards are adequate to protect investors. If not, what Congress, the Securities and Exchange Commission, and the Financial

Accounting Standards Board should do to make necessary changes.

Last week, Chairman Tauzin kicked off our review by holding a

full committee hearing examining accounting standards, corporate

disclosure, corporate governance, and the state of the auditing industry.

We will follow up on that hearing today with an in-depth look

at the adequacy of current accounting standards. The central tenet

underlying financial reporting is fair and transparent disclosure.

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2

stand the conditions of those with whom they transact, investors

can make informed investment decisions, and companies themselves benefit from a cost-of-capital that accurately reflects risk

profiles.

Our look at financial reporting today will focus on two main

issues, off balance sheet accounting for special purposes entities

and accounting for derivatives and financial contracts.

My colleagues, to qualify for off balance sheet treatment, current

accounting rules require 3 percent of total capitalization of an SPE

be an equity investment of an unrelated third party. The Enron implosion highlighted deficiency in the off balance sheet test even

though for various reasons Enron’s SPEs failed to meet the requisite 3 percent threshold.

The 3 percent test is arbitrary and does not adequately capture

the economics of the transactions it records. It allows liabilities to

be moved off balance sheet, without a true transfer of risk from the

sponsoring company to the SPE.

FASB has been working on off balance sheet issues for some 10

years now. I look forward to an update on the progress of that

project and hope for discussion on how we can expedite a resolution.

The second issue we will examine is the mark-to-market issue for

derivatives in financial contracts. Mark-to-market accounting has

increased transparency for liquid instruments in short-term contracts. It has, however, presented difficulties for valuing assets in

long-term contracts. Valuation is arbitrary where there is no ready

market for an asset. To assign a value to these assets, companies

develop mathematical evaluation models. However, there is significant leeway in the assumptions underlying valuations, and since

companies consider the models proprietary, assumptions underlying valuations are neither disclosed nor audited. Values assigned

in this so-called mark-to-model accounting can be misleading to investors. So, I look forward to hearing what our witnesses have to

say about mark-to-market accounting and the disclosure necessary

to make the reported information transparent and meaningful to

investors.

Congress, the SEC and FASB must be diligent in assessing the

state of our financial reporting in the United States today. While

today is a good start, I assure you this is just an ongoing process.

With this, I urge the SEC to begin to fulfill its responsibilities of

ensuring adequate disclosure in financial statements. If the SEC

had reviewed Enron’s filings over the past 3 years, it may have discovered the lack of disclosure and the problems the inadequate disclosure concealed.

Also, I am troubled by the SEC’s recent assertion that one can

violate SEC law even while fully complying with GAAP. It is clear

that companies and their auditors have an obligation to comply

with both the letter and the intent of GAAP. However, the SEC’s

comments go too far. The SEC seems to be ducking its responsibility to fix problems with GAAP and corporate disclosure by using

its enforcement authority to impose burdensome standards on public companies and their auditors. As in a planned economy of old,

that which is not explicitly permitted is prohibited. This is not a

proper standard for a flourishing market economy.

3

I also urge FASB to be more expeditious in its review of financial

standards. While I commend the fair process by which FASB has

produced standards, I suggest FASB work with this committee to

come up with a way to ensure due process while fixing deficiencies

in a timely fashion.

As for this committee, it is clear we must start with the issues

that have been highlighted by the Enron implosion, but our work

cannot stop there. Improving financial reporting is a full-time job.

As the markets evolve, we must keep pace with them to assure a

robust and transparent reporting system.

So, I look forward to hearing from our distinguished panel today,

and working with them to improve accounting standards and, obviously, financial reporting.

With that, for an opening statement, the gentlelady from California.

Ms. ESHOO. Good morning, Mr. Chairman.

Mr. STEARNS. Good morning.

Ms. ESHOO. It seems as if the morning came very quickly. Well,

I want to thank you for having this hearing. It is an important one,

and welcome to the gentlemen at the table. We have a few chairs

between us, but I think it is because the hearing room, our main

hearing room downstairs, is being redone. So, we are kind of scuttling all over the place to find a place to have these hearings but,

nonetheless, it is important that we are here this morning on this

issue of financial accounting standards.

We have had many hearings on the issue of financial accounting

standards over the years. Now, because of the Enron implosion, as

the chairman said, we need to examine very, very carefully what

went wrong, and the steps that we need to take in order to make

things right.

We know that there has been expanded participation by investors in our financial markets, and that is really based on their having informed—being able to make informed decisions, and informed

decisions are really more important than ever. But when information provided by companies is false, investors, of course, are deprived of the opportunity to make these informed decisions. False

information, bad information, can destroy the wealth, what employees are accumulating, and that leads to—obviously, has led to severe losses.

Investor confidence is really the ‘‘coin of the realm.’’ If, in fact,

investors have confidence—and our markets depend on that—then

they will make good decisions. If that is not the case, then that is

undermined, and timely information is very important as well.

We are also all dependent upon the decisions of accountants

being accurate, that they are timely, that they are comprehensible,

and that they are complete. The collapse of Enron, of course, has

shaken investor confidence. It has shaken all of us.

I think, on September 12, Americans said, ‘‘How could this have

happened to us?’’ With the failure, with the collapse of Enron, we

are now all saying, ‘‘How could this have happened?’’ How could

this have happened in the corporate world?

So, we have to be really vigilant in terms of examining the extensive financial knowledge and how it was applied, how it was misVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 W:\DISC\77990 pfrm11 PsN: 77990
4

applied, and the complex accounting schemes that were developed,

and I think this is very important to the American people.

I don’t think, at the end of our examination and at the end of

our legislating, that everyone in the country is going to understand

complex accounting standards, but we can, indeed, I think, bring

more transparency, and we need to weed out what went wrong

with what is right in America. What I am concerned about is that

we are going to be throwing the baby out with the bathwater in

this. And our job as legislators is to be very prudent, to be tough,

to be fair, and at the end of this, really come out with standards

that are going to be fit for the nobility of the American people because that is what we are here for.

So, this hearing, Mr. Chairman, provides us with the first opportunity to assess what investor protections should be bolstered, and

also where better enforcement, much better enforcement, will serve

future employees and future generations because that is what we

are here for.

So, again, I thank the witnesses for being here. I thank the

chairman for calling this hearing. And I will stay on it and stay

with you to make the system better. Thank you, Mr. Chairman.

Mr. STEARNS. I thank you for also coming on this early time. The

gentleman from Nebraska, Mr. Terry.

Mr. TERRY. Thank you, Mr. Chairman, for calling this hearing.

When I received notice of this hearing, I thought the 9 o’clock start

was completely appropriate. Now, since it is 6 hours after our last

vote, it doesn’t seem so much that way. But this is an important

matter and we need to get as much information, so I appreciate

you calling this hearing.

Last week, Mr. Chairman, as you may recall, we had the opportunity to listen to many distinguished accounting professors from

some of the most esteemed business colleges from this country, and

they were asked one question, and that was if they thought an

MBA graduate from their institution would be able to understand

Enron’s financial statements, and they answered no.

The Wall Street Journal recently published a story characterizing the byzantine financial procedures as the ‘‘black box’’ of accounting. The article went on to state that ‘‘in some instances,

these black-box methods are so difficult to comprehend that even

audit committees and CFOs have difficulty deciphering them.’’ At

least in the Omaha World Herald, one of the most renowned papers

in the Nation, or at least the one I read mostly, there was an article about Warren Buffett saying a similar thing, that many of the

financial statements that he reads are so complex that he concludes that ‘‘sometimes they are trying to tell him nothing,’’ and

maybe that is the point.

In light of these very complicated methods of accounting, I was

interested to read in Mr. Jenkins’ testimony, the listing of some of

FASB’s recent initiatives, which include issuance of standards that

improved the transparency of business combinations; issuance of a

standard that improved the transparency of purchased good will

and tangible assets; issuance of a standard that improved the

transparency of asset retirement obligations; issuance of standards

that improve the transparency of impairment or disposal of longlived assets; and the issuance of a report that encourages compaVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 W:\DISC\77990 pfrm11 PsN: 77990
5

nies to continue improving their business reporting and to experiment with the types of information disclosed in the manner by

which it is disclosed. That is why we are here today, is to discuss

those types of solutions to the problems that face our economy and

businesses today.

Ms. Eshoo, you echoed a concern of mine that was echoed by at

least one witness to our full hearing last week, and that is, we

have to restore the confidence back into the capital market system,

the investors have to have confidence that what they read is accurate and true.

So, I appreciate you holding this hearing, Mr. Chairman.

Mr. STEARNS. I thank the gentleman. The gentlelady from Colorado, Ms. DeGette.

Ms. DEGETTE. Thank you, Mr. Chairman. Most of my constituents think that accounting is easy, you just add up the numbers

and then you check the bottom. I know one corporate accounting

office, for example, that has teeshirts that say ‘‘Go figure,’’ and that

is what they do. But the complexities of regulatory requirements

and interpretations of corporate practice make accounting these

days difficult in the best of times.

One practitioner I talked to said that ‘‘accounting is a combination of basic math, medieval alchemy, and religious insight.’’ Accounting is an imperfect practice requiring the judgment of individual accountants and auditors. Of course, difficulties multiply

when the auditor faces an inherent conflict of interest and when

the bottom line of the consulting practice is more lucrative than the

full disclosure and transparency for investors.

We learned about the failure of adequate accounting at Enron

last week from the Power’s report, and 2 weeks ago in the Oversight and Investigations Committee on which I sit. Our hearings on

Arthur Andersen’s accounting practices in Enron were illuminating

because what we found is there was nothing inherently wrong in

Andersen’s accounting rules that would stop document shredding,

for example, and, of course, if you shred the documents, it becomes

that much harder for investors to find out what is going on.

Now, Congress has the duty to determine how the system failed

and what, if any, actions Congress can take to restore public trust

through more transparency safeguards, more public accountability,

and better public oversight.

We have heard a number of proposals for reforms, including

more shareholder involvement with auditors, more regulations to

prevent conflicts of interest, more rigorous and independent peer

review, and full disclosure of partnership interactions among others.

I hope that we will, Mr. Chairman, examine many of these potential reforms in detail because there is no magic bullet in this instance. We cannot fix with one swoop all the problems that we

have encountered from the Enron collapse.

Today, I would like to focus on ways to ensure adequate disclosure of financial risks on company statements, which is really the

heart of the problem here, I think. One of Enron’s failings was its

ability to engage in highly volatile transactions while not disclosing

the risk involved. Enron, and probably their auditors, will argue

that disclosure was made in the footnotes of these financial stateVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 W:\DISC\77990 pfrm11 PsN: 77990
6

ments. However, these financial statements were dense, opaque,

and difficult to understand.

In today’s marketplace, with increasing ease of investment and

increasingly less sophisticated investors, it is necessary to devise

accounting standards that will provide average investors with their

stock in 401(k) programs, as well as Wall Street analysts, with a

truthful snapshot of a particular company’s risk. This story is still

unfolding.

As Congress continues to investigate the collapse of Enron, we

will likely encounter additional accounting and auditing issues.

This is a unique time for Congress to review accounting standards

and assure that we have protection and transparency for the investor.

I am glad you are having this hearing, Mr. Chairman, even at

9 o’clock, and I look forward to hearing all the witnesses today, and

yield back my time.

Mr. STEARNS. Thank the gentlelady. The gentleman from New

Hampshire, Mr. Bass, is recognized.

Mr. BASS. Thank you very much, Mr. Chairman. I guess there

is a theme this morning, however, I had a meeting at 8, so this is

my second event of the day.

I guess the old saying ‘‘show me the money’’ is certainly more applicable now than ever before, with respect to accounting and business practices of investors, and I have learned a lot about accounting even as a small business person myself over the last few

months, and I have come to understand the old saying ‘‘cash is fact,

everything else is opinion’’ certainly applies more than I ever

thought it might.

Others have said today that re-establishing confidence in the

capital market through good new accounting standards and enforcement tools are certainly going to be one of the biggest opportunities and challenges for this subcommittee and the whole committee, and I will be looking to our panelists today to amplify on

what areas of our accounting reviews need to be re-examined and

what potentially new enforcement standards may be required from

Congress.

So, with that, Mr. Chairman, I will yield back to you, and I think

we are ready to listen to the panel.

Mr. STEARNS. Thank the gentleman. We have the distinguished

ranking member, Mr. Towns, from New York, and I welcome his

opening statement this morning. Good morning.

Mr. TOWNS. Thank you very much, Mr. Chairman. Fourteen

years ago, then Chairman of this Commerce Committee was a gentleman by the name of John Dingell, held a number of oversight

hearings on some of the very same accounting standards that confront us today. In response to these hearings, the Financial Accounting Standards Board was established. Unfortunately, it seems

that this well-intentioned measure has failed the American people

and the American investor. Of course, I am referring to the example of the Enron Corporation, the once seventh largest corporations

in America. Two of the main reasons that this corporation filed for

bankruptcy was a combination of bad accounting practices and conflict of interest between consultant services and auditing services.

7

The collapse and related scrutiny of its accounting practices has

increased investors’ awareness of a number of accounting standards that previously had been ignored by investors. The American

investor is all too aware that many of these standards are being

abused by many in corporate America and industries. These standards include the following: Nonconsolidation of the so-called ‘‘special purpose entity,’’ the disclosure of related party transactions,

issues of equity securities for something other than cash mark-tomarket accounting, accounting for contracts involving energy trading and risk management activities, and restatements of previously

issued financial statements.

Members of the accounting industry must improve these standards and prove to the American public that their industry and

membership can, and should, be trusted once again.

I look forward, Mr. Chairman, to the hearing of the witnesses

today, and I yield back.

Mr. STEARNS. Thank the gentleman. The gentlelady from California is recognized for an opening statement.

Ms. HARMAN. Thank you, Mr. Chairman. Happy Valentine’s Day,

everyone. Let us hope that on this day and on following days, we

both have improved national security and economic security. This

hearing is really about how to improve our economic security and

now to assess whether accounting practices that have been employed by Enron and other firms are what they need to be or,

whether in the interest of economic security for America, we need

to make some changes.

In particular, today I hope our witnesses will focus on whether

deficiencies of current accounting standards, or their implementation or lack thereof, allow the shortcomings and failures that led

to the bankruptcy of Enron and perhaps a few other recent entities.

The Enron bankruptcy has all the elements for scandal—avarice,

deceit, hubris, obfuscation, malfeasance, self-dealing, influence peddling, manipulation, indifference and, unfortunately, even suicide.

But it has at its core—and this is the saddest, I think, observation—dereliction of duty: dereliction of the duty board members

have to shareholders; dereliction of the duty corporate management

has to investors, employees and customers; dereliction of the duty

auditors have to market analysts, the public and regulators; and

even dereliction of duty that lawyers—and I happen to be a lawyer—have both to our clients and our system of justice. To be sure

we have in place a system of checks-and-balances to protect investors in the public, but whatever the checks-and-balances in place

at the time came for naught as those expected to exercise their responsibilities violated them or, worse, ignored them.

We may learn that there were many motivations for the behavior

we have observed at Enron, Andersen, and elsewhere but, more importantly, what does that say for any additional checks-and-balances Congress or regulators may impose in the future? We may

never be completely successful in changing behavior or the corporate environment that nurtured it, but we can, and we must, try.

We must, as legislators, as parents, and as citizens, respect the

obligations we assume as members of society. We must also work

to ensure that collateral damage is limited, and that those responsible are brought to a full accounting, and that public confidence

8

in our markets, in our government institutions and our regulatory

agencies, and in American business is restored as quickly as possible.

Thank you again, Mr. Chairman, for convening today’s hearings.

I look forward to participating as this committee seriously, professionally, and completely fulfills its obligations.

Mr. STEARNS. I thank the gentlelady. Mr. Buyer is recognized for

an opening statement.

Mr. BUYER. I will pass.

Mr. STEARNS. The gentleman will pass. The gentleman from Tennessee, Mr. Bryant.

Mr. BRYANT. Thank you, Mr. Chairman. I want to thank you also

for holding this hearing today, and the panelists for coming to testify before us today.

One of the most amazing aspects of Enron’s collapse was that

virtually no one saw it coming. And, of course, the question now

is, or did they. It certainly seems that Enron had built a complex

house of cards, seemingly over-valued for massive amounts of hidden debt and manipulative bookkeeping. That is why this hearing

is so important today.

We have the opportunity to roll up our sleeves and take a look

at the complexities of accounting standards. It is now evident that

Enron violated existing accounting standards set by the national

Accounting Standards Board, however, the rule on mark-to-market

accounting is hard to enforce because the formula has so many factors. Enron was able to move its debts off the books by using special purpose entities. I understand that the rules regarding SPEs

have been under review for sometime now, and I look for to hearing from the panelists today on this issue.

The fear of many of my constituents invested in the stock market

is that you no longer can trust corporate financial statements. It

is a legitimate worry that more companies may have Enron-type

accounting bombshells to drop. I think certainly we can see that

with the reaction of the stock market almost on a daily basis.

Large corporations with complex business models are susceptible

to investor fears because their exact financial position is difficult

to measure. Investors have been fraught amid questions about the

market’s biggest players’ profits being the result of creative accounting. Our fragile economy does not need mass hysteria in the

market resulting from innuendo and hearsay about a corporation’s

accounting standards. We must restore investor confidence in the

accounting profession.

I am interested in hearing from the accountants on the panel regarding regulatory reforms of the accounting profession. Shareholders deserve better disclosure of accounting information and financial reports prepared in plain English.

I look forward to today’s hearing, and again thank the chairman

for holding this important hearing.

Mr. STEARNS. I thank the gentleman. I think we are complete

with the opening statements.

[Additional statements submitted for the record follow:]

9

PREPARED STATEMENT OF HON. GEORGE RADANOVICH, A REPRESENTATIVE IN

CONGRESS FROM THE STATE OF CALIFORNIA

Mr. Chairman, today’s hearing is a vital step in protecting our nation’s capital

markets. The integrity and stability of our capital markets are heavily dependent

on the accuracy and proficiency of our financial accounting system. If corrupt business executives continue to find ways to bypass financial accounting rules, investor

confidence will deteriorate.

The special purpose entities (SPEs) that were designed to enrich top Enron executives and defraud stockholders have raised public concern about whether the current accounting standards are insufficient. Investors of Enron were not provided the

correct information needed to properly review the complex financial instruments

and structures that were set up by Enron executives. We need to find out if the accounting standards are capable of extracting the transparency required by investors

or whether corrupt companies are breaking the rules.

The Enron Special Investigation Committee uncovered dozens of transactions with

special purpose entities effectively controlled by the company to hide bad investments. In California, Enron used one of their SPEs to form Azurix, a water trading

company that dissolved this year, but not before a handful of executives made millions. In aggregate these transactions were used to report over $1 billion of false

income through mark-to-market accounting and hide the decline in Enron’s asset

value. Such transactions should reflect true market conditions, and not false predictions made up of twenty-year forecast.

In the end, I hope we can answer these troubling questions raised by Enron regarding the efficacy and relevance of the existing financial accounting standards.

Thank you, Mr. Chairman, for holding this hearing today. I look forward to the witnesses’ testimony.

PREPARED STATEMENT OF HON. W.J. ‘‘BILLY’’ TAUZIN, CHAIRMAN, COMMITTEE ON

ENERGY AND COMMERCE

Today we are continuing to explore the policy implications of the Enron collapse—

specifically whether accounting standards are adequate to present meaningful and

transparent views of the financial health of our publicly traded companies.

We have learned that Enron filed false and misleading accounting statements

that were not in accordance with GAAP. We have seen that some of Enron’s management engaged in self-dealing that amounted to theft of shareholder assets and

that the Directors and auditors who were suppose to supervise the corporation failed

to prevent this theft.

We have also learned that Enron had a tangled web of off-balance sheet partnerships serving to hide billions of dollars in debt and other liabilities from public accounting statements and the market.

Today we will consider whether rules that facilitate off-balance sheet accounting

need revision. Under current accounting practice, if an outside person owns as little

as 3% of the equity of a company, that company’s assets and liabilities can be taken

off the books of the sponsoring company.

A test of real economic control makes more sense than the 3% rule. The Financial

Accounting Standards Board has a long running project on off-balance sheet accounting. We will be looking for a status report on that project, and want to encourage FASB to expedite its consideration. I understand, yesterday, as an interim

measure, FASB has proposed raising the 3% level to 10%.

We also want to consider issues like market-to-market accounting, and the use

of pro forma statements rather than GAAP.

I have a message for the SEC officials here for you to deliver to Chairman Pitt.

We have learned the SEC conducted no meaningful review of Enron’s financial

statements and required SEC disclosure from 1997 to 2001. The SEC should be taking steps under existing law to prevent additional Enrons. Such steps would include

reviewing filed financial disclosure. Yesterday, an SEC official was quoted in the

press as saying a company could comply completely with GAAP and still commit securities fraud. Such grandstanding is unhelpful. The SEC has not provided adequate

guidance on what constitutes materiality for purposes of disclosure. Although this

stance preserves all bureaucratic options in the event of a collapse like Enron, it

does little to guide the overwhelming majority of honest companies who want to provide complete disclosure to the markets.

Chairman Pitt has also called for the creation of an oversight mechanism for auditors. This proposal appears to be a continuance of the status quo in which oversight

is conducted by the accounting trade association. This hasty proposal appears to

10

have little substance and provides us with little comfort that meaningful change is

coming. We in Congress will have to take a look at this question.

I commend Chairman Stearns and Ranking Member Towns for holding this hearing. I commend my friend John Dingell for the continuing bipartisan cooperation we

have had in the Enron investigation. We have important issues to consider today.

I yield back the balance of my time.

PREPARED STATEMENT OF HON. JOHN D. DINGELL, A REPRESENTATIVE IN CONGRESS

FROM THE STATE OF MICHIGAN

Mr. Chairman, I commend you for scheduling today’s hearing into whether our

current accounting standards are protecting investors.

Enron’s demise has focused public attention on accountants and auditors and the

rules that they apply. A growing body of evidence suggests that Enron represents

an egregious case of bad if not corrupt corporate management, misleading accounting and financial disclosure, shoddy auditing, and outright fraud. But the weaknesses illuminated by this debacle have long been familiar from previous scandals

involving appalling audit failures. These include Cendant, Sunbeam, Waste Management, Microstrategy, and, most recently, Global Crossing. It is urgent that we

respond soon with the right reforms.

I have been and remain a strong supporter of the Financial Accounting Standards

Board (FASB) and the important work that it does. FASB has always produced

high-quality standards, often against great odds. One criticism that we will hear

today is that FASB’s standard-setting process is too cumbersome and FASB is too

slow in addressing a number of controversial and cutting-edge issues. FASB has

been too slow, but not without help. I recall a rash of appropriations riders, as well

as nasty letters, from key Members of Congress on some of these same issues in

the past, telling FASB to go back and study for a year or more, re-propose the

standard for public comment, or hold more hearings. You can’t have it both ways.

Another criticism is that FASB’s standards are too complex. So too are the financial transactions and structures to which they apply. A lot of the complexity is the

result of comment letters to FASB asking for specific interpretations and clarifications. It seems that we may be damning FASB for the act of being responsive to

its constituents. If FASB did simpler rules, I suspect we would be hearing complaints that FASB wasn’t giving appropriate guidance.

I believe that we should aim for improvements that make sense. We should be

mindful of the trade-offs and the unintended consequences. We should not compromise the public interest.

That brings me to the proposal to scrap ‘‘rule-based’’ standards and instead go to

‘‘principle-based’’ accounting standards. Mr. Herdman’s testimony warns us that: ‘‘A

move to principle-based standards will require greater discipline by the corporate

community, the accounting profession, private-sector standard-setting bodies, and

SEC staff...[A]ll constituencies must make concerted efforts to report transactions

consistent with the objectives of the standards.’’ I have no such faith in human nature. I don’t believe for an instant that the good folks at Enron and Arthur Andersen would have felt more constrained by general principles than they were by explicit rules. Enron happened because these bad actors stood the rulebook on its head

in order to achieve illegal objectives. Crooked management and abetting accountants

will have more room to maneuver under general principles with no rules.

Nonetheless, Mr. Chairman, I have an open mind about these things, and I look

forward to being educated by our witnesses. I welcome them and look forward to

hearing what they have to say. I am especially interested in hearing more about

how FASB intends to improve accounting for special purpose entities and the determination of fair values.

Mr. STEARNS. We will move to our first panel.

I want to welcome Mr. Robert Herdman, Chief Accountant for

the U.S. Securities and Exchange Commission; Mr. Edmund Jenkins, the Chairman of the Financial Accounting Standards Board,

and Mr. James C. Castellano, Chairman of the American Institute

of Certified Public Accountants. We welcome all three of you on

this early morning, and we look forward to your opening statement,

and we will start with you, Mr. Herdman.

11

STATEMENTS OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT,

U.S. SECURITIES AND EXCHANGE COMMISSION; EDMUND L.

JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING STANDARDS

BOARD; AND JAMES G. CASTELLANO, CHAIRMAN OF THE

BOARD, AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS

Mr. HERDMAN. Chairman Stearns, Ranking Member Towns, and

members of the subcommittee, I am pleased to appear before you

on behalf of the Securities and Exchange Commission to testify on

the importance of responsive and transparent financial reporting to

investors and our capital markets. My written testimony addresses

these issues in more detail, and I ask that it be included in the

record.

Our financial reporting system has long been considered the best

in the world and is one of the underpinnings of our capital markets, which are the deepest and most liquid in the world. However,

certain aspects of the system can and should be improved so

changes to accounting standards can be implemented more quickly,

be more responsive to market changes, and provide more transparent information to investors.

Concerns about our financial reporting system precede the bankruptcy of Enron Corporation and my testimony reflects that. The

Commission is investigating events associated with Enron’s collapse; and, consistent with the Commission’s rules and practice, I

am unable to discuss the specifics of that ongoing investigation.

The Commission requests that the subcommittee respect the confidential nature of the Commission’s investigation and our reluctance to address specific issues related to Enron’s compliance with

Federal securities laws in this public forum.

The SEC relies on an independent, private sector standards-setting process that is thorough, open and deliberate. While the Commission has the statutory authority to set accounting principles, for

over 60 years it has looked to the private sector for leadership in

establishing and improving accounting standards. The quality of

our accounting standards and our capital markets can be attributed in large part to the private sector standards-setting process,

as overseen by the SEC.

The primary private sector standards-setter is the Financial Accounting Standards Board. The FASB’s standards are designated

as the primary level of generally accepted accounting principles,

which is the framework for accounting.

The interpretative body of the FASB is the Emerging Issues Task

Force. The secondary standard-setter is the Accounting Standards

Executive Committee of the AICPA. The principal purpose of

AcSEC is to develop standards for specialized industries under the

oversight of the FASB.

Even before Enron’s collapse, we called upon the FASB to work

with us to address concerns about timeliness, transparency, and

complexity. Specifically, we asked the FASB to address criticisms

that: The current standard-setting process is too cumbersome and

slow, much of the recent FASB guidance is rule-based and focuses

on a check-the-box mentality that inhibits transparency, and much

of the recent FASB guidance is too complex.

12

Recently, some people have suggested that the FASB should be

Federalized instead of remaining in the private sector. There is no

assurance that simply placing the structure within the Federal

Government would result in better accounting standards. For example, many question whether the FASB’s proposal to expense

stock compensation, before the Congress intervened, would have

been better for investors.

I believe that with the Commission’s leadership, the FASB can

be effective, and confidence in the process can be restored. Privatesector standard-setting can work in our current business environment, even as financial transactions become more complex. Our financial reporting system can continue to be the best in the world.

When done properly, standard-setting in the private-sector has

greater flexibility to complete rules more quickly than accounting

standards set by the government. Furthermore, the FASB, the

EITF and AcSEC are comprised almost entirely of people with accounting expertise, and the FASB has greater ability to attract and

retain qualified personnel.

To understand the criticisms, it is important to understand how

the current system of standard setting evolved. In the late 1970’s

and early 1980’s, the FASB undertook a series of projects to drastically change how financial information is reported to investors

and other financial users. As you might expect, such sweeping

change has been very controversial and sapped the resources of the

FASB.

As a result, issues such as revenue recognition, which is a factor

in approximately one-half of all restatements and SEC enforcement

cases, and consolidation of SPEs have not been adequately addressed by the Board. The EITF and the SEC staff have attempted

to address some of the issues, but without an underlying principle

the result has been disappointing.

Another criticism that has arisen over time is the trend to complex, rule-based accounting standards, particularly for financial instruments such as derivatives. This can be attributed to a number

of factors including (1) changes in how companies do business; (2)

granting exceptions to new controversial standards; (3) internal

conflicts in the accounting literature as the conceptual

underpinnings change; and (4) demands for a single answer to

every question.

As I mentioned in my introduction, over the last few years many

of the standards have become rule-based as opposed to principlebased, and we believe that that trend needs to be reversed and that

more principle-based standards need to be enacted. The rule-based

approach makes it difficult for preparers and auditors to step back

and evaluate whether the overall impact is consistent with the objectives of the standards, and rule-based standards invite financial

engineering, which is one of the reasons why yesterday I sent a letter to the AICPA’s Auditing Standards Board asking it to prohibit

opinions on accounting interpretations that accompany investment

bankers’ products that are designed to achieve a particular financial statement result by taking a path around the detailed rules.

And so while FASB addresses issues of timeliness, transparency

and complexity, it must remain nimble to deal with changes in the

market. It must accelerate its efforts to achieve short-term converVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00016 Fmt 6633 Sfmt 6602 W:\DISC\77990 pfrm11 PsN: 77990
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1 In a Form 8-K dated November 8, 2001, Enron Corporation stated that it would restate its

financial statements for the years ended December 31, 1997 through 2000 and quarters ended

March 31 and June 30 2001 because it did not follow GAAP. On December 2, 2001 Enron filed

for bankruptcy. 2See, e.g., section 19(a) of the Securities Act of 1933, 15USC 77s(a), and section 13(b)(1) of

the Securities Exchange Act of 1934, 15 USC 78m(b)(1). 3 Accounting Series Release (ASR) No. 4 (April 1938) and ASR No. 150 (December 1972).

gence with the International Accounting Standards Board and coordinate with the SEC’s financial reporting and disclosure reform

initiatives so our capital markets can continue to be the deepest

and most liquid in the world.

In summary, let me reiterate that we have the deepest and most

liquid capital markets in the world now largely because of the high

quality of our financial reporting system. While it is imperative

that the issues of standard-setting timeliness, transparency, and

simplification of accounting standards be addressed, we should not

abandon the system that has allowed us to achieve what we have

to date. Instead let us take the opportunity to make fundamental

changes to standard setting and SEC oversight. Thank you.

[The prepared statement of Robert K. Herdman follows:]

PREPARED STATEMENT OF ROBERT K. HERDMAN, CHIEF ACCOUNTANT, U.S.

SECURITIES AND EXCHANGE COMMISSION

Chairman Stearns, Ranking Member Towns, and members of the Subcommittee:

I am pleased to appear before you on behalf of the Securities and Exchange Commission (‘‘SEC’’ or ‘‘Commission’’) to testify on the importance of responsive and

transparent financial reporting to investors and our capital markets. The specific

question this panel was asked to address is ‘‘Are current financial accounting standards protecting investors?’’ Our financial reporting system has long been considered the best in the world and

is one of the underpinnings of our capital markets, which are the deepest and most

liquid in the world. However, certain aspects of the system can and should be improved so changes to accounting standards can be implemented more quickly, be

more responsive to market changes, and provide more transparent information to

investors. Our current system’s weaknesses are more visible as a result of Enron’s failure.1 However, these weaknesses did not arise overnight, rather they evolved

over many years. Investors expect our system to be the finest in the world. We intend to see that it remains the finest. Today I will discuss what should be done.

Concerns about our financial reporting system precede the bankruptcy of Enron

Corporation and my testimony reflects that. The Commission is investigating events

associated with Enron’s collapse; and, consistent with the Commission’s rules and

practice, I am unable to discuss the specifics of that ongoing investigation. The Commission requests that the Subcommittee respect the confidential nature of the Commission’s investigation and our reluctance to address specific issues related to

Enron’s compliance with federal securities laws in this public forum.

OVERVIEW OF US STANDARD-SETTING PROCESS

The SEC relies on an independent, private sector standards-setting process that

is thorough, open, and deliberate. While the Commission has the statutory authority

to set accounting principles,2 for over 60 years it has looked to the private sector

for leadership in establishing and improving accounting standards.3 The quality of

our accounting standards and our capital markets can be attributed in large part

to the private sector standards-setting process, as overseen by the SEC.

The primary private sector standards-setter is the Financial Accounting Standards Board (the ‘‘FASB’’), which was established in 1972. An oversight body appoints the members of the FASB. This oversight body, the Financial Accounting

Foundation, is comprised of investors, business people, and accountants. The FASB’s

standards are designated as the primary level of generally accepted accounting principles (‘‘GAAP’’), which is the framework for accounting. The FASB’s standards set

forth recognition, measurement, and disclosure principles to be used in preparing

financial statements.

The secondary standard setter is the Accounting Standards Executive Committee

(AcSEC), which provides guidance in the form of Statements of Position (SOPs), subVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00017 Fmt 6633 Sfmt 6621 W:\DISC\77990 pfrm11 PsN: 77990
14

ject to the affirmative concurrence by the FASB at every step in the process. The

principal purpose of AcSEC, which is a committee of the American Institute of Certified Public Accountants (AICPA), is to develop standards for specialized industries.

The interpretative body of the FASB is the Emerging Issues Task Force (EITF).

It meets every other month to provide interpretative guidance, or develop new guidance, on narrow, new or emerging issues that arise under existing GAAP and when

GAAP does not exist.

CRITICISMS OF U.S. ACCOUNTING STANDARDS AND STANDARD SETTING

Even before Enron’s collapse, we called upon the FASB to work with us to address

concerns about timeliness, transparency, and complexity. Specifically, we asked the

FASB to address criticisms that:

• The current standard-setting process is too cumbersome and slow. • Much of the recent FASB guidance is rule based and focuses on a check-the-box

mentality that inhibits transparency. • Much of the recent FASB guidance is too complex.

Recently, some people have suggested that the FASB should be federalized instead of remaining in the private sector. Those who suggest this apparently have

lost confidence in the FASB’s process. There is no assurance that simply placing the

structure within the federal government would result in better accounting standards. For example, many question whether the FASB’s proposal to expense stock

compensation, before the Congress intervened, would have been better for investors.

Federalization of the FASB not only would require increases to the federal budget,

but also might disenfranchise those who are best qualified to address the highly

complex business and accounting issues that must be resolved. I believe that with

the Commission’s leadership and cooperation by the FASB, the FASB can be effective, and confidence in the process can be restored. Private-sector standard setting

can work in our current business environment, even as financial transactions become more complex. In spite of recent events, we still have the best financial reporting system in the world, and the Commission is intent on making it even better.

When done properly, standard setting in the private sector is the best alternative

for our capital markets as it provides a number of advantages over federalized

standard setting. Private sector standard setting has greater flexibility to complete

rules more quickly than accounting standards set by the government. The FASB is

comprised almost entirely of accounting experts and has a greater ability to attract

and retain qualified personnel. Similarly, AcSEC and the EITF are composed of

members with accounting expertise.

EVOLUTION OF STANDARD SETTING

It is important to understand how the current system of standard setting evolved.

As we contemplate reform, we need to consider how we got here. In the late 1970s

and early 1980s, the FASB undertook a series of projects to drastically change how

financial information is reported to investors and other financial users. These

projects, which include consolidation of financial statements and accounting for financial instruments, represent major conceptual changes in financial reporting. As

you might expect, such sweeping change has been very controversial and sapped the

resources of the FASB.

As a result, issues such as revenue recognition (which is a factor in approximately

one-half of all restatements and financial reporting enforcement cases) and consolidation of SPEs have not been adequately addressed by the FASB. The EITF and

the SEC staff have attempted to address some of the issues, but without an underlying principle the result has been disappointing.

In other cases, the FASB has delegated broad issues such as accounting for partnerships; property, plant and equipment; and the accounting for environmental liabilities to AcSEC. AcSEC is comprised of part-time volunteers from the preparer,

auditor, and user communities and is subject to affirmative review by the FASB

each step of the way. As a result, AcSEC is ill equipped to deal with broad issues

in a timely manner. While AcSEC’s guidance has been of high quality, it often takes

years to issue because of its infrastructure constraints.

Another criticism that has arisen over time is the trend to complex, rule-based

accounting standards. This trend can be attributed to a number of factors including

(1) changes in how companies do business; (2) granting exceptions to new controversial standards; (3) internal conflicts in the accounting literature as the conceptual

underpinnings change; and (4) demands for a single answer to every question. FASB

Statement No. 133 on accounting for derivatives and hedging and Statement No.

140 on transfers of financial assets and extinguishments of financial liabilities are

two prominent standards that have been subject to such criticism.

15

IMPROVING TIMELINESS

Now I would like to review with the Subcommittee actions that should be taken

to continue to ensure that our financial reporting system remains the premier system in the world. Let’s begin with the FASB. The FASB must change the scope of

many of its technical projects and the manner in which it carries out its activities.

The FASB uses a building-block approach when developing standards. That is, the

Board addresses a handful of issues at any given meeting instead of all of the issues

that comprise a single proposal. This approach tends to expand the time it takes

to resolve reporting issues. In contrast, the SEC staff generally will present an entire proposal to the Commission for consideration. The FASB needs to reconsider its

approach.

The Board’s major projects tend to be very broad. For example, the FASB currently has on its agenda a liabilities and equity project that raises six or seven important issues. I believe this project has too broad a scope. It attempts to weave too

many issues into a conceptual framework everyone can agree on. Most people agree

that more guidance is needed on equity derivatives and redeemable preferred stock.

Why not separate out these issues and provide timely guidance on them? The remaining issues, where many believe no additional guidance is necessary, can be addressed at later dates. Narrowing the scope to its critical elements allows the process to move forward in a timely manner.

Some are calling for a limitation on the time a project can be on the FASB’s agenda. I share their concerns about timeliness. It is clear that the FASB must work

more quickly and be more responsive to market needs. For example, how it deals

with the issue of when to consolidate SPEs is important. This project must be finished so it can be both effective for, and implemented by, the end of this year. If

the FASB is not able to make progress on such important issues as they arise, the

SEC should take action. We must improve our oversight of the standard-setting

agenda.

PRINCIPLE-BASED ACCOUNTING STANDARDS

As I mentioned in my introduction, over the last few years many of the FASB

standards have been rule based, as opposed to principle based. Rule-based accounting standards provide extremely detailed rules that attempt to contemplate virtually

every application of the standard. This encourages a check-the-box mentality to financial reporting that eliminates judgments from the application of the reporting.

Examples of rule-based accounting guidance include the accounting for derivatives,

employee stock options, and leasing. And, of course, questions keep coming. Rulebased standards make it more difficult for preparers and auditors to step back and

evaluate whether the overall impact is consistent with the objectives of the standard.

An ideal accounting standard is one that is principle-based and requires financial

reporting to reflect the economic substance, not the form, of the transaction. FASB

Statement Nos. 141, Business Combinations, and 142, Goodwill and Other Intangible Assets, which were issued in 2001, appear to be steps in the right direction.

These standards will serve as a test of the level of specificity needed to strike a balance between rules and principles. Principle-based standards will yield a less complex financial reporting paradigm that is more responsive to emerging issues.

Furthermore, a byproduct of rule-based accounting standards has been an increase in the number of ‘‘SAS 50’’ letters issued to investment banks providing opinions as to whether hypothetical transactions follow accounting standards. SAS 50

letters may be used as the basis to structure complex transactions that technically

comply with accounting standards, but do not accurately reflect the objectives of the

standards. I believe it is in the public interest that the Auditing Standards Board

ban those types of letters, and yesterday I sent a letter to the Auditing Standards

Board urging that it do so.

A move to principle-based standards will require greater discipline by the corporate community, the accounting profession, private-sector standard-setting bodies,

and the SEC staff. A move away from a check-the-box approach to financial reporting means that all constituencies must make concerted efforts to report transactions

consistent with the objectives of the standards. While this may mean that not all

transactions are recorded in exactly the same manner, it is my belief that similar

transactions in this system of principle-based standards will not be reported in materially different ways, preserving comparability.

While the FASB addresses issues of timeliness, transparency and complexity it

must remain nimble to deal with changes in the market. Looking ahead, it must

accelerate its efforts to achieve short-term convergence with the International Accounting Standards Board and coordinate with the SEC’s financial reporting and

16

disclosure reform initiatives so our capital markets can continue to be the deepest

and most liquid in the world.

RESOURCE MANAGEMENT

Now I would like to discuss how better resource management should improve

timeliness of standard setting. This is where the leadership of the SEC is important.

As I stated at the outset, the FASB is subject to the oversight of the SEC.

Allow me to describe how I believe that oversight should work. In light of its enforcement and review activities, the SEC is in a unique position to provide input

into the FASB’s agenda. We have a responsibility to do that, and the FASB has a

responsibility to address the issues we refer to them in the time frame that we request, even if it is 180 days. I believe that we can and should stay out of their way

once we ask them to take on a project. However, we should meet with the FASB

frequently to monitor the status of their projects. If projects are languishing, we

must determine why.

Generally, there are two reasons that topics remain on FASB’s agenda for extended periods. First, there may not be a problem with existing guidance, as many

believe is the case with the basic consolidations model. Using resources to revisit

this model slows the process and detracts from the Board’s ability to address the

more important issues such as SPEs.

Second, a topic may remain on the agenda for an extended period because it is

too broad. This is a principal reason why the Board has had to spend much time

on its liability and equity project. Instead of focusing solely on the pressing issues

of accounting for redeemable preferred stock and equity derivatives, the FASB has

decided to use the project to make conceptual changes to minority interest and require separate accounting for elements of certain debt instruments, delaying project

completion.

The changes I have discussed in my testimony should allow the FASB time to address important issues as they arise, and eliminate the need to refer broad issues

to AcSEC and the EITF, so they can focus on developing industry and interpretative

guidance, respectively, as they were designed to do.

CONCLUSIONS

In summary, let me reiterate that we have the deepest and most liquid capital

markets in the world largely because of the high quality of our financial reporting

system. While it is imperative that the issues of standard-setting timeliness, transparency, and simplification of accounting standards be addressed, we should not

abandon the system that has allowed us to achieve what we have to date. Instead

let us take the opportunity to make fundamental changes to standard setting and

SEC oversight.

Mr. STEARNS. I thank the gentleman.

Mr. Jenkins.

STATEMENT OF EDMUND L. JENKINS

Mr. JENKINS. Good morning, Chairman Stearns, Ranking Member Towns, and the members of the subcommittee. I appreciate the

opportunity to speak to you this morning again.

I appear here on behalf of the Financial Accounting Standards

Board. I have brief prepared remarks, and I would respectfully request that the full text of my testimony and all supporting materials be entered into the public record.

Mr. STEARNS. By unanimous consent, so ordered.

Mr. JENKINS. As you know, the FASB is an independent privatesector organization. We are not part of the Federal Government

and we receive no Federal funding.

We are an independent group, and our independence comes from

the fact that our seven-member Board serves full-time and we are

required to sever all financial ties with our former employers. We

are funded primarily through the sale of our publications and to a

lesser extent through private donations solicited by the Trustees of

a not-for-profit foundation, the Financial Accounting Foundation.

17

Board members and members of the FASB staff are prohibited

from being associated with fundraising activities.

Our mission is to establish and improve standards of financial

accounting and reporting for both public and private enterprises.

Those standards are essential to the efficient functioning of the

capital markets because investors, creditors, and other consumers

of financial reports rely heavily on credible, transparent, and comparable financial information.

Because the actions of the FASB affect so many organizations

and are so important to the efficient functioning of the capital markets, our decisionmaking process must be open and thorough.

Many times Congress has asked us to assure them that that process is working, and we believe it is. An open and thorough process

is essential for ensuring both the credibility and quality of the resulting standards. The standards in the U.S. are generally recognized as the highest quality standards in the world.

It is important to understand that the FASB has no authority for

to enforce its standards. Responsibility for ensuring that financial

statements comply with accounting requirements rests with the officers and directors of the reporting entity’s financial statements,

and for public companies, the SEC. It is also important to understand that the FASB has no authority or responsibility with respect to auditing, independence, or scope of services matters. Rather, our responsibility relates solely to establishing financial accounting and reporting standards.

Now, the FASB does not know many of the facts relating to

Enron’s financial accounting and reporting. However, it is clear

that Enron publicly acknowledged in its filings with the SEC that

its financial statements did not comply with existing accounting requirements in at least two areas. Those failures resulted in financial statements that materially inflated assets and net income and

materially understated liabilities in years beginning in 1997

through 2000. In addition, the February 1, 2002 Report of Investigation by the Special Investigative Committee of the Board of Directors of Enron further suggests that Enron’s financial statements

included other violations of existing accounting requirements. One

such reference in the report states: ‘‘Enron’s original accounting

treatment of the Chewco and LJM1 transactions that led to

Enron’s November 2001 restatement was clearly wrong, apparently

the result of mistakes either in structuring the transactions or in

basic accounting. In other cases, the accounting treatment was likely wrong, notwithstanding creative efforts to circumvent accounting

principles through the complex structuring of transactions that

lacked fundamental substance.’’

I want to assure you, Mr. Chairman and members of this Committee, that consistent with the FASB’s mission and due process,

the Board is prepared and committed to work with the subcommittee, with the SEC, and all other constituents to proceed expeditiously to resolve any and all financial accounting and reporting issues that may arise as a result of the Enron bankruptcy.

Attachment 4 to the full text of my testimony provides a detailed

listing of the FASB’s extensive existing guidance relating to accounting and disclosures of related party transactions, special purVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00021 Fmt 6633 Sfmt 6602 W:\DISC\77990 pfrm11 PsN: 77990
18

pose entities, and off-balance-sheet financial arrangements and

guarantees.

The Board has active projects underway in over a half-dozen

areas that will propose significant improvements to existing requirements, including a project to improve the accounting for consolidations, and a project to improve the guidance for determining

the fair values of financial instruments. With respect to the project

on consolidations, which we have struggled with for far too long,

the Board plans to issue a proposal on an expedited basis in the

second quarter of this year that will resolve some of the more common issues encountered by some entities in present practice, including issues relating to consolidation of SPEs.

Yesterday at our public Board meeting, the Board concluded to

go forward with a proposal developed by our staff that will address

these issues. We are going to bring the full proposal to our Board

in a meeting in 2 weeks on the 27th, and debate that proposal with

the intent of issuing it for public comment as quickly as we can

thereafter.

I discuss mark-to-market accounting in my testimony. I need to

point out to you that we cannot alone sustain the transparency necessary to maintain the vibrancy of our capital markets. Other parties must also carry out their responsibilities in the public interest.

They include reporting entities, auditors and regulators. We can no

longer tolerate reporting entities that seek loopholes to existing

standards and don’t apply them with the intent with which they

were written. We no longer can tolerate reporting entities and

auditors that look to see ‘‘where does it say that I can’t do that.’’ Just one more comment in summary, Mr. Chairman, please. If

anything positive results from the Enron bankruptcy, it may be

that this highly publicized investor and employee tragedy serves as

an indelible reminder to all of us, as you, Mr. Chairman, stated in

your opening comments, that transparent financial accounting and

reporting do matter and that the lack of transparency imposes significant costs on all who participate in our capital markets. Thank

you very much.

[The prepared statement of Edmund L. Jenkins follows:]

PREPARED STATEMENT OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING

STANDARDS BOARD

Chairman Stearns, Ranking Member Towns, and Members of the Subcommittee:

I am pleased to appear before you today on behalf of the Financial Accounting

Standards Board (‘‘FASB’’ or ‘‘Board’’). My testimony includes an overview of the

FASB, its structure, and due process. My testimony also includes an overview of the

existing accounting requirements for special-purpose entities (‘‘SPEs’’), related party

transactions, and mark-to-market accounting, and Enron Corp.’s (‘‘Enron’’) restatement of its financial statements to comply with the existing accounting requirements. Finally, my testimony includes the actions the FASB has undertaken to improve our process for setting standards, to address issues relating to the complexity

of our standards, and to address other financial accounting and reporting issues

that are necessary to further improve the transparency of financial reports. I want

to thank you for the opportunity to again appear before your Subcommittee. I understand and appreciate your important oversight role.

WHAT IS THE FASB, WHAT DOES IT DO, AND WHAT HAS IT DONE LATELY?

The FASB is an independent private-sector organization. We are not part of the

federal government and receive no federal funding.

Our mission is to establish and improve standards of financial accounting and reporting for both public and private enterprises. Those standards are essential to the

19

1Letter from Federal Reserve System Chairman Alan Greenspan to SEC Chairman Arthur

Levitt (June 4, 1998). 2See FASB Statement No. 141, Business Combinations (June 2001). 3See FASB Statement No. 142, Goodwill and Intangible Assets (June 2001). 4See FASB Statement No. 143, Accounting for Asset Retirement Obligations (June 2001). 5See FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (August 2001). 6See FASB Presents Financially Correct with Ben Stein (2001). 7See Business Reporting Research Project, Steering Committee Report, Improving Business

Reporting: Insights into Enhancing Voluntary Disclosures (2001). 8See Attachment 1 for a list of the sponsoring organizations.

efficient functioning of the economy because investors, creditors, and other consumers of financial reports rely heavily on credible, transparent, and comparable financial information.

The FASB’s authority with respect to public enterprises comes from the US Securities and Exchange Commission (‘‘SEC’’). The SEC has the statutory authority to

establish financial accounting and reporting standards for publicly held enterprises.

For more than 60 years, the SEC has looked to the private sector for leadership in

establishing and improving those standards.

The FASB has no power to enforce its standards. Responsibility for ensuring that

financial statements comply with financial accounting and reporting standards rests

with the auditors of those statements and, for public companies, ultimately with the

SEC. It is also important to understand that the FASB has no authority or responsibility with respect to auditing, independence or scope of services matters. Rather,

our responsibility relates solely to establishing financial accounting and reporting

standards.

The focus of the FASB is on consumers—users of financial information, such as

investors, creditors, and others. We attempt to ensure that corporate financial reports give consumers an informative picture of an enterprise’s financial condition

and activities and do not color the image to influence behavior in any particular direction.

The US capital markets continue to be the deepest, most liquid, and most efficient

markets in the world. The unparalleled success and competitive advantage of the

US capital markets are due, in no small part, to the high-quality and continually

improving US financial accounting and reporting standards. As Federal Reserve

System Chairman Alan Greenspan stated:

Transparent accounting plays an important role in maintaining the vibrancy

of our financial markets . . . An integral part of this process involves the Financial Accounting Standards Board (FASB) working directly with its constituents

to develop appropriate accounting standards that reflect the needs of the marketplace. 1

Some of the FASB’s significant activities during 2001 included the following:

• Issuance of a standard that improved the transparency of business combinations.2

• Issuance of a standard that improved the transparency of purchased goodwill and

intangible assets.3

• Issuance of a standard that improved the transparency of asset retirement obligations.4

• Issuance of a standard that improved the transparency of impairment or disposal

of long-lived assets.5

• Issuance of a video to assist the public in understanding the importance of financial reporting to the US capital markets and to individual investment decisions.6

• Issuance of a report that encourages companies to continue improving their business reporting and to experiment with the types of information disclosed and

the manner by which it is disclosed.7

WHAT IS THE FINANCIAL ACCOUNTING FOUNDATION (‘‘FAF’’), AND WHAT IS THE FAF’S

RELATIONSHIP TO THE FASB?

The FASB is an operating unit of the Financial Accounting Foundation (‘‘FAF’’).

The FAF is a not-for-profit foundation that was incorporated in 1973 to operate exclusively for charitable, educational, scientific, and literary purposes within the

meaning of Section 501(c)(3) of the Internal Revenue Code.

The Foundation is separate from all other organizations. Its 16-member Board of

Trustees is made up of 11 nominees from sponsoring organizations whose members

have special knowledge of, and interest in, financial reporting.8 There also are 5

20

9See Attachment 1 for a list of the current FAF Trustees.

10See Attachment 2 for information about the Financial Accounting Standards Advisory Council.11See Attachment 1 for information about the EITF.

Trustees-at-large who are not nominated by those organizations but are chosen by

the sitting Trustees.

The FAF Trustees are prominent individuals with a broad range of backgrounds.

Each of them shares a common understanding of the importance of independent private-sector accounting standard setting to the efficiency of the US capital markets.9

The FAF Trustees have several important responsibilities with respect to the

FASB.

Those responsibilities include:

1. Oversight of the FASB’s process to ensure that the FASB is fulfilling its stated

mission (see below the discussion, ‘‘What Process Does the FASB Follow in Developing Accounting Standards?’’)

2. Selecting the FASB Board members, and

3. Arranging for the financing of the FASB.

FAF Trustees select the FASB Board members based on their technical expertise

in financial accounting and reporting. Board members, however, have diverse backgrounds. Of the seven current members of the Board, three are from the accounting

profession, two from corporations, one from the analyst community, and one from

the academic community. A public vote of five Board members is required to issue

a proposal or standard.

Each of the Board members is a full-time employee of the FAF and is required

to be independent of all other business and professional organizations. Thus, upon

joining the FASB, Board members are required to sever all financial ties with

former employers. Board members can serve no more than two full five-year terms. Approximately two-thirds ($14 million in 2000) of the FASB’s financing results

from the public sale and licensing of the FASB’s publications. The remaining one- third ($6 million in 2000) results from the fundraising efforts of the FAF Trustees

who solicit donations from a broad range of consumers, preparers, and auditors of

financial reports.

To ensure the independence and objectivity of the FASB, the Board members are

prohibited from participating in the FAF Trustee’s fundraising efforts, and the FAF

Trustees are prohibited from participating in the Board’s technical decisions on establishing and improving accounting standards.

WHAT PROCESS DOES THE FASB FOLLOW IN DEVELOPING ACCOUNTING STANDARDS?

Because the actions of the FASB affect so many organizations and are so important to the efficient functioning of the capital markets, its decision-making process

must be open and thorough. An open and thorough process is essential to ensuring

the credibility and quality of the resulting standards. An open and thorough process

also reduces the possibility that standards will create unintended consequences inconsistent with transparent financial reporting.

Our Rules of Procedure require an extensive and public due process that is broader and more open in several ways than the Federal Administrative Procedure Act,

on which it was modeled. The FASB process involves public meetings, public hearings, field tests, and exposure of our proposed standards to external scrutiny and

public comment. The Board makes final decisions only after carefully considering

and understanding the views of all parties, including consumers, preparers, and

auditors of financial information.

The FASB and the FAF, in consultation with the Board’s constituents, periodically review the FASB’s due process to ensure that the process is working efficiently

and effectively. In response to constituent requests, including requests from our Financial Accounting Standards Advisory Council, 10 the FASB has recently initiated

several administrative projects and activities to improve upon the Board’s due process procedures, including the timeliness of the Board’s standard setting.

Those projects and activities include the following:

• Making it easier for constituents to find all of the appropriate accounting requirements for a particular topic by including references to all applicable US accounting literature in the FASB’s future standards and in the FASB’s Current

Text, a compilation of all FASB accounting standards categorized by subject. In

addition, the FASB is seeking to partner with others in developing an online

database that will include all of the US accounting literature.

• Working with the Emerging Issues Task Force (EITF), 11 the American Institute

of Certified Public Accountants, and the SEC to more clearly define and coordiVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00024 Fmt 6633 Sfmt 6621 W:\DISC\77990 pfrm11 PsN: 77990
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12See Attachment 1 for information about the Board’s agenda criteria. 13See Attachment 3 for a simple example of one such SPE structure that illustrates some of

the potential business purposes that accompany the decision to form and transact with an SPE. 14See EITF Issue No. 90-15, ‘‘Impact of Nonsubstantive Lessors, Residual Value Guarantees,

and Other Provisions in Leasing Transactions’’; EITF Issue No. 96-21, ‘‘Implementation Issues

in Accounting for Leasing Transactions involving Special-Purpose Entities’’; and EITF Topic No.

D-14, ‘‘Transactions involving Special-Purpose Entities.’’

nate their accounting-standard-setting roles with those of the FASB with an eye

toward streamlining certain activities.

• Reducing the complexity of accounting literature by (1) seeking to determine if the

FASB can issue standards that are less detailed and have few, if any, exceptions or alternatives and (2) more actively engaging FASB constituents in discussions about the cost-benefit relationship of proposed standards.

• Working with the SEC in its initiative to modernize financial reporting and disclosure.

• Implementing an improved approach to determining what major new topics

should be added to the FASB’s technical agenda. That approach involves issuing

a proposal for public comment before the Board decides whether to add a particular project to its agenda. The proposal discusses the problem to be addressed

(that is, the reason for the project), its proposed scope, relationship to the conceptual framework and relevant research, the main issues and alternatives the

Board expects to consider, and how practice might be affected. It also explicitly

reviews the Board’s agenda decision criteria.12 The Board believes this improved

approach provides additional discipline to the Board’s project management capabilities, particularly in the area of defining and refining the scope of a new

agenda project. Scope expansion during the life of a project has sometimes been

a significant impediment to the timeliness of the Board’s standard setting.

• Implementing a more rigorous project planning and management process, which

requires the establishment of clear project milestones and plans for meeting

them, resource budgets, and status reporting in terms of previously established

milestones.

WHAT IS AN SPE, AND WHAT ARE THE ACCOUNTING REQUIREMENTS FOR SPES?

‘‘Special-purpose entity’’ or ‘‘SPE’’ are terms frequently used to refer to an entity

that is created solely to carry out an activity or series of transactions directly related to a specific purpose. An SPE may take on any legal form including a corporation, a partnership, a limited liability company, or a trust.

SPEs are commonly used as financing vehicles to which an entity (the sponsor)

sells assets (such as a pool of mortgage loans) in exchange for cash or other assets.

The funding for the SPE’s purchase comes primarily from the SPE issuing debt or

equity (or both) to third-party lenders or investors. An SPE also may be established

to acquire, construct, or manufacture assets that are used by another entity (its

sponsor) under leases, management contracts, or other arrangements.13 When properly structured, an SPE often reduces the credit risk or other risks for lenders or

investors and, thus, lowers financing costs. SPEs also may create certain tax advantages for the participating parties.

SPEs raise a number of complex financial accounting and reporting issues. One

issue is which party, if any, should be responsible for reporting or consolidating the

assets and liabilities of the SPE into its financial statements.

The existing accounting requirements generally provide that the sponsor of the

SPE (for example, Enron) is required to report all of the assets and liabilities of the

SPE in its financial statements unless all of the following criteria are met:

1. A third-party owner (or owners) independent of the sponsor has a sufficient equity investment in the SPE;

2. The independent third-party owner (or owners) investment is substantive (generally meaning at least 3 percent of the SPE’s total debt and equity or total assets);

3. The independent third-party owner (or owners) has a controlling financial interest

in the SPE (generally meaning that the owner holds more than 50 percent of

the voting interest of the SPE—thus, if the SPE’s total equity is only 3 percent

of total assets, all of its equity must be held by one or more independent third

parties); and

4. The independent third-party owner (or owners) possesses the substantive risks

and rewards of its investment in the SPE (generally meaning the owner’s investment and potential return are ‘‘at risk’’ and not guaranteed by another

party).14

22

15See FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets

and Extinguishments of Liabilities (September 2000). 16See FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities

(June 1998); and EITF Issue No. 98-10, ‘‘Accounting for Contracts Involved in Energy Trading

and Risk Management Activities.’’ 17See FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments (December 1991). 18See FASB Statement No. 47, Disclosure of Long-Term Obligations (March 1981). 19See FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others

(March 1981). 20See FASB Statement No. 5, Accounting for Contingencies (March 1975). 21See Transcript of hearing before the Capital Markets, Insurance, and Government Sponsored Enterprises Subcommittee and Oversight and Investigations Subcommittee of the Committee on Financial Services, United States House of Representatives, page 28 (December 12,

2001). 22Transcript of hearing, page 28. The SEC recently issued a Commission statement setting

forth certain of its views regarding disclosure that should be considered by public companies

while preparing annual reports for the year ended December 31, 2001. Those views included a

reminder of existing disclosure requirements relating to liquidity and capital resources, including off-balance-sheet arrangements, certain trading activities that include non-exchange-traded

contracts accounted for at fair value, and effects of transactions with related and certain other

parties. See Release Nos. 33-8056; 34-45321; FR-61 (January 22, 2002).

Although a sponsor of an SPE that meets all of the above conditions is not required to consolidate the assets and liabilities of the SPE in its financial statements,

the sponsor is required either to recognize in its financial statements or to disclose

in the footnotes to its financial statements the obligations, including conditional or

contingent obligations or guarantees, that may arise from its transactions and relationships with the SPE. Whether the obligations must be recognized in the financial

statements or disclosed in the footnotes generally depends on their nature and the

extent to which payments are probable. The following is a brief summary of some

of the more significant accounting requirements that might apply to the sponsor’s (reporting entity’s) financial statements:

• A reporting entity that sells financial assets is required to report information

about what was sold. It is also required to report liabilities, including guarantees and recourse obligations, incurred in the sale, on the face of its financial

statements at their fair value on the date of sale.15

• A reporting entity that enters into certain derivatives or energy trading contracts

is required to recognize those contracts in its financial statements at fair value,

including the fair value of any obligation that arises from those contracts.16

• A reporting entity is required to disclose in the footnotes to its financial statements the fair value of its financial instruments, including the fair value of any

commitments, letters of credit, financial guarantees, or debt.17

• A reporting entity is required to disclose certain unrecorded long-term obligations

in its financial statements.18

• A reporting entity is required to disclose indirect guarantees of indebtedness of

others in its financial statements.19

• A reporting entity is required to recognize certain loss contingencies in its financial statements, including guarantees of indebtedness of others, and to disclose

the nature and amount of loss contingencies in its financial statements even

though the possibility of loss may be remote.20

In recent testimony before Congress, SEC Chief Accountant Robert K. Herdman

commented on the existing accounting requirements for SPEs.21 He stated, ‘‘On balance I think that the special purpose entity accounting is working as well as could

be expected right now, but it does cry out for the FASB to finish their project here

and conclude whether . . . a different set of rules should be enacted.’’ 22 The FASB

project that Chief Accountant Herdman was referring to in his testimony is one of

a group of the Board’s related projects on consolidations and related matters.

In 1982, the Board added a group of projects on consolidations and related matters to its agenda. The projects were intended to cover all aspects of accounting for

affiliations between entities along with several other matters that raise similar or

potentially related issues about financial statements. Specific areas to be addressed

by the projects included:

• Consolidations policy and procedures • The equity method of accounting • Disaggregated disclosures or segment reporting • Investments in unconsolidated entities and joint ventures • New basis or ‘‘push down’’ accounting in the financial statements of subsidiaries.

Since adding the group of projects to its agenda, the Board has issued two major

standards. The Board has also issued, through other projects, extensive guidance in

23

23See Attachment 4 for a detailed listing of guidance provided by FASB Statements and Interpretations related to related party transactions, special purpose entities, and off-balance sheet

financial arrangements. 24See Attachment 5 for a detailed listing of significant EITF issues related to special purpose

entities and off-balance-sheet financial arrangements. 25See FASB Statement No. 94, Consolidation of All Majority-Owned Subsidiaries (October

1987). 26See FASB Statement No. 131, Disclosures about Segments of an Enterprise and Related Information (June 1997). 27See FASB Exposure Draft, Consolidated Financial Statements: Policy and Procedures (October 16, 1995); and FASB Revised Exposure Draft, Consolidated Financial Statements: Purpose

and Policy (February 23, 1999). 28See Attachments 6 and 7 for a summary of the Board’s project on consolidations policy and

procedures and a detailed timeline of the Board’s activities in connection with the project, respectively.

the form of Statements and Interpretations that address the accounting for SPEs

or other off-balance-sheet financing arrangements.23 The EITF also has issued guidance in the form of consensuses that address those areas.24

The first major standard, issued in 1987, requires consolidation of the assets and

liabilities of all majority-owned and controlled subsidiaries in the financial statements of the parent entity.25 That standard eliminates what was arguably the major

vehicle for off-balance-sheet financing at the time in terms of the amounts involved.

Before that standard, many entities established a financing subsidiary that borrowed capital and utilized that capital to finance customer purchases of the products

of its parent and other affiliates or finance other parts of the operations of the consolidated group. Such subsidiary assets and liabilities often were not consolidated,

even if the parent entity owned all of the subsidiary’s equity.

The second major standard, issued in 1997, requires improved reporting of information about an entity’s various operating segments.26

In addition, the Board issued two Exposure Drafts addressing consolidation policy—the first in 1995 and the second in 1999.27 Establishing criteria or policy for

determining which entities should be included in a set of consolidated financial

statements involves many difficult considerations extending beyond SPEs, and both

of those proposals were extremely controversial. For example, the most controversial

issue in the project on consolidations policy has been whether to require consolidation of entities that a parent entity effectively controls by means other than majority

ownership, such as a large minority holding if ownership of the majority is widely

dispersed. That issue extends beyond what are usually thought of as SPEs, and both

Board members and constituents have been sharply divided on it.

The Board continues to actively pursue further improvements in connection with

its longstanding project on consolidations policy and procedures.28 In November

2001, the Board decided to concentrate its efforts on developing guidance on an expedited basis fordealing with consolidation policy issues that have been identified

by constituents in the following four areas:

1. So-called strawman situations (for example, situations in which control of an entity is indirect and perhaps disguised through holdings of an entity’s agents,

management, or other related parties)

2. Entities that lack sufficient independent economic substance

3. Convertible instruments and other contractual arrangements that involve latent

control

4. The distinction between participating rights and protective rights of various

shareholders, partners, and other investors in an entity.

The Board believes that effective guidance for the above situations would resolve

many of the issues encountered by some entities in present practice, including

issues relating to consolidation of SPEs. The Board’s immediate plans are to issue

proposed guidance dealing with the first two of those situations in the second quarter of this year and the following two situations soon thereafter.

WHAT ARE RELATED PARTIES, AND WHAT ARE THE ACCOUNTING REQUIREMENTS FOR

RELATED PARTY TRANSACTIONS?

For accounting purposes, related parties are defined quite broadly to include:

• Affiliates of the enterprise

• Entities in which the enterprise has investments that it accounts for using the

equity method

• Management of the enterprise (including members of the board of directors, the

chief executive officer, chief operating officer, vice presidents in charge of prinVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00027 Fmt 6633 Sfmt 6621 W:\DISC\77990 pfrm11 PsN: 77990
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29FASB Statement No. 57, Related Party Disclosures, paragraph 24(f) (March 1982). 30One exception involves the accounting for leases. In cases where ‘‘it is clear that the terms

of the transaction have been significantly affected by the fact that the lessee and lessor are related...the classification and/or accounting shall be modified as necessary to recognize economic

substance rather than legal form’’ (FASB Statement No. 13, Accounting for Leases, paragraph

29 [November 1976]). 31Statement 57, paragraph 2. 32Statement 57, paragraphs 16 and 17.

cipal business functions, and other persons who perform similar policy-making

functions) • Other parties with which the enterprise may deal if one party controls or can significantly influence the management and operating policies of the other to the

extent that one of the transacting parties might be prevented from fully pursuing its own separate interests • Another party also is a related party if it can significantly influence the management or operating policies of the transacting parties or if it has an ownership

interest in one of the transacting parties and can significantly influence the

other to an extent that one or more of the transacting parties might be prevented from fully pursuing its separate interests.29

Transactions with related parties generally are accounted for in the same way as

if they were transactions with unrelated parties. More specifically, related party

transactions generally are required to be accounted for in accordance with their

terms; it usually would not be feasible to account for a transaction based on what

the terms might have been had the transaction been between unrelated parties.30

Reporting entities, however, are required to disclose detailed information in their financial statements about their related party transactions. Those requirements include, but are not limited to, disclosure of:

1. The nature of the relationship(s) involved

2. A description of the transactions, including transactions to which no amounts or

nominal amounts were ascribed, for each of the periods for which income statements are presented, and such other information deemed necessary to an understanding of the effects of the transactions on the financial statements

3. The dollar amounts of transactions for each of the periods for which income statements are presented and the effects of any change in the method of establishing

the terms from that used in the preceding period

4. Amounts due from or to related parties as of the date of each balance sheet presented and, if not otherwise apparent, the terms and manner of settlement.31

In describing the basis for the Board’s conclusions regarding those requirements

the Board stated:

The Board believes that an enterprise’s financial statements may not be complete without additional explanations of and information about related party

transactions and thus may not be reliable. Completeness implies that

‘‘. . . nothing material is left out of the information that may be necessary to insure that it validly represents the underlying events and conditions.’’ The Board also believes that relevant information is omitted if disclosures

about significant related party transactions required by this Statement are not

made. ‘‘Completeness of information also affects its relevance. Relevance of information is adversely affected if a relevant piece of information is omitted,

even if the omission does not falsify what is shown.’’ [Footnote references omitted.] 32

WHAT IS MARK-TO-MARKET (‘‘MTM’’) ACCOUNTING, AND WHAT ARE THE REQUIREMENTS

FOR MTM ACCOUNTING?

‘‘Mark-to-market’’ or ‘‘MTM’’ accounting describes an accounting method whereby

certain contracts (largely financial contracts but also some nonfinancial contracts)

and the changes in the value of those contracts are reported at their fair value on

the face of an entity’s financial statements. MTM accounting has long been used by

broker-dealers and traders of financial contracts, for both internal and external reporting purposes, to provide transparent and relevant information to management

and investors about the economic results—favorable and unfavorable—of the entity’s trading activities. Those entities utilize MTM accounting not only because it provides the most relevant information, but also because other cost-based accounting

methods present difficulties that can result in opaque and potentially misleading information about those activities.

Beginning nearly a decade ago, in an effort to further improve the transparency

of financial reports in the face of similar difficulties, accounting standards gradually

expanded MTM accounting beyond broker-dealers and traders of financial contracts

25

33See FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (May 1993). 34See EITF Issue 98-10. 35See Statement 133. 36Statement 107, paragraph 5. 37Statement 107, paragraph 11. The Board has an active agenda project to determine whether

the requirements in Statement 107 should be improved. The Board plans to issue a proposal

to replace Statement 107 in the first quarter of 2003. In addition, the EITF is in the process

of codifying additional interpretative guidance about the accounting for energy trading contracts,

including guidance for measuring the fair value of those contracts and providing disclosures

about the presentation of the gains and losses on those contracts. See EITF Issue No. 02-3, ‘‘Accounting for Contracts Involved in Energy Trading and Risk Management Activities.’’ 38Transcript of hearing, page 22. 39Transcript of hearing, page 22. 40Transcript of hearing, page 22.

to entities that buy or sell certain financial instruments and other contracts. Thus,

MTM accounting became required for certain debt and equity securities in 1994,33

energy trading contracts in 1999,34 and certain derivative instruments in 2000.35

MTM accounting is especially important in providing relevant and transparent information about energy trading contracts and many derivative instruments because

the alternative often would be not to account for the contracts at all during the period they are outstanding. Because energy trading contracts and many derivative instruments often are entered into at no net upfront cost (because they create rights

and obligations that are initially equal but opposite), those contracts escape accounting recognition in a cost-based accounting model until the contracts are transferred

or closed.

One element of MTM accounting is computing a contract’s fair value and changes

in fair value. The accounting requirements for determining those amounts include

the following:

Fair value of a financial instrument is the amount at which the instrument

could be exchanged in a current transaction between willing parties, other than

in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value to be disclosed for that instrument is...that market

price.36

Quoted market prices, if available, are the best evidence of the fair value of

financial instruments. If quoted market prices are not available, management’s

best estimate of fair value may be based on the quoted market price of a financial instrument with similar characteristics or on valuation techniques (for example, the present value of estimated future cash flows using a discount rate

commensurate with the risks involved, options pricing models, or matrix pricing

models).37

Chief Accountant Herdman in his recent testimony before Congress stated:

I don’t believe that there’s any evidence to indicate that Mark-to-Market accounting has led to misleading information to investors. The broker/dealers in

this country have used Mark-to-Market accounting . . . to account for their activities for many, many, many years. And they have sophisticated financial instruments that aren’t quoted on exchanges that need to be accounted for at market

value. And so estimates need to be made of value in order to accomplish the

mark-to-market process.38

He also added, ‘‘We haven’t seen any indication that Mark-to-Market accounting

has caused problems...for any... companies within the energy industry.’’ 39

Finally, in commenting on the existing MTM accounting requirements, Chief Accountant Herdman stated, ‘‘I think the principles of Mark-to-Market accounting are

quite clear in the accounting literature that exists today, and the circumstances

under which it should be done.’’ 40

DID ENRON’S FINANCIAL STATEMENTS COMPLY WITH EXISTING ACCOUNTING

REQUIREMENTS?

Enron publicly acknowledged in its November 8, 2001, Form 8-K and November

19, 2001, Form 10-Q filings with the SEC that it had failed to comply with existing

accounting requirements in at least two areas. First, Enron indicated that with respect to four SPEs that it created during the year 2000, it issued Enron common

stock to the SPEs in exchange for notes receivable from the SPEs. At the time,

Enron reported an increase in assets and shareholder’s equity to reflect those transactions. Longstanding accounting requirements, however, provide that notes receivVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00029 Fmt 6633 Sfmt 6621 W:\DISC\77990 pfrm11 PsN: 77990
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41See EITF Issue No. 85-1, ‘‘Classifying Notes Received for Capital,’’ and SEC Staff Accounting Bulletin No. 40, Topic 4-E, ‘‘Receivables from Sale of Stock.’’ 42Written statement by Lynn Turner in testimony before the Committee on Governmental Affairs, United States Senate, page 3 (January 24, 2002). 43William C. Powers, Jr., Chair, Raymond S. Troubh, and Herbert S. Winokur, Jr., Report

of Investigation by the Special Investigative Committee of the Board of Directors of Enron Corp.,

page 3 (February 1, 2002). 44Powers Report, page 4. 45Powers Report, page 4. 46Powers Report, page 17.

able arising from transactions involving an entity’s own capital stock are generally

required to be reported as deductions from stockholders’ equity and not as assets.41

As a result of this error, Enron indicated that it had overstated both total assets

and shareholders’ equity in its financial statements for the second and third quar- ters of 2000, and its annual financial statements for 2000, by $172 million. It also

indicated that it had overstated both total assets and shareholders’ equity in its fi- nancial statements for the first and second quarters of 2001 by $1.0 billion.

Second, Enron indicated that the assets, liabilities, gains, and losses of three previously unconsolidated SPEs should have been included in Enron’s financial statements under existing accounting requirements (see above discussion, ‘‘What Is an

SPE, and What Are the Accounting Requirements for SPEs?’’). As a result of that

error, Enron indicated that it had overstated reported net income by approximately

$96 million in 1997, $113 million in 1998, $250 million in 1999, and $132 million

in 2000. It also indicated that it had understated net income by $17 million and

$5 million in the first and second quarters of 2001, respectively, and overstated net

income by $17 million in the third quarter of 2001. Finally, Enron indicated that

as a result of this error, it also had understated debt (or liabilities) by approximately $711 million in 1997, $561 million in 1998, $685 million in 1999, and $628

million in 2000.

In commenting on Enron’s restatements in recent testimony before Congress,

former SEC Chief Accountant Lynn Turner stated:

New accounting rules were not needed to prevent the restatements of Enron’s financial statements or improve the quality of some of its disclosures. Compliance with and enforcement of the accounting rules that have been on the books

for years would have given investors a timely and more transparent picture of

the trouble the company was in.42

More recently, a committee of three outside members of Enron’s board of directors

filed a public report (‘‘Powers Report’’) that stated that its investigation ‘‘identified

significant problems beyond those Enron has already disclosed.’’ 43

Those further problems included entering into transactions that Enron

could not, or would not, do with unrelated commercial entities. Many of the

more significant transactions apparently were designed to accomplish favorable

financial statement results, not to achieve bona fide economic objectives or to

transfer risk. Some transactions were designed so that, had they followed applicable accounting rules, Enron could have kept assets and liabilities (especially

debt) off its balance sheet; but the transactions did not follow those rules.44

The Powers Report suggests that ‘‘other transactions’’ resulted in ‘‘Enron reporting earnings from the third quarter of 2000 through the third quarter of 2001 that

were almost $1 billion higher than should have been reported.’’ 45

The Powers Report also states that Enron’s disclosures about its transactions with

the partnerships were ‘‘obtuse, did not convey the essence of the transactions completely or clearly, and failed to convey the substance of what was going on between

Enron and the parternships.’’ 46

CONCLUSION

The FASB is responsible for establishing and improving financial accounting and

reporting standards that ensure that financial reports provide transparent information to investors and other consumers.

I want to assure you, Mr. Chairman, Ranking Member Towns, and all the Members of the Subcommittee, and all investors and other consumers that participate

in the US capital markets, that consistent with the FASB’s mission and due process,

the Board is prepared and committed to proceed expeditiously to resolve any and

all financial accounting and reporting issues that may arise as a result of Enron’s

bankruptcy.

The Board already has active projects under way in over a half-dozen areas that

will propose significant improvements to existing requirements in the areas of:

• Accounting for consolidations, including consolidations of SPEs

27

47The Royal Swedish Academy of Sciences, ‘‘The Prize in Economic Sciences 2001,’’ press release (October 10, 2001).

• Determining the fair values of financial instruments

• Disclosing fair values and changes in fair values of financial instruments, and

• Distinguishing liability instruments from equity instruments and accounting for

complex instruments with both debt and equity components.

The Board also is cognizant that some, including SEC Chairman Harvey L. Pitt,

have raised concerns about the speed of our standard-setting activities. As described

above, we have begun pursuing a number of projects and activities to improve our

efficiency and effectiveness without jeopardizing the openness and thoroughness of

our due process that are essential to maintaining high-quality accounting standards.

The FASB and the accounting standards we issue, however, cannot alone sustain

the transparency necessary to maintain the vibrancy of our capital markets. Other

market participants also must carry out their responsibilities in the public interest.

Those participants include officers and directors of reporting entities, auditors, and

regulators.

Officers and directors of reporting entities that seek to access the capital markets

to finance their needs are responsible for preparing their financial statements and

presenting those statements to investors and other consumers. They must apply the

accounting standards in a way that is faithful not only to the language of the requirements, but to the requirements’ clear intent. Seeking loopholes to find ways

around the language or intent of the standards obfuscates reporting and harms investors and other consumers by creating information that is not transparent and

that is not a true reflection of the economics of the underlying transactions.

Auditors are required to examine a reporting entity’s application of accounting

standards to determine that the requirements have been fairly applied. They too

must ensure that not only the language, but the stated intent, of the standards are

followed, and not accept facile arguments by a reporting entity’s management that

the financial statements are acceptable just because the language of the standards

does not explicitly prohibit an inventive reporting technique or methodology that is

intended to hide information from unsuspecting consumers. Auditors’ primary responsibility is to the investing public who do not have the benefits of the same level

of access as auditors do to the underlying facts about an entity’s operations and

transactions.

Finally, regulators, principally the SEC, also have an important role to play. The

SEC’s responsibility is investor protection. Through its oversight and enforcement

activities it must also seek to ensure that reporting entities provide information consistent with the language and intent of the relevant standards. The SEC must also

ensure that auditors, in accordance with accepted auditing standards, have properly

and thoroughly examined and certified the reporting entity’s information.

If anything positive results from the Enron bankruptcy, it may be that this highly

publicized investor and employee tragedy serves as an indelible reminder to all of

us, including reporting entities, auditors, and regulators, that transparent financial

accounting and reporting do matter and that the lack of transparency imposes significant costs on all who participate in the US capital markets. Conversely, providing transparent financial information the markets need to operate efficiently benefits not only those who use the information but also the entities who provide it.

The Royal Swedish Academy of Sciences recognized the importance of adequate

transparent information to markets in awarding the 2001 Nobel Prize for Economics

to three Americans for their pioneering contributions to the theory of how markets

work when buyers and sellers have differing amounts of information.47

The work describes why market participants may overdiscount for the effects of

uncertainty if they do not trust the information available to them. The result is that

items traded in that market, whether it is the market for stock in entities or the

market for used cars, are not efficiently priced. In essence, providing transparent,

credible information lowers the risk premium charged by market participants.

Thank you, Mr. Chairman. I very much appreciate this opportunity and would be

pleased to respond to any questions.

Mr. STEARNS. I thank the gentleman.

Mr. Castellano.

STATEMENT OF JAMES G. CASTELLANO

Mr. CASTELLANO. Thank you, Chairman Stearns, Ranking Member Towns and other distinguished members of the subcommittee,

28

for inviting me to testify before you today. I am Jim Castellano,

elected Chairman of the Board of The American Institute of Certified Public Accountants, the AICPA. I live in St. Louis, Missouri.

I am the managing partner of a local CPA firm in St. Louis—

Ruben, Brown, Gorenstein and Company. I welcome this opportunity to appear before you today on behalf of the AICPA’s 340,000

members in public practice, in industry and academia, and government. I, too, have submitted written testimony that I ask be included in the record of today’s hearing.

Events of the past few months are deeply disturbing to the accounting profession. What happened at Enron is a tragedy on many

levels, and this is a difficult time for us and all those involved with

the financial reporting process.

We are proud of our profession. We take seriously our public responsibility, and we are committed to doing our part to restore confidence in the financial reporting system.

No one has all the facts about the Enron failure, and jumping to

conclusions prematurely disserves everyone, including investors.

But the accounting profession wants to make one thing perfectly

clear, and that is that our profession has zero tolerance for those

who break the rules.

The accounting profession is actively engaged on a number of

fronts. Some are new initiatives, and many more are an acceleration of initiatives that have been underway.

Since the Enron collapse, we have come forward to embrace some

reform proposals that we previously opposed, such as some scope

of service restrictions for auditors of public companies, and we are

supporting the SEC’s initiative to move from self-regulation to public regulation, from public oversight to public participation, a move

that is unprecedented in the 100-year history of our profession.

The United States General Accounting Office, in its 1996 study

of the profession, concluded that the actions taken by the profession in response to the major issues raised from the many studies

from 1972 through 1995 show that the profession has been responsive in making changes to improve financial reporting and auditing

of public companies, but we cannot rest on the past.

There are a number of additional reforms that need to be enacted. These include revising current accounting rules for special

purpose entities such as those used by Enron to deter accounting

abuses; requiring additional disclosures in company filings with the

SEC including management’s discussion and analysis, MD&A; requiring reporting on a company’s internal control system to evaluate its effectiveness in making that report available to investors;

requiring auditors to take additional steps to search for fraud; requiring nonfinancial information to supplement the historical financial statement; increasing the frequency of financial reporting,

and making it illegal for anyone in the company to lie to an auditor

or withhold material information.

We also stand ready to provide additional assurances over management’s discussion and analysis. In June 2001, we introduced a

new audit level service to examine management’s discussion and

analysis, so we hope that more audit committees and board members will avail themselves of this added assurance.

29

The focus of auditing must change as well. Auditors will be reporting on information systems. They will be focusing heavily on

preventive controls and providing assurance that information systems are operating effectively and sufficiently to produce reliable

information.

This transition is going to require that the accounting profession

attracts the most talented professionals to serve the public interest.

But there will still be pitfalls even in this scenario. There is the

threat of management overriding the systems and preparing fraudulent and untruthful disclosures. That is why our profession, even

before these recent Enron events, has been working on improving

auditing standards and guidance to auditors to help them better

detect fraud.

An exposure draft of a new board standard intended to elicit public comments will be issued by this month’s end, with the final

standard issued later this year. In addition to these changes, we

are also reviewing the adequacy of all auditing standards regarding

all issues emanating from Enron.

Now to the reporting model. No reporting model will protect investors from greed and bad judgment. However, an improved reporting model will provide every investor with better quality information and increase the likelihood of better investment decisions.

We need more information, timely disclosures and plain English.

Reporting models should also address off-balance-sheet activity,

liquidity issues, other risks and uncertainties, forward-looking information, nonfinancial performance indicators, unreported intangibles, and other information.

To modernize the model, we must focus on three things. First, a

broader bandwidth of information; second, different distribution

channels, namely, the Internet; and, third, increased reporting frequency, ultimately, we can see in the future leading to on-line,

real-time reporting. The profession has been working actively on

additional reforms, and they are outlined in my written testimony.

We, too, look forward to working with Congress, the SEC, and the

FASB to develop meaningful reforms in these areas, and we are

open to other areas of inquiry. This is a debate that is long overdue

and one that we welcome.

In conclusion, Congress and others should carefully consider

these reforms. They are essential to restoring investor confidence

in the financial reporting system, and I can assure you that the

CPA profession wants, as I know you do, to assure that this future

comes about to the benefit of shareholders, consumers and, indeed,

all American citizens.

Again, I thank you for the opportunity to address this important

issue with you today.

[The prepared statement of James G. Castellano follows:]

PREPARED STATEMENT OF JAMES G. CASTELLANO, CHAIR, AMERICAN INSTITUTE OF

CERTIFIED PUBLIC ACCOUNTANTS

Thank you, Chairman Stearns, Ranking Minority Member Towns and other distinguished members of the committee for permitting me to testify today on the adequacy of current accounting standards. I am Jim Castellano, Chairman of the Board

of the American Institute of Certified Public Accountants. Corporate accountability

is of great importance to the continued strength of the American economy and confidence in our capital markets. In order for our capital markets to function effectively and for our economy to allocate resources efficiently, it is essential that busiVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00033 Fmt 6633 Sfmt 6621 W:\DISC\77990 pfrm11 PsN: 77990
30

ness enterprises report accurately and fairly to investors and that investors perceive

that they do so. Our economy needs both the fact and appearance of credible financial reporting.

The business collapse of Enron last year has shaken the faith of America, and of

the world, in our financial markets. The personal tragedy to Enron’s employees, retirees, and investors goes far beyond the dollars and jobs they have lost. And this

tragedy occurred despite the fact that we have the freest, most open, transparent,

and dynamic financial market in the world. The accounting profession has also been

deeply disturbed by what has occurred. We are proud of our history of serving the

public interest by providing assurance to the investors that the financial statements

of public companies fairly present, in all material respects, the financial position of

these companies’.

The Enron business failure has added additional pressures on our economy and

raised questions concerning confidence in our capital markets. Legitimate questions

are being asked about corporate ethics and governance, including the role of a company’s board of directors and its audit and finance committees, internal controls,

compliance with accounting and audit standards and other SEC reporting requirements, financial reporting transparency, the adequacy of the current financial reporting model, the auditor disciplinary and quality review process, how analysts use

available financial information in making buy/sell recommendations to investors,

and other issues.

While no one has all the facts and relevant information about the failure, it appears to be the result of many contributing factors, all of which need to be addressed

to restore investor confidence in the system. Our profession has zero tolerance for

those who do not adhere to the rules. The AICPA and its members are committed

to the goal of assuring that investors and creditors have the highest quality of financial information. We will take the necessary steps to restore public confidence in the

accounting profession and capital market system, and will work with Congress to

develop meaningful public policy reform.

My goal today will be to touch on some of the reforms we have supported and

will continue to support for the accounting and auditing system, and to suggest additional reforms which we as CPAs believe will strengthen the financial reporting

system.

Capital should be deployed where it can be most productive. At the root of productive capital investment is the availability of timely, reliable and meaningful information. The success of our capital markets depends upon informative, reliable financial reporting—often referred to as ‘‘transparency.’’ Three critical conditions must

exist for investor information reporting to be meaningful. There must be:

1. Adequate reporting standards that provide full transparency of all meaningful

and relevant information to investors;

2. Compliance with those reporting standards, including appropriate auditing;

3. Timely access to, and sufficient user understanding of, the information available.

ADEQUACY OF CURRENT ACCOUNTING STANDARDS AND REPORTING SYSTEM

The current accounting model has historically performed well. But to work for today’s economy, it must be modernized. Economic change has moved much more

swiftly than accounting for such changes has adapted. Intellectual capital has become the greatest engine for corporate growth. Yet, accounting is still based on hard

assets—physical plant and related items for producing goods. Many companies, like

those in advertising, produce revenues based almost exclusively from knowledge

work. Knowledge work has become the key to all companies’ effectiveness. Even

companies producing tangible goods have become highly dependent on intangible

sources of revenues and competitive advantage.

Changes in business prospects have made quarterly reports outdated. Timely information has always been prized, but the pace of change in corporate dynamics and

earnings capabilities has made it much more important. Corporate diversification,

alliances of all sorts, the rate and depth of economic change, and transnational relationships have enormously changed the risks facing modern corporations. The relative absence of up-to-date information with which to assess corporate earning capacity coupled with the pace of change, helps explain the volatility of today’s share

prices. Meanwhile, the use of the Internet for economic communications has been

exploding. Real-time disclosure of selected financial information—that is, information that can be useful to investors without creating competitive disadvantage to

companies—on the Internet is clearly foreseeable. Investors need more frequent corporate financial and non-financial disclosures (i.e. on-line, real-time) to make informed investment decisions.

31

1 AICPA Special Committee on Financial Reporting, Improving Business Reporting—A Customer Focus, 1994. 2A Framework for Understanding Our New Economy, part of a joint project with Stephen

Cohen and John Zysman, http://econ161.berkeley.edu/OpEd/virtual/technet—outline.html. 3GAO, The Accounting Profession: Major Issues: Progress and Concerns, GAO/AIMD-96-98,

September 1996,p.16.

The accounting profession was first among those convinced the accounting model

needed to be modernized. From 1991-1994, a special committee of the American Institute of Certified Public Accountants (AICPA) studied the state of business reporting.1 The committee’s greatest achievement was its research on the needs of investors and creditors. The research showed that investors have many unmet information needs. This evidence was new because investors and creditors do not actively

make their information needs known to the accounting community.

The findings on information needs should have been a loud wake-up call to those

who depend on the disclosure system or have responsibility for it. Investors and

creditors are, figuratively speaking, the customers of financial reporting. More precisely, because corporations seek capital from investors and creditors, investors and

creditors are customers of the corporation’s sale of securities. Monetary exchanges

do not take place without information, and the better the information about a prospective purchase, the better the purchaser’s chance to make a satisfactory pricing

assessment. Putting the same point in terms of investors’ purchases of securities,

the better the information they have the lower the risk of poor investment or credit

decisions.

The report concluded that investors’ needs were not being fully met. It described

needs that go far beyond what is required by the current financial reporting model.

In fact, to capture the idea of reporting non-financial information, the report adopted the broader term ‘‘business reporting.’’ The report contained an illustrated, comprehensive model of business reporting designed by the Special Committee, as well.

Business reporting is wider than financial statements. It should include non-financial information and presentations outside the financial statements. The Special

Committee’s business reporting model was not limited to financial statements, although it at all times includes them, in recognition of their importance to investors

and creditors. The ‘‘accounting model’’ has in the past referred only to financial

statements, but in the future it will refer as well to business reporting to investors

and creditors.

It is very disappointing that the report was produced seven years ago and so little

has been done in response. If investors’ needs were not being met seven years ago,

they are likely being met even less today. Calls for reform have come from many

different sources, including nonaccountants. They include former SEC Commissioner

Steven M. H. Wallman, economist Robert E. Litan, and Yale School of Management

dean and former Under Secretary of Commerce for International Trade Jeffrey E.

Garten. Wallman has written on his own and with Margaret Blair as part of a

Brookings Institution project on intangibles. Litan joined Peter Wallison in a project

for the AEI-Brookings Joint Center for Regulatory Studies.

Garten recommended that companies be given incentives to provide more information on intangible assets and performance metrics, in a report by a group commissioned by the SEC. Economists recognize the importance of intellectual capital as

a source of economic growth, which means a source of revenue. For example, Brad

DeLong wrote, ‘‘Economic development has become less and less about accumulating

more and more physical capital and more and more about the creation and deployment of intellectual capital.’’ 2 A 1996 United States General Accounting Office report said: ‘‘[T]he current reporting model does not provide information about important business assets. As a result, historical cost-based financial statements are not

fully meeting users’ needs.’’ 3

In the broadest sense, if we are going to modernize the accounting model, we

must focus on these things:

• First, a broader ‘‘bandwidth’’ of information, such as was endorsed by the AICPA’s

Special Committee;

• Second, different distribution channels, namely, the Internet;

• And third, increased reporting frequency, ultimately, on-line, real-time reporting.

The root problem is the mismatch between widespread agreement that users’ information needs are not being met and the lack of consensus on how best to meet

those needs. Efforts to modernize business reporting must be accelerated, but where

should they start?

Reform should address unreported intangibles, off balance sheet activity, non-financial performance indicators, forward-looking information, enterprise opportunity

32

4Statement of Financial Reporting Concepts No. 2, Qualitative Characteristics of Accounting

Information (FASB 1980), states: ‘‘Improving comparability may destroy or weaken relevance or

reliability if, to secure comparability between two measures, one of them has to be obtained by

a method yielding less relevant or less reliable information’’ (par. 116). 5 Available at the FASB’s website: http://www.fasb.org. 6Wayne Upton, Business and Financial Reporting, Challenges from the New Economy (April

2001). Available at the FASB’s website: www.fasb.org. Upton’s potential projects were as follows: ‘‘Address’’ the format and content of non-financial metrics, in notes or elsewhere (5 issues are

set out, including whether standard setters should develop a standard format); the format and

content of disclosure about recognized and unrecognized intangible assets; recognition of intangible assets created as the result of a ‘‘project’’ effort (e.g., R&D); and recognition and measurement of embedded intangibles and service obligations (e.g., a bank’s core-deposit intangible and

an insurer’s claim-handling obligation). The list is in Appendix A, pp.111-113, of the website

version.

and risk, and more timely reporting. These could become time-consuming projects.

However, we support the following list of near term reforms.

NEAR TERM REFORMS:

The FASB should issue standards-level guidance on the location, form, and content of non-financial information that would supplement the historical financial

statements. In particular, the FASB should address non-financial performance indicators, unrecorded intangible assets, and forward-looking information. The FASB

should determine whether such supplementary reporting should be required, based

on experience with voluntary reporting or any other relevant factors it chooses to

bring to bear.

As part of the its standards-level guidance, the FASB should make explicit that

for purposes of its mandate, disclosures that supplement the financial statements

can be desirable to meet users’ needs, even if the disclosures go beyond what some

believe is necessary to understand the financial statements. The broader criterion

of information useful for making investment and credit decisions should apply. In

addition, in the same guidance, the Board should make more explicit the tension

between the desirability of comparability and of relevance in business reporting,

making clear that users’ needs can at times be satisfied best by relevant information

that is not comparable across a population of companies.4

The FASB, working with the SEC, should begin a project to consider revising the

frequency of reporting based upon the needs of users utilizing the capabilities of

modern accounting software and telecommunications.

The accounting profession stands ready to sponsor projects to help the FASB and

the SEC complete the projects recommended above in the shortest reasonable timeframe.

These recommendations to the FASB are compatible with its adoption of its

project on intangibles.5 The project would establish standards for disclosures about

intangible assets not recognized as assets in the financial statements. The proposed

project follows the publication of a study by the FASB staff which identified four

possible intangibles projects.6 We strongly support the FASB’s adoption of the proposed agenda item. Although the project will entail some difficult subjects, it should

be put on a fast track.

OTHER REFORMS

Support for reform should not be limited to standard setters, regulators, and those

whose oversight can take on formal qualities. All interested parties—including but

not limited to the accounting profession, the investment community, registrants,

creditors, and the financial industry—should be actively and constructively engaged.

They should be united by the common goal of improving the national welfare by empowering investors with better information and thereby spurring growth-creating

capital allocation.

For example, we recommend reforms in the following areas:

OFF BALANCE SHEET DISCLOSURES:

We encourage FASB to reprioritize its project agenda and move quickly on its consolidation project to address off-balance sheet disclosure transparency issues. Existing accounting rules for special purpose entities should be reviewed for possible accounting abuses and new types of financing vehicles.

REPORTS ON EFFECTIVENESS OF INTERNAL CONTROLS:

In the near term, company management should be required to make an analysis

and assertion as to the effectiveness of the company’s internal control apparatus.

33

7 A letter with relevant proposals, in the context of reforming the regulatory regime under the

1993 Securities Act, was sent to the SEC Division of Corporation Finance on August 22, 2001.

See www.abanet.org/buslaw/fedsec/comments.html.

The auditor should be required to attest to and report separately on the effectiveness of the management assertion. Management and auditor’s reports on internal

controls could make a positive and cost effective contribution to the assurance system and will improve investor confidence in the integrity and reliability of financial

statements issued by those who access the capital market. In the wake of the savings and loan collapse, congress placed similar requirements on depository institutions and their auditors.

DISCLOSURES BY COMPANY MANAGEMENT:

Stock Options: The FASB working with the SEC should require expanded disclosure of stock options received by the company management.

Insider Trading: Currently, company insiders do not have to disclose stock sales

on the open market until the month after the transaction at the earliest. We believe

it would make more sense to require disclosure of the intent to sell shares PRIOR

to the transaction. In addition to the SEC, all other interested parties such as employees, shareholders, retirees, and pension fund managers should be notified.

Other Disclosures: We encourage the SEC to initiate additional rulemaking action

to enhance disclosures in public company filings related to other management disclosure issues. The AICPA recently endorsed a petition to the SEC calling for more

disclosure in a company’s proxy statement about a company’s liquidity, off-balance

sheet entities, related party transactions and hedging contracts.

We are encouraged by the SEC’s desire to make rapid progress on business-reporting reform and its desire to achieve timely and more informative filings that can

help better inform investors without harm to the SEC’s investor-protection mission.

It should consider carefully the relevant recommendations of the ABA Committee

on Federal Regulation of Securities 7 and revisit the proposals made in 1996 by the

SEC’s own Advisory Committee on the Capital Formation and Regulatory Processes.

The Congress should support these efforts.

MANAGEMENT DISCUSSION AND ANALYSIS OF OPERATIONS:

As auditors, we also stand ready to provide additional assurances over management’s discussion and analysis (‘‘MD&A’’). Our responsibility, under a traditional

audit, is to read the MD&A and consider whether such information is materially

inconsistent with the financial information presented in the audited financial statements. We are not required to render a report on our findings; rather we are only

required to inform management of our findings if we believe the information is materially inconsistent. Because as a profession we believed that audit committees and

boards of directors may want additional assurances relative to MD&A, we introduced, in June 2001, a new audit level service to examine the MD&A. This service,

which is separate from our traditional audit, examines MD&A for the purpose of

expressing an opinion as to whether:

a) The presentation includes, in all material respects, the required elements of the

rules and regulations adopted by the SEC.

b) The historical financial amounts have been accurately derived, in all material respects, from the entity’s financial statements.

c) The underlying information, determinations, estimates, and assumptions of the

entity provide a reasonable basis for the disclosures contained therein.

While the demand for this additional voluntary examination has been slow to develop, we hope that more audit committees and board members will avail themselves of this added assurance.

AUDITOR RESPONSIBLITY:

We also need new audit strategies and technologies. In an ideal world, companies

would be producing the new disclosures with the desired frequency over the Internet; auditors would be providing contemporaneous assurance that the information

was reliable; investors would benefit from better decision making information; productive corporations would benefit from a lower cost of capital; and the economy

would be growing with more stability and promise, even than now.

To accomplish this result, not only must the reporting model change but also the

focus of auditing must change. Steps toward this new direction have already begun.

Auditors in this new world would be reporting on information systems. They would

be focusing heavily on preventive controls and providing assurance that information

34

systems were operating effectively and sufficiently to produce reliable information.

The transition is also going to demand personnel of the highest caliber. But there

will still be pitfalls even in this scenario. While new disclosures could be produced,

and the auditors could provide assurance over the systems producing the disclosures, there is still the threat of management overriding the systems and preparing

fraudulent and untruthful disclosures. That is why our profession, even before these

recent Enron events, has been working on improving auditing standards and guidance to help auditors better detect fraud. Two of the more noted proposed changes,

among others, are explicit procedures addressing the risk of management override

of controls and required procedures to evaluate the business rationale for significant

unusual transactions. A draft of this new standard, intended to elicit public comments, will be issued by month’s end with the expectation of issuing a final standard by the end of the year.

In addition to these changes, we are also looking at the following reforms:

We are reviewing the adequacy of professional auditing standards regarding all

issues emanating from Enron, including audit procedures from related party transactions, special purpose entities, hedging contracts, internal controls established by

the finance or audit committees, and working paper and record retention, and others. We will work with the SEC, FASB and Members of Congress on these recommendations.

We believe it should be illegal to lie to your auditor in the same way for example,

that it is a illegal to lie to a prosecutor. We would support legislation or regulations

that would accomplish that.

Public Participation:

The AICPA, is committed to working diligently with Congress and the SEC to develop a new regulatory model that improves and goes beyond the current self-regulatory processes. While the current self-regulatory model provides for significant

public oversight over the existing peer review process, there is no public oversight

over discipline. This new model would affect all firms doing SEC audits. We will

diligently work to improve the profession’s peer review and disciplinary process as

it relates to auditors of SEC registrants. We strongly support moving from public

oversight to public participation and increasing the transparency, effectiveness, and

timeliness of the process. We will work with the Congress and the SEC to strengthen regulation of the profession as they implement a system that incorporates active

public participation to enhance discipline and quality monitoring.

Non-Audit Services

We will not oppose prohibitions on auditors of public companies from providing

financial systems design and implementation and internal audit outsourcing. We believe such prohibitions will help to restore the public’s confidence in the financial

reporting system.

Preparing For the Future Now:

But there is another way of viewing this scenario. The disclosures could be produced, and auditors could find themselves inadequately prepared to provide assurance to investors about the information’s reliability. The transition to new reporting

and auditing models is going to demand not only new audit approaches but personnel of the highest caliber. With this in mind, the profession has been working

actively in the following areas:

Continuous Auditing. Continuous auditing or continuous assurance involves reporting on short time frames and can pertain to either reporting on the effectiveness

of a system producing data or more frequent reporting on the data itself. An AICPA

task force has concluded that the enabling technologies, if not the tools, required

to provide continuous assurance services, are, for the most part, currently available.

Their actual implementation will evolve with progressive adoption of the concept

and the emergence of appropriate specialized software tools. Work is needed, however, to better understand the market potential for continuous assurance. A clearer

insight is needed into both users’ needs as well as decision-makers’ perceptions of

the value of this service. A marketing study of user needs would help assess the

types of key performance indicators, system reliability issues, and financial and nonfinancial information that would benefit users. Depending on corporate platforms

and established monitoring processes used for other purposes the costs of providing

continuous auditing or assurance will vary. Therefore, further research is also needed to better understand how the potential purchasers of these services, such as

management, boards and institutional investors, perceive the value of continuous

assurance relative to the current model of periodic assurance.

XBRL. XBRL (or Extensible Business Reporting Language) is a freely available

internet-based language for business reporting. It is a framework that provides the

35

business community a standards based method to prepare, publish, reliably extract

and automatically exchange business reports of companies and the information they

contain. Whatever new reporting standards are considered appropriate, it is likely

to be richer in disclosure than what we have today and will need XBRL to facilitate.

SysTrust. SysTrust is an assurance level service that independently verifies the

reliability of a particular system (including a financial reporting system) against a

framework of standards that address security, availability and integrity. Providing

a freely available benchmark for what makes a system reliable, SysTrust is designed to provide assurance to boards of directors, corporate management, and investors that the systems that support a business or a particular activity are reliable.

Performance Measures and Value Measurement. The Value Measurement and Reporting Collaborative (VMRC) is the culmination of years of discussion about the

need to change the reporting model. Numerous reports, white papers and books

have cited the need for better information to be disclosed by publicly traded companies, not merely more information. Over the past year, the AICPA has been approached by a number of organizations that claim to have the solution to the need

for better disclosure. While some companies are already taking steps to report information that investors want, currently these efforts are isolated and may not be comparable between companies. Rather than work with one organization, the AICPA

and the Canadian Institute of Chartered Accountants are establishing the VMRC

as a means to allow the various stakeholders to work together to determine the best

methodology for reporting. Current suggestions include, but are not limited to, reporting of non-financial measures, intangible assets or a combined discounted cash

flow and risk analyses. Specifically, the collaborative will:

• Understand the needs of the user community/stakeholder groups;

• Determine what is currently taking place in the field;

• Undertake an in-depth review of 7 or 8 alternative approaches to value measurement and reporting;

Further, this new framework, which will work in conjunction with the current

model, will move the current reporting forward not in an incremental step, but in

the revolutionary change that is needed today.

Student Recruitment. The AICPA has embarked on a new student marketing and

recruitment plan, designed to attract more students—and the best students—to the

accounting profession. This five-year, $25 million initiative is targeted toward late

high school and college students, and is interactive in its approach, using web-based

business simulations and games, college TV networks and other technology-based

techniques to reach this important generation of young people. The campaign will

help students understand the important role that CPAs play in all facets of the

business world, and the important responsibilities CPAs have in helping businesses

and individuals succeed.

In conclusion, I maintain that Congress and others should carefully consider these

reforms as they are essential to restore investor confidence in the financial reporting

system. I can assure you that the CPA profession wants, as I know you do, to assure

that this future comes about for the benefit of shareholders, consumers, and indeed,

all American citizens.

Thank you for this opportunity to express our views.

Mr. STEARNS. I thank the witnesses of the first panel. I will start

with questions. The accounting profession has been looked at as

something that is arcane and difficult to understand, but I think

Mr. Bass, from New Hampshire, sort of summarized the whole

process, that ‘‘cash is fact and everything else is opinion,’’ and we

have a major corporation, of course, that imploded with a collapse

and a bankruptcy, and we read in the paper there are other corporations that are now questioning their accountants, they are

questioning their procedures, and even down to Krispy Kreme now.

I saw in yesterday’s Washington Post there was some question

about how they are putting assets to hide the amount of debt they

have. So, whether it is Tyco or Global Crossing or Enron, you have

a host of these companies out there.

The purpose of our hearing today is to try and tell the American

people and our colleagues to come up with answers so that investors feel confident in the market, there is transparency.

36

So, the first basic question is, we talk about GAAP, which is generally accepted accounting principles, so let me just ask yes or no,

going from left to right, Mr. Herdman, did Enron practice GAAP?

Mr. HERDMAN. Chairman Stearns, they have announced that in

a couple of instances they needed to restate their financial statements. Beyond that, because of the pendency of our investigation,

I can’t comment.

Mr. STEARNS. Okay.

Mr. JENKINS. As I testified, Enron and the board committee have

both acknowledged that they did not follow GAAP.

Mr. STEARNS. Okay. We have Enron that said they did not follow

the generally accepted accounting principles, is that true, Mr.

Castellano? Do you agree with that?

Mr. CASTELLANO. Chairman Stearns, they have reported that in

their filings to the SEC, that is correct.

Mr. STEARNS. Okay. So, Mr. Herdman, I don’t think that that is

a secret, it is public knowledge, you should acknowledge it, too,

that they didn’t do it. I mean, on-line investigation is good, but

they have said it publicly, so I think we are at that point.

So, the next question is, they didn’t follow it, but there are a lot

of other corporations that say they are doing it, and yet investors

can’t find the transparency and confidence. Do we need, based upon

the modern technological innovation that we are seeing in today’s

market, do we need to change the generally accepted accounting

principles? Just start left to right, yes or no?

Mr. HERDMAN. We need to continue to improve them.

Mr. STEARNS. Do they need to be revised and modernized, or can

we just continue the way we are going with the GAAP accounting

principles?

Mr. HERDMAN. We need to have accounting principles that are

responsive to developments in the marketplace and have accounting principles today to be responsive to the questions about consolidation of SPEs. We need better accounting principles with respect

to the very important issue of revenue recognition. I believe, Mr.

Chairman, what I am describing is a system of continuing to improve rather than just throwing out the entire system.

Mr. STEARNS. Do you think we need major change, or just on the

edges?

Mr. HERDMAN. We need a variety of change. Not only do we need

to continue to change the underlying principles themselves, we

need to find ways—and we at the SEC are working very hard on

projects to accomplish—ways to make financial statements more

understandable to ordinary investors. Financial statements today

are very complex because businesses are very complex, transactions

are very complex. But we need to find a way through plain English

disclosure, through some type of condensation of disclosure, while

not taking away anything that exists today, to find methods whereby ordinary investors can indeed read financial statements.

Mr. STEARNS. So, you are saying we probably need some major

reform.

Mr. HERDMAN. Yes, we do.

Mr. STEARNS. Mr. Jenkins?

Mr. JENKINS. As I testified, we have six initiatives underway

right now that I think are needed to improve financial reporting

37

and will. I would put them in the area of continuous change and

improvement. Certainly, the accounting for special purpose entities

has been an issue that has been on our agenda, as I said, for far

too long, and we need to address that and, as I also said, we are

addressing it expeditiously, and we expect to have a completed

standard in that area by the end of the year.

Mr. STEARNS. Okay. Mr. Jenkins, you are saying this morning we

do need to make major changes, and you have these along the way.

Mr. JENKINS. But I put them in the area of continuous improvement. I don’t want to throw the baby out with the bathwater. I

think our basic model is sound.

Mr. STEARNS. Okay. Mr. Castellano?

Mr. CASTELLANO. I would concur that the basic model is sound

and that we do need continuous improvement, but I would take a

step further, and that is that we need to look well into the future

and envision a broader business reporting model that would include more disclosure about nonfinancial performance indicators,

for example. I know the FASB has done research on this. I encourage them to continue to pursue the results of that research, and

work toward additional disclosures that will help investors make

decisions about whether companies are worth investing in for the

future.

Mr. STEARNS. Mr. Castellano, here there are two areas that I am

looking at—one, GAAP, but then oversight, trust to verify. And we

are at the point—are we at the point like we were in 1934 when

we established the Securities and Exchange Commission, where we

need to do something truly new to give confidence to investors, and

what should that be.

We have a corporation that has to comply with the SEC. We

have the American Institute for Certified Public Accountants, yourself, and the arm of that, as I understand it, was the Public Oversight Commission, and all these three in some ways failed to find

Enron. I think that is true.

And so a lot of us are trying to say, what is a better structure?

Now, the SEC has come out with the idea they think the Public

Oversight Commission should be abolished, isn’t that true, Mr.

Herdman?

Mr. HERDMAN. Yes, it is.

Mr. STEARNS. Explain to us what you want to replace that with.

You did it in your opening statement, but is this going to be appointed by Members of Congress, appointed by you, or the American Institute of Certified Public Accountants? Tell us what this

new structure is that you think will make sure we don’t have anymore Enrons?

Mr. HERDMAN. Mr. Chairman, what we have decided on is a

framework whereby the current system of self-regulation of the accounting profession would be replaced by a system that would no

longer be under the auspices of the AICPA. It would be composed

of a board of people who would be nominated by members representing the public rather than members representing the profession. It would replace the current system of peer review with a

more vibrant and more frequent system of quality control review,

and it would have real disciplinary power to proceed against acVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00041 Fmt 6633 Sfmt 6602 W:\DISC\77990 pfrm11 PsN: 77990
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countants that have violated either ethical or competency requirements.

As to the details of how that will all be implemented, we are still

in the process of fleshing that out. We have announced that we are

going to seek input from all constituencies including Congress, before proceeding to a rulemaking. We are going to be doing that partially through some round tables that are in the process of being

scheduled. After we get our input, we are going to determine the

particulars of a rule proposal which would go out for public comment and final implementation.

Mr. STEARNS. Okay. My time is expired, and we do have a vote,

but I think we have some more time so Mr. Towns is recognized

for his questions.

Mr. TOWNS. Thank you, Mr. Chairman. This Committee actually

promoted pay equity for the SEC. The President recently signed

this bill into law. However, no additional funds were included for

the SEC in the President’s budget. If the SEC’s funding is not enhanced, then why should we expect that a new accounting oversight board would have the resources to properly do its job? If we

put a board in place without additional resources, what have we

really accomplished? Mr. Herdman.

Mr. HERDMAN. Congressman Towns, you raise two very important points. We at the Commission very much look forward to—we

applaud Congress’ passing the pay parity legislation. We applaud

the President signing it. And we certainly hope that it gets funded

promptly.

The funding for the new regulatory board would not necessarily

come from the SEC. In fact, the way we have discussed it is coming

from the public sector broadly, not just the accounting profession

definitely, but from the public sector more broadly.

Mr. TOWNS. Well, I am a little concerned because I don’t want

you to get involved in fundraising and not doing your job. I mean,

that is my concern.

And let me just say also, Mr. Jenkins, that is the complaint we

get about you and your agency, the fact that you are so involved

in fundraising that sometimes your other responsibilities sort of all

through the cracks.

Let Mr. Herdman respond first, and then I will come to you.

Mr. HERDMAN. And I think I erred in my comment, it is not the

public sector, it is the private sector more broadly.

In terms of fundraising, you are entirely correct that a credible

and consistent and reliable system of funding these oversight activities needs to be developed just as it has been developed with respect to the FASB, and it needs to be money that is there year in

and year out to fund the important activities of these boards.

Mr. TOWNS. Now, let me say that the reason I am pushing this

issue is because it was also stated that the annual report of all Fortune 500 companies, that you also review them. I am just trying

to see where you are going to get the resources to do that, that is

my concern.

Mr. HERDMAN. We have the resources to review the financial

statements of the Fortune 500 companies. That project is beginning, and while that necessarily takes away from other activities,

39

we believe that it is an appropriate deployment of our resources to

review those financial statements.

Mr. TOWNS. I sure hope you can, but you have got to convince

me on that because you have more people than IRS in order to do

what you are saying. You would have to have as many.

Mr. HERDMAN. As Chairman Pitt indicated in his testimony last

week, the Commission is undertaking a review of the sufficiency of

its resources. When it makes a determination as to whether resources are sufficient, it will communicate that to Congress. If it

makes a determination that we need more resources, we will certainly be up here asking you for the money to provide those additional resources.

Mr. TOWNS. Mr. Jenkins?

Mr. JENKINS. Yes, thank you, Congressman Towns. The FASB

board members, the people who set the rules, we are prohibited by

our enabling legislation, by our enabling contracts, we are prohibited from fundraising. The fundraising takes place by an independent, largely public interest Board of Trustees that is over the

FASB itself. And that accounting foundation does three things—it

selects the board members, it raises the money, and it makes sure

that our due process is open and complete.

On the contrary, it is prohibited, again by our enabling documents, it is prohibited—the Trustees are—from getting involved in

technical accounting standard matters.

So, we have divorced fundraising from standard-setting in our

projects. So the Board members spend no time, nor do our staff

spend any time, on fundraising.

Mr. TOWNS. Thank you very much. I yield back, Mr. Chairman.

Mr. STEARNS. The gentleman yields back. I think we will take a

break here while we have a vote, and we will be back shortly. A

few members will be back immediately, so we will be able to continue.

The subcommittee will stand in recess.

[Brief recess.]

Mr. STEARNS. The Committee will come to order. I think in the

absence of a Republican member, Ms. DeGette, why don’t you start.

Ms. DEGETTE. Thank you, Mr. Chairman. Mr. Castellano, in your

testimony, you said that your organization was now willing to consider scope of services restrictions. What exactly did you mean by

that?

Mr. CASTELLANO. Congresswoman, what we have said is that the

accounting profession, the American Institute of CPAs, will not oppose restrictions on auditors of public companies performing internal audit outsourcing services or financial systems implementation

and design services for their publicly held clients.

Ms. DEGETTE. And previously you had opposed such restrictions.

Why was that?

Mr. CASTELLANO. This change in——

Ms. DEGETTE. Why did you oppose it previously?

Mr. CASTELLANO. Because we don’t believe even now in not opposing those restrictions today. We don’t believe that there is an

inherent conflict in auditors performing nonaudit services for their

clients, that there are safeguards that must be followed within our

40

code of ethics today, and if those safeguards are followed, the auditor’s judgment would not be impaired.

Ms. DEGETTE. Well, in your opinion, Mr. Castellano, were those

safeguards followed in Arthur Andersen’s representation of Enron?

Mr. CASTELLANO. I don’t know the details of Arthur Andersen’s

relationship with Enron.

Ms. DEGETTE. So, if you still think that there are safeguards,

why have you shifted your position that you are now not opposing

such restrictions? Is it a political decision?

Mr. CASTELLANO. No, not political. Thank you for the question.

Ms. DEGETTE. You are welcome.

Mr. CASTELLANO. We recognize that public perception is a critical

element in restoring public confidence to the capital market system

and in our profession, and that because of the debate that has gone

on about this issue of those two services going back to the prior

SEC administration’s rulemaking initiative in this matter, that has

raised the public’s interest, the public’s sensitivity to those. We recognize that. We know that we need to move on beyond this.

Ms. DEGETTE. So what you are saying is you don’t think there

is a problem, but you are shifting your position because of public

perception that there is a problem, correct?

Mr. CASTELLANO. Because it appears now that the public believes

there is a conflict in the appearance of independence of those two

services.

Ms. DEGETTE. But you don’t think there is, right?

Mr. CASTELLANO. We don’t think, with appropriate safeguards as

required by our code of ethics today—— Ms. DEGETTE. You think that the safeguards are in place now,

right?

Mr. CASTELLANO. I do believe that the safeguards are in place

now and they must be followed under our code of ethics.

Ms. DEGETTE. Thanks. Mr. Jenkins, I wanted to ask you a question about FASB because a couple of weeks ago, the Oversight and

Investigations Subcommittee had a hearing on Arthur Andersen’s

destruction of documents, and what we found when we looked at

Arthur Andersen’s client engagement information with Enron,

which is a long document, what we found is that while Arthur Andersen said Mr. Duncan willy nilly destroyed documents, in fact,

Arthur Andersen’s own client engagement said that the auditor is

required to destroy at the end of every engagement, all documents,

all work documents except for the final work product, and that only

in the instance where someone is served with a subpoena, either

civil or criminal summons, is document destruction to cease. Is that

consistent with FASB policy?

Mr. JENKINS. The FASB has no responsibility or authority over

that particular issue. That issue does not impact financial reporting. That is an auditing issue. Auditing is under the purview of the

AICPA through the Auditing Standards Board, as enforced by the

SEC. We don’t have anything to do in that area.

Ms. DEGETTE. That is what I thought, so let me ask Mr.

Castellano, is that kind of policy allowed under your organization’s

standards?

Mr. CASTELLANO. I think to a certain extent, it is a legal issue,

but we do have standards, auditing standards, covering documentaVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00044 Fmt 6633 Sfmt 6602 W:\DISC\77990 pfrm11 PsN: 77990
41

tion that, in general, require that the auditor maintain sufficient

and adequate documentation to support the procedures that were

performed and the level of review that was conducted on the procedure.

Ms. DEGETTE. Okay. Let me read you this policy and see if you

think it is standard in the—let me ask you, how long have you

been involved in the industry?

Mr. CASTELLANO. I have been a CPA for about 28 years.

Ms. DEGETTE. About 28 years. What Arthur Andersen’s policy

says is, ‘‘Drafts and preliminary versions of memos and reports, superseded workpapers, backup diskettes, and other types of information not in the central client engagement file should be destroyed

when they are no longer useful to the engagement, and no later

than when the engagement is completed.’’ Is that standard practice

in the industry?

Mr. CASTELLANO. That practice is not governed by our auditing

standards.

Ms. DEGETTE. Okay. Who governs that?

Mr. CASTELLANO. I think that is really a legal issue as to what

documentation must be retained.

Ms. DEGETTE. Is there some organization that would govern

what papers are destroyed by auditors, if you don’t do it and Mr.

Jenkins’ organization doesn’t do it? Mr. Herdman, does your organization cover that?

Mr. HERDMAN. No.

Ms. DEGETTE. Who regulates that?

Mr. CASTELLANO. As I said, there is an audit standard that requires documentation of the matters that I mentioned. Those matters do not include, I don’t believe, the items that you mentioned.

Ms. DEGETTE. I gotcha. Who is in charge of regulating what documents auditors keep or destroy? Does anybody regulate that?

Mr. CASTELLANO. I don’t believe so.

Ms. DEGETTE. Thank you.

Mr. STEARNS. I thank the gentlelady. The gentleman from Nebraska is recognized for questions.

Mr. TERRY. Thank you, Mr. Chairman. I have two questions. My

first, Mr. Jenkins, if you could help me. I need to tie down the

cause-and-effect to make sure that the policy that we embrace here

can actually help fix the problem and instill the confidence back

into the capital markets and investors, so help me.

On page 23 of your testimony, you note—here is the way I am

going to frame your question—that in 1997, Enron indicated—in

1997 it had overstated its income, net income, by $96 million, and

then every year that was compounded to some extent, but yet it

wasn’t until 2001, mid to late 2001, that anyone became aware of

these problems.

So, as a layman, help me understand which of your suggestions

for changes that transparency in a variety of areas will help shine

the light as quickly as possible. Through the changes that you suggest, would somebody have caught in 1997 that Enron had overstated its net income by $96 million? Why did it take 5 years?

Mr. JENKINS. We don’t know why Enron didn’t follow generally

accepted accounting principles in 1997 and other years, apparently.

We don’t know what caused them to do that.

42

What do know from the public record is that they didn’t follow

now existing generally accepted accounting principles. So, we

wouldn’t need to make any changes apparently in our existing requirements in order to have had that result in 1997 had Enron followed our rules. What we are trying to do is to further improve

those rules for the future.

Mr. TERRY. But that doesn’t answer the question. What policy—

what can we adopt if there is a company like Enron or Global

Crossing who wants to manipulate the system? How do we catch

that? If this started in 1997, what policy can you suggest to us that

in that same year that this type of shenanigans is undertaken, that

it can be discovered?

Mr. JENKINS. Well, again, I am not trying to avoid your question

at all, on the contrary. But until we know why they didn’t follow

the rules, it is a little hard to address how we might correct it.

Mr. TERRY. Well, let us just say they did want to and we will

make that assumption and go forward. They were intentionally

being deceptive perhaps.

Mr. JENKINS. Then it seems to me that it gets over to a question

of the responsibilities of top management, the responsibilities of

the audit committee, the responsibilities of the auditors, and that

that is accepting at face value that Enron said they didn’t follow,

as they stated in 2001, they didn’t follow existing standards, I

think that is where that trail has to lead.

Mr. TERRY. All right. Then, Mr. Castellano, then maybe your

suggestion that we somehow criminalize lying to your auditor as a

solution, explain how that will work, and then I want to come back

to Mr. Herdman and ask if that is appropriate, to criminalize providing false information to your auditor. In fact, isn’t it already—

aren’t there already laws in place? In essence, what you are trying

to do is deceive your shareholder and using your auditor as the

conduit in which to deceive.

So, Mr. Castellano, if you would expand on why we should criminalize and if you think it will be effective, and then, Mr. Herdman,

if you could follow up and answer the same questions.

Mr. CASTELLANO. Well, let me first say that as I said in my oral

testimony that I don’t believe any changes in the reporting model

are going to protect investors from greed and bad judgment. I

mean, that starts with the entity itself. They have to have the right

tone at the top, and the right system of corporate governance from

the Board of Directors, the Audit Committee, the senior investors

in the company. That is where it starts.

Auditors need protection along the lines that I described, so that

those who may be so inclined to withhold material information

from an auditor, is that a violation of securities law? I don’t know,

I am not an attorney. Lying to an auditor, is that a violation of securities law? I don’t know. Perhaps we need clarification. We are

raising the issue because we think this net of scrutiny here, that

it is appropriately being cast, needs to be cast far and wide, and

all need to do a very thorough self-review.

Mr. HERDMAN. Under Section 13 of the 1934 Act, lying to the

auditor is already forbidden. And I believe I have the citation—correct me—under Section 20(c) of that Act, we believe that through

43

the operation of that section it would be a criminal violation of the

law.

Mr. TERRY. Thank you, Mr. Chairman.

Mr. STEARNS. Thank the gentleman. The gentleman from Illinois,

Mr. Rush.

Mr. RUSH. Thank you, Mr. Chairman. I want to thank the chairman, and I also want to thank the witnesses for being present this

morning.

Mr. Herdman, the SEC has the primary responsibility for enforcing FASB’s accounting standards. That is correct, is that right?

Mr. HERDMAN. The SEC has the primary responsibility for oversight of the entire disclosure system.

Mr. RUSH. Well, I want to return to Mr. Towns’ line of questioning. Until the capital markets relief act is fully funded, the

SEC would find it hard to retain and attract high quality staff as

well as meet its current staggering workloads. Now, how does the

SEC intend to return investor confidence if it is unable to provide

pay parity for the very people responsible for protecting those investors? How can SEC fulfill its responsibility to the American public if you have a disparity and you lack pay parity among your employees?

Mr. HERDMAN. Congressman, as I said earlier, we believe that

the pay parity issue is very important to the Commission’s ability

to attract and retain the high caliber people necessary to fulfill our

role. However, if we don’t get it, I would have to say we will just

have to continue to muddle through as we have in the past.

Mr. RUSH. What type of initiatives are you approaching in terms

of trying to get the money to pay your people a decent wage over

there?

Mr. HERDMAN. I am sure that our Chairman is doing everything

that he can with respect to that.

Mr. RUSH. Let me ask you, can you describe what your agency

did to ensure the Enron and others were or are following the accounting principles regarding SPEs and mark-to-market accounting?

Mr. HERDMAN. I believe this Committee is aware of the fact that

we did review Enron’s financial statements for its year ended December 31, 1997, and included in that review process we took a

look at their quarterly reports that had been filed up through

March 1999.

Mr. RUSH. So you haven’t looked at them since 1997, is that

what you are saying?

Mr. HERDMAN. We haven’t looked at any annual financial statements since 1997.

Mr. RUSH. What is the reason for that?

Mr. HERDMAN. Well, I think the Commission staff, in its review

of filings, uses what is referred to as a ‘‘selective’’ process for picking which filings will be reviewed, with the goal of reviewing each

company’s filings no less frequently than once every 3 years. As I

understand it, when Enron’s turn came up for review earlier in

2001, which was prior to my return to the Commission, Congressman, it was decided to wait to conduct that review in 2002 because

of the fact that our new accounting rules went into place in early

2001 concerning derivative financial instruments. It was known

44

that Enron engaged in a lot of derivative financial instruments,

and it was felt—and it was a very principal decision—that it would

be more productive to review Enron in 2002 when the financial

statements for the first time then would reflect these new accounting requirements.

Mr. RUSH. So your decision was based primarily on the fact that

there were new requirements that you were enforcing, and it

wasn’t based on any kind of funding issues, just primarily based

on changes in terms of your procedures?

Mr. HERDMAN. That is my understanding, yes.

Mr. RUSH. Okay. So, in other words, you have reviewed corporate

accounting work products as it relates to your regulations for other

corporations since 1997, is that correct?

Mr. HERDMAN. Yes, we have.

Mr. RUSH. Have you found any accounting irregularities similar

to the ones at Enron pervasive throughout the economy, or should

this committee—is there a red flag that should be waved as relates

to other corporations in terms of their accounting procedures at

other corporations?

Mr. HERDMAN. We have, in our review process, found instances

where we disagreed with a company’s interpretation of the accounting rules or other requirements, and have required restatement or

amendment to filings with respect to that. I am not familiar with

any situations—— Mr. RUSH. Does the SEC view the accounting climate in terms

of corporate America as being a situation of crises at this point?

Mr. HERDMAN. I wouldn’t say, Congressman, we see it as a crisis.

I don’t know of any other Enron-type situations that are out there,

but we certainly are not going to just hope that that is the case.

We initiated just yesterday announcements about new rulemaking

activities that we are entering into. That is just the start of our activities with respect to it. In the wake of Enron, everything is on

the table. There is nothing that is off the table. We are fundamentally relooking at all of our requirements in order to make sure

that investors are adequately protected.

Mr. RUSH. Mr. Herdman, my view of the SEC—and maybe it is

correct or maybe it is not correct—but I certainly would like the

SEC be a lean, mean, fighting machine as it relates to protecting

the investors and the investors’ interest in this country, and I certainly think that we all must do all that we can to ensure that the

employees that we have to count on to protect our investing public,

that those employees are paid adequately so that they will be able

to do their job and so that we will be able to retain those employees.

With that, Mr. Chairman, I yield back the balance of my time.

Mr. STEARNS. The gentleman yields back.

Mr. TOWNS. Mr. Chairman, may I ask a question?

Mr. STEARNS. Sure.

Mr. TOWNS. Are you going to have another round?

Mr. STEARNS. I think we will have another short round. The gentleman from Illinois, Mr. Shimkus. Excuse me, Mr. Shimkus,I am

sorry. Mr. Buyer.

Mr. BUYER. Thank you, Mr. Chairman. King Solomon said long

ago that there is nothing new under the sun. And so I took a little

45

look at history here. To be a good listener to all of you—and it is

not just about you and how you react to this, it is different institutions will react to something. Immediately, you circle the wagons.

You begin your introspection. You examine yourself. Sometimes

you are hard on yourself, sometimes you are not. Sometimes you

say—and I will use your quote—‘‘our basic model is sound,’’ which

means you like yourself, but you are willing to do a self-examination. You throw out some recommendations. But, you know, you

have been here before.

So, as I was looking and reading about the Treadway Commission, I look at this and say, well, what we are all having to deal

with is confidence in the markets, the integrity of your systems,

you are self-regulated in your profession as CPAs. You are well respected in my hometown, and I would hate to see anything erode

that respect that the CPAs have in my hometown.

So, when I looked at the milestone in shenanigan prevention that

the Treadway Commission did—see, all of you came together back

in 1985 to do this, and you financed it. You did it. Government

didn’t do it. You said, ‘‘If we are going to be self-regulated out

there, we are also going to lean forward,’’ and there are oftentimes

you get blown back on your heels, and that is what has happened

here, I think. You have been blown back on your heels. And when

I read the conclusions and recommendations of the Treadway Commission, it almost sounds like everything that is applicable to

today.

And so when I went over here to the SEC, the SEC should have

the authority to impose fines in an administrative proceeding, seek

fines directly from court, authority to issue cease and desist orders

when securities laws are violated—it goes on and on—criminal

prosecution, fraudulent financial reporting cases—why do fines become the exception and not the rule? Why are you so hesitant? I

don’t understand.

If the academic community and all of you embraced the

Treadway Commission’s findings, you get out there, you try to

teach the students, the academic curricula embraces it, and we are

trying to do the teaching, some things still failed. If we try to set

the proper tone for top management and directors, some things

failed. With regard to independent public accounting and auditors

having responsibility for the detection of fraudulent financial reports, some things failed.

So, I almost have to pause here, gentlemen, and I want to have

a constructive dialog with you. If you lean forward to prevent shenanigans—and King Solomon is right, you know, we can set the

rules in place, we can do everything we can, but that is why we

still have a criminal code. But I don’t want to lose sight of the ball

here. The ball is making sure that that marketplace—that there is

integrity and there is confidence out there, and that there is enforcement with teeth.

So, here is my ultimate question. Are we at a point where instead of every entity out there saying ‘‘circle the wagons,’’ introspection, and then say, ‘‘well, here are some recommendations we

have,’’ and that Enron isn’t the—don’t cast the Enron shadow on

everyone, and that is sort of the fear in the marketplace.

46

Are we at a time where perhaps all of you should come together

once again on Round 2 of your National Commission, examining

Treadway and—I mean, we have got to have a single entity, you

know what I am saying? Congress is out here. We are doing all our

hearings. Each of you are doing it. I don’t want government-fund

a national commission that does this. Do we need now a second

sort of Treadway Commission that sort of brings all this together,

and that is what I throw on the table. I welcome your comments.

Mr. HERDMAN. Congressman, I would say at this point that we

believe that that is the role that the SEC should be fulfilling. We

have started a number of initiatives. We have asked the stock exchanges to once again consider the governance provisions related to

public companies, and they have set up a committee that will start

to do that. We have encouraged the Financial Executives Institute

to take a hard look at their code of conduct and to reinforce it in

the wake of recent events. We are working with the FASB. We are

working to re-establish the regulation of the auditing profession.

We last week announced new protocols and agreements with the

exchanges and with the brokerage firms with respect to the analyst

community. We are working on a number of fronts, and believe

that we are covering all the bases and that everyone right now is

engaged, I believe, in very critical introspection with respect to

what needs to be done in the wake of these events, and that is productive and that is appropriate.

Mr. JENKINS. The issue of the Treadway Commission which really does, as Mr. Herdman suggested, relate to corporate governance

issues, is an important one. The tone at the top, which I think is

the basic theme of Treadway, I think is essential and we, at the

FASB, are going to try to issue financial reporting standards that

are more principle-based rather than detailed rule-based in the

hopes that we can do away with the attitude of some in the corporate arena, and some perhaps in the auditing arena, that apply

the rules on the basis of ‘‘where does it say I can’t do that’’ rather

than on the basis of the clear intent of the rule and the clear representation of the underlying economic events.

If we move in that direction, which we are being encouraged

strongly to do, and would like to do because I think it would also

expedite our process, then having the proper tone at the top, to

summarize in one phrase the Treadway report, will become even

more essential.

Mr. CASTELLANO. The American Institute of CPAs is absolutely

committed to meaningful reform. The Treadway Commission was

sponsored by COSO, the Committee on Sponsoring Organizations,

which is a group that includes the American Institute of CPAs,

FEI, the American Accounting Association, Institute of Management Accountants, and the Institute of Internal Auditors. COSO

still exists. COSO continues to work and to meet. In fact, I understand there is a meeting February 19th where they are addressing

enterprise risk management.

So, I would expect that through our participation and support of

COSO that we will continue to work toward meaningful reform

along the lines that you suggest, Congressman.

Mr. BUYER. Thank you, Mr. Chairman.

47

Mr. STEARNS. Thank the gentleman. The gentleman from Massachusetts, Mr. Markey.

Mr. MARKEY. Thank you, Mr. Chairman, very much. My brother

Johnny was a 1969 Magna Cum Laude graduate of Boston College,

majoring in finance. I said to my brother at the time, asking wisdom from a 21-year-old, ‘‘Why are you a finance major, Johnny,

why weren’t you an accounting major?’’ And he said, ‘‘Well, Eddie,

the finance majors play the game and the accountants keep score.

I want to play the game.’’ Well, about 10 years later, the accountants said to themselves, ‘‘Why don’t we play the game and keep

score at the same time inside of corporations.’’ And, of course, that

is the underlying pathology here in the accounting industry, that

they believe that they could play both roles at the same time. You

can’t do it. It is an inherent conflict of interest.

Now, we are having this hearing, Mr. Chairman, in the Armed

Services Committee room, and I look at this painting at the back

of the room, and I think it is symbolic of why we are here because

I see that painting characterizing investors trying to fight their

way out of a jungle of misleading documents and fraudulent accounting statements, left to fight their own way out without any

help from the accounting industry or the Securities and Exchange

Commission in protecting their 401(k) plans, protecting their investments for their families because they weren’t given the proper

information, they were just dropped into a jungle that was rough

and tough but misled in terms of how many protections were being

given to them.

So the question now is, what are we going to do to protect these

people? Mr. Castellano, I understand that Chairman Pitt was an

attorney for the AICPA, for the accountants, and the Big Five accounting firms prior to being appointed as the Chairman of the Securities and Exchange Commission, now the public’s Number One

protector against the accounting industry’s abuses.

What were Mr. Pitt’s duties for the accounting industry when he

was your attorney?

Mr. CASTELLANO. Congressman, I wasn’t involved at the time

Mr. Pitt was serving as attorney for the American Institute of

CPAs, so I can’t specifically answer your question, but I will be

happy to get back to you with a response on that.

Mr. MARKEY. So you have no idea what he did for AICPA, is that

what you are telling us today?

Mr. CASTELLANO. I don’t know the details of what he did. I know

that he had worked at the time of the formation of the Independent

Standards Board, I believe, in some of the work in the creation of

the Independent Standards Board, but I don’t know the specifics of

what his services were.

Mr. MARKEY. Well, how much did AICPA pay the new Chairman

of the Securities and Exchange Commission at the point at which

he was working for the accountants?

Mr. CASTELLANO. I have no idea, Congressman, but we can get

that for you.

Mr. MARKEY. Did the AICPA, did the accountants recommend

Mr. Pitt to the White House when the White House was considering who to appoint as the new head of the Securities and Exchange Commission?

48

Mr. CASTELLANO. I am not aware that the American Institute of

CPAs recommended Mr. Pitt to the White House.

Mr. MARKEY. So you are saying that you did not endorse his candidacy?

Mr. CASTELLANO. I am not aware that the AICPA recommended

the chairman—— Mr. MARKEY. Aha, so they did not recommend him.

Mr. CASTELLANO. Not to my knowledge.

Mr. MARKEY. But you don’t know that they didn’t, is that what

you are saying?

Mr. CASTELLANO. To my knowledge, we did not, but I—to my

knowledge, we did not. I believe I have answered.

Mr. MARKEY. So AICPA never wrote any letters to the White

House, or call anyone at the White House, or meet with anyone at

the White House to discuss Mr. Pitt’s appointment?

Mr. CASTELLANO. My advisor tells me that we did not, and we

were not consulted.

Mr. MARKEY. Okay. Now, how many times has the AICPA met

with Mr. Pitt since he has been at the Securities and Exchange

Commission?

Mr. CASTELLANO. There have been a number of meetings, I don’t

know how many. We have stated very clearly that we are very interested in supporting the Commission’s recommendations to move

from self-regulation to public regulation, from public oversight to

public participation in the areas of discipline in what was formerly

called ‘‘peer’’ review, but will probably have another name under

the SEC’s new structure. So there have been a number of meetings,

I don’t know how many, where we have been asked to work with

and support the Commission in their proposal for moving from selfregulation to public regulation of our profession.

Mr. MARKEY. Can you provide for the record each meeting that

you have had so far with the new Chairman of the Securities and

Exchange Commission?

Mr. CASTELLANO. I believe we can, certainly.

Mr. MARKEY. Now, I understand that Mr. Paul Atkins and Ms.

Cynthia Glassman are also alumni of two large accounting firms,

and that they are both under consideration to become Commissioners at the Securities and Exchange Commission, is that correct?

Mr. CASTELLANO. As I understand, that is correct, yes, sir.

Mr. MARKEY. So, if those two accountants, combined with Mr.

Pitt, are at the Securities and Exchange Commission, and there are

only five members, that would mean three out of the five members

of the Securities and Exchange Commission would then be alumni

of the accounting industry at the point at which there is the greatest crisis in the history of the accounting industry, would that be

correct?

Mr. CASTELLANO. Well, Mr. Pitt is not an alumni of the accounting profession, but he has performed services, as you said.

Mr. MARKEY. He was your lawyer.

Mr. CASTELLANO. He has done work for the accounting profession, but he has never been a practicing member of the profession.

Mr. MARKEY. But he was the lawyer for your profession, for the

AICPA, was he not?

49

Mr. CASTELLANO. Yes. I just want to be clear that in my view,

in my understanding, alumni means someone who is part of the

profession itself. I am not familiar with the background of the other

two Commissioners who have been recommended, although I do

understand that they do come from accounting firms in some capacity.

Mr. MARKEY. Well, I guess what I am saying is, with your former

lawyer and two former accountants comprising three of the five

votes at the Securities and Exchange Commission, it puts the accounting industry in the catbird seat.

May I continue for 1 additional minute, Mr. Chairman?

Mr. STEARNS. Unanimous consent, so ordered.

Mr. MARKEY. Mr. Herdman, where did you work before you went

to the SEC?

Mr. HERDMAN. I worked at Ernst and Young.

Mr. MARKEY. Mr. Herdman, I have heard concerns raised that

one of the first acts taken by Chairman Pitt when he took office

was to remove the top accountant in the Corporation Finance Division and announce to the Securities and Exchange Commission

that they would now have a ‘‘kinder and gentler’’ Securities and

Exchange Commission that wouldn’t force companies to restate

earnings.

I have also heard that the number of accounting slots at the Corporation Finance Division is being slashed in the SEC’s budget request. How do you, as the Chief Accountant now at the SEC, respond to those concerns?

Mr. HERDMAN. I respond that you have been misinformed. The

Chief Accountant of the Division of Corporation Finance resigned

that position. As to the question of whether the number of accounting slots in the division has been cut, that is not consistent with

what I believe to be the case.

Mr. MARKEY. You are saying there is not going to be a reduction

in slots at the SEC Accounting Division?

Mr. HERDMAN. That is my understanding.

Mr. MARKEY. Will you submit that to the committee because that

is completely at-odds with what we are being told.

I think, Mr. Chairman, if I may, that there is a problem at the

Securities and Exchange Commission at this point in time. When

it comes to giving confidence to the capital formation process in

this country, that the reforms are going to be put in place which

are going to give to every ordinary family, every investor, the real

confidence that the numbers are real, that there is some reason to

trust the stock market.

Now, I know Mr. Pitt is saying that he is going to recuse himself

from any enforcement action against any particular company or individual, but he is not going to recuse himself from the rulemaking

process in terms of putting on the books for the next generation,

the rules that are going to give every family—and let us not kid

ourselves, every single family that was in mutual funds over the

last 10 years probably had Enron stock, or the stock of some of

these other companies that had phony numbers.

And so I think we have really got a huge question that we have

got to ask because we are not talking just about the reality, we are

also talking about the perception because confidence is the key to

50

investment in the stock market. And if we don’t have a public that

believes that the people who have this responsibility are independent enough from those who are seeking to not put the toughest

rules on the books to protect the investor, then I am afraid that

we might not see the investment in the stock market in the next

generation that will create the jobs that will make our country as

prosperous as it should be.

Mr. STEARNS. Thank the gentleman. The gentleman from New

Hampshire, Mr. Bass.

Mr. BASS. Thank you, Mr. Chairman. I have some reservations

about my friend from Massachusetts’ very eloquent remarks. Having accountants on the SEC certainly might be cause for concern,

but accounting is not a simple craft, and it might not hurt to have

people who understand the industry, understanding that they have

no ethical conflicts of interest, might not be a bad way to deal with

the question of where we go. After all, President Eisenhower was

the head of NATO and was an important military officer in American history, and yet he did more to cut and carve and make the

U.S. military more efficient as President, even though some

thought he might have a conflict of interest there.

A couple quick items. I think perhaps we should, in light of what

my friend has said prior to me, have a look at the other picture

on the wall over here. Perhaps there are some issues that we can

draw allusion to here. We have those contrails up in the high atmosphere, the business community moving forward, and the accounting industry not quite knowing how to catch up with the businesses because the businesses have so much more money than they

do, and they are uncertain in this day and age. There is a lot of

interesting artwork in this room that really does have some bearing on the hearing that we are having this morning.

Mr. MARKEY. Can I say, I see that as Enron carpetbombing the

investors of their company all throughout the year 2001 without

any——

Mr. BASS. Touche. Mr. Herdman, I heard you say something at

the end of I think it was Mr. Buyer’s questioning, and you said,

‘‘There are no other Enron-type situations out there’’—I am quoting

you now. Is that true?

Mr. HERDMAN. I believe I said, Congressman, that I am not

aware of any Enron-types of situations that are out there. I certainly am not going to say that there are no other Enron situations

out there.

Mr. BASS. How do you define an Enron-type situation?

Mr. HERDMAN. Well, I would define it as a huge, huge company

that within a matter of months, a very short period of time, goes

from being a high-flier to being bankrupt.

Mr. BASS. And just one more time just to confirm it, you are the

Chief Accountant for the SEC, you are not aware of any other

Enron-type situation, as you defined it, out there?

Mr. HERDMAN. That is correct.

Mr. BASS. Thank you very much. What a difference a couple of

years makes. I wonder what the subject of this hearing, the tone

and tenor of this hearing might have been 2 years ago. As I recall,

the debate was quite different, how to state the real value of

dot.coms and so forth—we discussed this—but how it has changed

51

in the last couple of years. Third, I am surprised at the disparity

between the amount of resources that the regulators have versus

those which are available to the people whom you regulate. I would

guess, I will make this up, that the top Fortune 500 companies

probably spend about average—I will be conservative—$10 million

apiece on accounting each year. If you add that up, it comes to

about $100 million—no—$100 billion, and you guys have a budget of what, about $250 or $270 million?

Mr. HERDMAN. I believe it is just below $500 million.

Mr. BASS. So there is a discrepancy here. My friend, Mr. Towns,

and others on the committee need—I think we need to examine

that issue.

The last issue or open-end question I want to ask is, we are not

the only country that regulates accounting practices and financial

information. Are there any other models in any other countries, industrialized countries around the world, that we might look at as

a guide to figure out what works better and what doesn’t work so

well versus the system that we have here in this country. Can any

of the three of you address that, do you have any knowledge?

Mr. HERDMAN. I think that it is safe to say that there is no other

country in the world that has anything that approaches the SEC

in terms of its oversight of the markets, oversight of the preparer,

the registrants and the auditors. It just doesn’t exist.

One thing that we are looking at is a fairly recent form of regulation adopted in the United Kingdom with respect to auditors, and

we think that there are some valuable lessons to be learned from

that.

Mr. BASS. What are they?

Mr. JENKINS. There are a lot of different kinds of regimes around

the world. Up until quite recently, most of the regimes that were

involved with accounting and financial reporting were directly a

part of the government of those countries. But, interestingly, the

trend is significantly moving toward private sector standard setting

for the setting of accounting standards—maybe not for the regulation of auditors or scope of services or tax services. But for accounting standards setting, for example, Germany has moved to a private sector standard setter, Australia somewhat the same way,

New Zealand, and other Anglo-Saxon countries. In particular,

Japan has recently established a private sector accounting standards setter in an effort to overcome their very significant capital

market issues.

Mr. BASS. Mr. Castellano, do you have anything to add?

Mr. CASTELLANO. Just to say that the American Institute of

CPAs is a member of the International Federation of Accountants,

IFAC. We participate actively in that international organization of

accountancy organizations, and we are looking at all different models to see if we can learn something.

Mr. BASS. Mr. Chairman, my time is expired. I would like at

some point in the future if Mr. Herdman could tell us what lessons

we may have learned—the very last phrase of your answer to the

question—I would be interested in knowing that.

Mr. STEARNS. Can you answer that question quickly?

Mr. HERDMAN. I think the predominant one concerns regulation

of the auditing profession, and that the oversight body and the varVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00055 Fmt 6633 Sfmt 6602 W:\DISC\77990 pfrm11 PsN: 77990
52

ious committees that carry out the regulation should be dominated

by members representing the public interest as opposed to those

representing the profession.

Mr. BASS. Interesting. Thank you very much.

Mr. STEARNS. I thank the gentleman. The gentleman from Illinois, Mr. Shimkus, is recognized for questions.

Mr. SHIMKUS. Thank you, Mr. Chairman. I, too, as an Army officer, really enjoy being in this room, although we are much more

constrained than if we had full access to our regular committee

room.

Bill Gates loses $1 billion in the tech crash—we call it—‘‘paper

loss.’’ Investors in Enron, who saw their portfolio balloon from $15

a share to $90 over a 2-year period, and we forget that a lot of that

is what we cavalierly say is a ‘‘paper loss.’’ And I am really interested in this period of time from January 2000 to January 2001 because we have a price increase from approximately $37 a share to

a high of $90 a share, and then by the end of the year it is back

to—well, at the end of the year it is at $80 a share, and then because of a lot of things it then falls off the chart.

Three things that I have been looking at—and I am not on the

Oversight Subcommittee, so I am not delving into all the issues—

but I want to know just three things, or just get some help in educating myself.

First of all, I don’t know how you could work in America auditing

major corporations and not be a member of a big accounting firm,

there are five. If you are in the business of accounting large entities, you are a member or employed by one of the major accounting

firms, that is just a reality.

But three things—and we will just go Mr. Herdman, Mr. Jenkins, Mr. Castellano—and maybe you can answer these, maybe not,

the problem of special purpose entities, a solution; the problem of

the employee stock option rollout issues, a possible solution; the

problem with performance statements—and you may not think

there is a problem with performance statements—a possible solution.

Mr. HERDMAN. I am not sure I understood your third point, Congressman.

Mr. SHIMKUS. Performance statements, you know, those statements which some people would say is ‘‘corporate spin’’ to explain

their balance sheets and all the other hard data that is out there.

I have my MBA, but I will never say I—some people will say it is

credible, it helps. Some people say it is spin. And it hides and deceives.

Mr. HERDMAN. I believe what you are referring to are earnings

press releases that present the results of operations on an alternative basis, an alternative of GAAP sometimes known as ‘‘pro

forma.’’

Mr. SHIMKUS. Right.

Mr. HERDMAN. Fine. I will start with the SPEs. I think, as I said

earlier, we definitely need to have more comprehensive rules about

when SPEs should be consolidated with the sponsoring entity, and

we need to have those done very, very quickly so that they are in

place for year 2002 financial reporting.

53

Mr. JENKINS. If you want to take each of these issues one at a

time, that is fine.

Mr. SHIMKUS. Yes, that would be great. Mr. Jenkins, why don’t

you follow on.

Mr. JENKINS. Well, as I told this committee briefly earlier this

morning, we at the FASB have been working on providing improved guidance with respect to special purpose entities. Yesterday,

at our public board meeting, we outlined and gained approval from

the Board of an approach that we think will significantly improve

that accounting, and our plan is to move rapidly to meet the goal

that Mr. Herdman described of existing standards being in place by

the end of this calendar year. And to that end, we are going to develop the full—we are going to develop a full document and have

a public discussion of it on the 27th of this month.

Mr. SHIMKUS. So you both agree it is a problem, and there is

movement to fix it. Mr. Castellano, on the special purpose entities?

Mr. CASTELLANO. Just to add to that, the AICPA in December,

I believe, asked that this issue arising from Enron be addressed,

and we are working with the FASB and absolutely support them

as a private sector standard setter to address this issue, and we

are delighted that it is being addressed. I am sure that they will

address the issue of better disclosures, the risk and uncertainties

involved in SPEs, and do so expeditiously.

Mr. SHIMKUS. Mr. Chairman, since my time is up, maybe they

can—if you want me to finish the question, I can. If you want them

to submit in writing, I will be willing to do that.

Mr. STEARNS. I think what we are going to do is have each member go around and ask one quick question, just take a second round

here quickly, and see if we can get through it.

Mr. SHIMKUS. So, would you want them to submit the other two

answers in writing, that is my question.

Mr. STEARNS. I think that would be a good idea.

Mr. SHIMKUS. If you would do that—— Mr. JENKINS. Could I ask just a point of clarification, please. On

the second issue, on employee——

Mr. SHIMKUS. I was basically referring to the employee stock option standard—consolidation in accounting and the standards that

apply to employee stock options.

Mr. JENKINS. Employee stock options, not 401(k) plans. Thank

you.

Mr. STEARNS. I think we are going to have a couple of votes here.

I think we will just each ask one quick question and start the second panel.

The question I have for Mr. Herdman is, in your testimony you

suggested that if the FASB is not able to make progress on important issues as they arise, the SEC should take action. However, you

also stated that FASB was better able to set quality accounting

standards than the SEC. How do you reconcile those two statements?

Mr. HERDMAN. I think, Mr. Chairman, that the fact of the matter

is that FASB has more resources than we do. They are better able

to conduct research. They are better able to reach out to various

constituencies, and they have a lot more money. But if there are

situations where, because of their process, because of delays, we

54

find that an area desperately needs attention and isn’t receiving

that attention, then we are going to have to step up and do it.

Our solutions might often be more directed toward improved disclosure as opposed to improved underlying accounting principles

because the SEC’s expertise is much greater in the area of disclosure and the rulemaking processes that surround it.

Mr. STEARNS. Just for the record, Mr. Herdman, how long have

you been with the SEC in your present position?

Mr. HERDMAN. About 4 months.

Mr. STEARNS. Thank you. Mr. Towns?

Mr. TOWNS. Thank you, Mr. Chairman. Mr. Castellano, you

raised a question, or you made a statement that really, really I

would like for you to explain further. The statement was, ‘‘The

focus of auditors must now change.’’ What do you really mean by

that? That statement bothered me.

Mr. CASTELLANO. I am happy to clarify, Congressman. What I

was talking about is if we can look to the future, toward financial

reporting that will be more real-time, on-line reporting, that our

profession must be in position to provide assurance to investors

that the underlying systems providing that information are reliable. That is what I am talking about, that as financial reporting

evolves from periodic reporting, annual reports, quarterly reports,

looking back at what happened in the past, to a new model eventually that has more forward-looking information, information about

the real drivers of future success in enterprises, our profession has

to be poised with audit approaches, audit standards to provide assurance to investors that they can rely on that information and

that they can rely on the underlying system that is providing it.

That is what my point was.

Mr. TOWNS. So that would deal with documents as well?

Mr. CASTELLANO. May deal with documents, but I foresee an environment where auditors are expressing assurance on the system

that is providing the information. We have an assurance service

that we have invested a substantial amount of intellectual capital

to develop called ‘‘SysTrust,’’ which is available today, that boards

of directors and companies could take advantage of to employ the

accounting profession to provide assurance that their underlying

system is reliable, available when needed, and maintainable. It is

processes like that that we as a profession are thinking about investing in, so that when this business model evolves over time, we

are poised with a vibrant accounting profession to provide the kind

of assurance that investors will need.

Mr. TOWNS. Thank you. Thank you very much.

Mr. STEARNS. Mr. Bass has indicated he is going to take a pass.

Ms. DeGette. What we are trying to do is just one question before

we have our vote.

Ms. DEGETTE. Thank you, Mr. Chairman. My question for all

three panelists is this. Last week, in our full committee hearing,

we heard a proposal which was endorsed by several of our witnesses that outside auditors should be chosen on a rotating basis,

and one of our witnesses at least said that they should be chosen

on a rotating basis by the shareholders of the corporation. Arthur

Andersen made $52 million last year from Enron, and slightly

more from consulting and auditing, but a lot from both.

55

So, my question to all three of you is, what do you think about

the proposal to have the outside auditors rotate and, second, how

do you feel about having them chosen by the shareholders? If you

agree, why, and if you disagree, why?

Mr. HERDMAN. Congresswoman, those are among the issues that

we will be considering as we go forward with respect to what modifications to the independence rules are necessary. I have no present

opinion about them.

Ms. DEGETTE. Thank you.

Mr. BASS. If the gentlelady would yield, I was under the impression that shareholders do select the outside auditors. Is that true?

Mr. HERDMAN. Congressman, I believe it is generally a matter of

State law as to whether the shareholders are required to elect the

auditors, or are required to ratify the appointment of the auditors

by the board of directors.

Ms. DEGETTE. Reclaiming my time, what normally happens, at

least as I have been told, Mr. Bass, is that the auditing team is

selected by the management of the company, and sometimes ratified by the shareholders, and that there is no requirement that the

auditors rotate.

Mr. JENKINS. That question is outside the purview of financial

reporting standards, so I don’t have an opinion, as the Chairman

of the FASB.

Ms. DEGETTE. Mr. Castellano?

Mr. CASTELLANO. On the issue of mandatory rotation of auditors,

I think, is what you are asking. My concern with that really is impact on audit quality, and I think that is what we all want, is to

make sure that the quality of audits is the best that it can possibly

be. And this concept of rotating auditors raises a question in my

mind as to whether or not the loss of experience with the entity— these businesses are complex, as you know, they are incredibly

complex—and—— Ms. DEGETTE. So I guess you are saying you don’t agree with the

idea of rotating auditors?

Mr. CASTELLANO. I think we have to very seriously and carefully

consider such far-ranging proposals like that so that we don’t have

unintended consequences, which could include actually a deterioration of audit quality. That would be my concern.

Ms. DEGETTE. What about having the auditors chosen by the

shareholders, the second half of my question?

Mr. CASTELLANO. I don’t have an opinion about that.

Ms. DEGETTE. Mr. Chairman, let me just say—I know we are

about done with this panel—what I have heard is everybody saying

they are concerned about what happens, and they are looking at

it and they are thinking about it. I don’t hear anybody saying what

they want to do about it, or when they are going to figure it out.

I think we need to get some answers from the industry, so I would

hope that the gentlemen would take this very seriously, and I

would hope, Mr. Chairman, you would consider bringing these gentlemen back in a few months so they can tell us what, if anything,

they have decided to do.

Mr. STEARNS. That is a good idea. And I would point out also

that five former Chairmen of the Securities and Exchange Commission, when talking about the collapse of Enron, all expressed the

56

flaws in the present accounting system and financial reporting system, and they say, all five of them, we need major reform to restore

investor confidence.

The gentleman from Massachusetts.

Mr. MARKEY. Thank you, Mr. Chairman, very much. Mr.

Castellano, in the 1995 Private Securities Litigation Act which

AICPA lobbied powerfully to pass, there was a provision which limited the liability of the accounting industry, even if the accounting

company was also providing consulting services to a particular outside firm like Enron, so that subsequent to 1995 defrauded investors and employees of Enron public companies would not be able

to receive from Arthur Andersen the same level of damages that

they would have before 1995.

Now, in light of what happened with Enron, Mr. Castellano, my

question to you is, would you support restoring liability for accounting companies when they also provide consulting services to a company, so that the full joint and several liability would be available

to defrauded investors, rather than the much limited settlement

which they can receive today?

Mr. CASTELLANO. Congressman, I think the 1995 Act has accomplished just what Congress intended. I think it is working.

Mr. MARKEY. I am just talking about this one area where the accounting firm is a consultant—they are playing the game and keeping score at the same time inside of a firm—they are not just the

accounting firm, they are the accounting firm and the advisor, simultaneously.

Mr. CASTELLANO. There is a supposition that the accounting

firm’s independence is impaired in that statement, and I think that

I don’t agree that the accounting firm’s independence is always

impaired——

Mr. MARKEY. I think that is the most troubling statement I have

heard in the whole hearing, that he does not believe that when a

firm is an accountant and a consultant at the same time, that its

independence is impaired, Mr. Chairman.

Mr. CASTELLANO. I believe, as I have testified, Congressman,

that our code of ethics very clearly states that accountants must be

independent, and there are safeguards, checks-and-balances in our

code of ethics that we, as CPAs, must comply with to protect our—

to be sure that we are independent. And that includes not acting

in the capacity of management, not being in position to audit our

own work. Auditors can’t do that.

Mr. MARKEY. I think what we saw in this case, though, was that

the accountants were intimately involved in the Enron process, and

that it was impossible to separate out the auditing from the consulting services, and it has just become one huge kind of hot-tub

in which the Enron employees and the Arthur Andersen employees

were working together constructing a strategy for Enron, and yet

Arthur Andersen is not liable in a way that they would have been

before 1995 and, as a result, there is much more of an incentive

for this new accounting profession that wants to play the game as

well as keeping score to turn a blind eye to activities which then

led to serious damage to investors.

57

Mr. CASTELLANO. Congressman, as I understand the law, Arthur

Andersen, should they be found liable, will be subject to their proportionate share of the liability.

Mr. MARKEY. Right, proportionate, but not joint and several.

They were a part of the corporation. That is the problem, see. You

continue to maintain this distinction when consulting services are

provided. You can’t say that when a company is paid $25 million

for consulting services, that they are not inside the corporation creating a plan. That is not just keeping score. And anyone who is

making a plan for the company has joint and several liability, with

the exception now of the accountants who are supposed to be protecting the public.

So, you are saying you just will oppose any changes that ensure

that that protection is built-in for the investor?

Mr. CASTELLANO. Let me say that I don’t know what Arthur Andersen was going at Enron. I don’t believe that any of us know

quite yet. But to the issue of the 1995 Act, I just will reiterate I

believe it is accomplishing what was intended. The number of suits,

as I understand, have not declined, but those that essentially have

no merit are being dismissed, and those that do are proceeding——

Mr. MARKEY. This is not a question of how many suits are

brought, it is a question of who is liable when a suit is brought,

and the accountants, Arthur Andersen, is not liable in this case. Do

you understand that? I mean, that is——

Mr. CASTELLANO. But they are liable.

Mr. MARKEY. Not as a player. They are players. They are as

guilty in Enron in this case as the consultant, as the company that

helped put together the plan. They are not just keeping score.

Mr. STEARNS. Let me let the gentleman finish and just make a

comment. One, in your behalf, Mr. Castellano, do you realize that

the five top accounting firms have already voluntarily decided that

they are not going to—as we understand it—in the newspaper, they

have decided they are not going to do consulting and accounting together. Is that true?

Mr. CASTELLANO. Yes, Congressman, and I have said earlier in

my testimony that we do not oppose restrictions on auditors of public companies from providing——

Mr. STEARNS. You don’t oppose, but five top accounting firms

thought it is not good and they are not going to do it, which is in

line with Mr. Markey’s question, don’t you think that this is a conflict of interest?

Mr. CASTELLANO. As I said before, those two services, internal

audit outsourcing and financial statements system design and implementation, it is apparent that there is a perception that when

the auditor for a public company provides those same services,

there is a perception, the appearance of independence is impaired

and, for that reason, we don’t oppose those restrictions.

Mr. STEARNS. Okay.

Mr. MARKEY. If I may, so you are saying the five big companies

are separating now consulting from auditing, but it is only because

of this perception, in your mind, that there is a conflict? But in

your mind, there is no conflict. You continue to maintain there is

no conflict, is that correct, Mr. Castellano?

58

Mr. CASTELLANO. I maintain that as long as the safeguards are

followed, that auditors exercise their professional judgment and follow the safeguards, that there would be—there should be no independence impairment in fact, but there is apparent that there is

a conflict in appearance in these two services, and for that reason

we don’t oppose—— Mr. STEARNS. Mr. Castellano, you can make the argument that

you should have a consultant and accountant together when you

are acquiring other property. If I am going out to acquire a property and you are doing my books, I am going to need you to help

acquire that property. Also, if the IRS is coming in to audit me and

you are my accountant, I am going to need you as a consultant, too.

So, I think your argument could be that there are areas where

it is not a conflict and in fact it is necessary—I don’t know all those

are, those are just two I can think of, but across-the-board, over a

long period of time, is that a problem, if you keep the same accountant in the position as auditor and consultant for 10 years,

don’t you think somewhere in that range there should be maybe a

stop and we say at the end of 3 years you have got to change auditors, or at the end of five—don’t you see that that kind of relationship over 10 years gets to create ‘‘go along to get along?’’ Am I off?

Mr. CASTELLANO. Well, it shouldn’t, and that is where audit committees should be exercising their fiduciary responsibility to the

shareholders, to make sure that that doesn’t happen, Congressman.

I think there are instances where—— Mr. STEARNS. You need a consultant and an auditor.

Mr. CASTELLANO. There are certain nonaudit services that are

deeply rooted in accounting. We just have to be cautious about dismantling an entire structure that could create unintended consequences, and that is my caution.

Mr. STEARNS. Okay. Let me just also come to your defense a little bit, Mr. Markey, he’s talking about the Securities and Exchange

Reform Bill. What it did is you are still liable for civil and criminal

penalties, but you are only liable to the effect that your accounting

affected the loss. And what happens is, a lot of these lawsuits were

frivolous in the fact they went to the deepest pockets. So, Mr. Markey and I will disagree on the legislation’s intent, but from my

standpoint, you know, you are still, from a civil and criminal standpoint, liable, and you can be sued. And right now, suits are going

against Arthur Andersen as we speak, and there is a lot of them

building up. So, the bill didn’t stop it, it just tried to say the liability on these accounting firms should not go because of the deepest

pockets—they might be doing a small company—but they are there

to help the small company, and if they are sued they will pay according to their losses.

So, I think this has been a helpful exchange.

Mr. MARKEY. If I may, Mr. Chairman, just to follow up on what

you were saying, I think what Mr. Castellano is telling us is that

from now on none of the big firms are going to provide auditing

and consulting services to the same company, and they are just

going to do that voluntarily.

Mr. STEARNS. Mr. Castellano, is that true? I mean, that is what

I read in the paper. Is that true, to your understanding? You

should know more than I.

59

Mr. CASTELLANO. Well, I believe all have reported that they are

divesting themselves of their formal consulting businesses, but I

believe their statements have been that they are no longer going

to provide internal audit outsourcing services nor financial system

design and implementation services for the public company clients

that they audit.

Mr. MARKEY. Does that mean that they won’t be consultants any

longer?

Mr. CASTELLANO. I don’t know that that means that they won’t

be consultants any longer.

Mr. MARKEY. So they still retain the right to become consultants

and auditors for the same company, is that correct?

Mr. CASTELLANO. In certain instances, following the safeguards

that must be followed, I believe that is right.

Mr. MARKEY. There you go. So, if I may, you see, I am willing—

I think we are going to wind up—let me just say this——

Mr. STEARNS. We are going to complete this because you and I

have taken——

Mr. MARKEY. Can I tell you, there is kind of a first principle of

politics—always try to start out in the same place you are going

to wind up because it is prettier that way. Now, the accounting industry is going to wind up where—what this committee, I think,

is all saying—the industry should wind up, which is separating

consulting from auditing. You are saying, no, they are going to retain the right to do consulting. And what I am saying to you is,

the longer they do that, the more pressure is going to be applied

to the accounting industry to then accept the liability for that, the

responsibility for that, because they are still playing the game

while they keep score, and the Enron investors and employees are

going to stand in silent, though loud, testimony that that is not

right. We have got, I think, a very serious issue here that has been

raised.

Mr. STEARNS. And I encourage the gentleman, we are going to

have another hearing on this. With that, I would say to the first

panel, thank you very much, and appreciate your waiting through

our voting, and also I would say that all members can submit their

statements for the record as well as ask questions, which the panel

can answer.

Our second panel today is Grace Hinchman, Senior Vice President of Public Affairs, Financial Executives International; Mr.

Thomas J. Linsmeier, Associate Professor of Accounting and Information Systems, Eli Broad College of Business, Michigan State

University, and we were waiting for Sarah Teslik, Executive Director of the Council of Institutional Investors. We have called her numerous times this morning. She indicated to us that she accepted

our invitation. She was to be here, and for some reason, we have

not been able to get to her and for some reason she has decided

not to testify this morning, and obviously we are disappointed, but

we would like to welcome the two of you and thank you for your

patience for waiting, and at this point we would like to have your

opening statements.

60

STATEMENTS OF GRACE L. HINCHMAN, SENIOR VICE PRESIDENT FOR PUBLIC AFFAIRS, FINANCIAL EXECUTIVES

INTERNATIONAL; AND THOMAS J. LINSMEIER, ASSOCIATE

PROFESSOR OF ACCOUNTING AND INFORMATION SYSTEMS,

ELI BROAD COLLEGE OF BUSINESS, MICHIGAN STATE UNIVERSITY

Ms. HINCHMAN. Thank you, Mr. Chairman. Good morning, Mr.

Chairman, Mr. Towns, and members of the subcommittee. My

name is Grace Hinchman. I am Senior Vice President, Public Affairs, of the Financial Executives International, the leading professional association representing 15,000 CFOs, treasurers and controllers from corporations around the world.

The subcommittee has identified three areas where it believes

deficiencies in the present financial reporting model may exist.

They are consolidation rules, particularly as they relate to special

purpose entities, mark-to-market accounting practices, and related

party transactions. I would like to comment on two of those areas.

First, let me say that more consolidation does not automatically

yield better accounting. With the FASB consolidation project, FEI

has been recommending for some time that FASB drop the control

solution portion of this project and focus instead on the area of limited purpose entities, which includes the now infamous SPEs.

We made this recommendation not so much because we think the

existing rules are unclear, but because consolidation without control is quite simply an oxymoron. While FEI has long supported reexamination and rationalization of SPE consolidation rules, it is

not because of the cases like Enron, rather, members of FEI would

like to make sure that the information being presented is meaningful because SPE assets could threaten to introduce irrelevant information into the financial statements.

Another area of concern I would like to mention is related party

transactions. The GAAP disclosure rules regarding such arrangements are clear and have been in place for more than 20 years. In

addition, the SEC’s proxy rules require a very thorough analysis to

be presented to shareholders.

In looking at existing arrangements, FEI is unable to suggest

any meaningful improvements that would better protect investors

beyond those already recommended by the SEC in its Financial Reporting Release 61.

There remains a more fundamental concern of accounting standards and the challenges that face this subcommittee. The broad

body of literature that we call ‘‘generally accepted accounting principles’’ has evolved into a puzzle palace of complexity. The days of

the onsite audit team being capable of fielding the majority of accounting questions that arise at corporations have long since

passed, standards are so complex today that finance executives, out

of necessity, are moving into a brave new world of accounting specialization.

One has to question whether anything of value, especially accounting information, should become so complex that it defies the

ability of even the most diligent investor to understand. A cry for

relief was voiced last year by the finance community and FASB

heard the plea. They have embarked on a project that will address

accounting simplification, but FASB has its work cut out for it.

61

As we begin this effort, we must be careful in the identification

of the root causes and distinguish the problems that arise from

fraud and misapplication of the rules from those problems which

arise from the rules themselves.

That concludes my prepared remarks. I would like to thank the

chairman for allowing FEI the opportunity to testify.

[The prepared statement of Grace L. Hinchman follows:]

PREPARED STATEMENT OF GRACE L. HINCHMAN, SENIOR VICE PRESIDENT-PUBLIC

AFFAIRS, FINANCIAL EXECUTIVES INTERNATIONAL

My name is Grace Hinchman. I am Senior Vice President, Public Affairs of Financial Executives International (FEI). FEI is the leading advocate for the views of corporate financial management, representing 15,000 CFOs, treasurers and controllers

from companies throughout the United States and Canada.

The Committee has identified three key areas where they believe deficiencies in

the present model may exist: consolidation rules, particularly as it relates to Special

Purpose Entities (SPE’s), mark to market accounting practices, and related party

transactions. In FEI’s view, these are only symptoms, however, of the problems confronted by a profession that is in crisis.

CONSOLIDATION RULES

FASB split its consolidation project into two parts this past year: one dealing with

the control situations and another dealing with limited purpose entities, which includes SPE’s as well as other, less well-defined entities. For its part, FEI has been

recommending that the first approach be dropped and examination be directed to

the latter area, although putting all SPE’s into sponsor’s financial statements does

not necessarily improve the clarity of financial reporting. We have made this recommendation, not so much because we think the existing rules are unclear, although they are in some respects, but because consolidation without control is quite

contrary to our consolidation model. Even in the present framework, it would be

helpful for the FASB to referee priorities between the existing rules.

While FEI has long supported reexamination and rationalization of SPE consolidation rules, it is not because of cases like Enron, which we believe the existing

rules address cleanly. Rather, we would like to make sure that the information we

are presenting is meaningful, and SPE assets threaten to introduce irrelevant clutter in the financial statements.

MARK TO MARKET ACCOUNTING

A second area of concern raised by the Committee concerns mark-to-market accounting. As you are aware, Enron was applying guidance for energy trading activities that was approved by the FASB’ Emerging Issues Task Force (EITF Issue 98-

10). That issue permitted energy trading operations to mark to market through

earnings all of its derivative contracts. Questions have been posed by analysts and

journalists about the propriety of methodologies underlying the valuations of these

energy contracts. FEI members do have experience with fair values of non-traded

instruments. We must report annually such fair values related to finance receivables that are not traded. FEI’s experience is that, in the absence of active, liquid

markets, these valuation exercises are imprecise. Some of our members, in fact, ensure that this fact is communicated clearly by disclosing ranges of values in their

disclosures.

For all of its proven flaws, support for mark to market accounting among its few

proponents has not abated. Unfortunately, the FASB is one of those few proponents

and has issued several fair value documents, including a so-called Preliminary

Views in 1999. Equally unfortunate, the International Accounting Standards Committee (predecessor of the International Accounting Standards Board) issued a similar preliminary document for comment in 2000. Both strongly support moving to a

new accounting model under which all financial instruments are reported at fair

value and changes in fair value are reflected in earnings. As detailed in our written

statement, there are a number of conceptual and practical issues associated with

this objective.

RELATED PARTY TRANSACTIONS

A third area of concern raised by the Committee is the area of related party transactions. The GAAP disclosure rules regarding such arrangements are clear and have

62

been in place for 20 years. In addition, the SEC’s proxy rules require a very thorough analysis to be presented to share owners. In looking at existing requirements,

we are unable to suggest meaningful improvements, beyond those recommended by

the SEC in its Financial Reporting Release 61, that would better protect investors.

OTHER ISSUES WITH ACCOUNTING STANDARDS

In addition to discussing the issues raised by the Committee, I would like to take

the opportunity to raise a more fundamental point on the present direction of accounting standards. The body of literature we call generally accepted accounting

principles has evolved into a labyrinth of specificity and complexity. The days of the

on-site audit team being capable of fielding the majority of the accounting questions

that arise at corporations have long since passed—the standards we have now are

so complex that we are, of necessity, moving into the brave new world of fragmentation and specialization. One has to question whether anything of value, especially

accounting information, should become so complex that it defies the ability of even

the most diligent investor to understand. And yet in an era when ‘‘plain English’’ disclosure has become the centerpiece of our new reporting model, standards on

securitization and derivative accounting stand as monuments to opacity dressed up

as rigorous standards. I mentioned the 800 pages of guidance on derivatives. In

comparison, the guidance on securitization is a mere 150 pages (of course that excludes the 100+ questions and answers that need to be considered). The cry for relief

was sounded late last year and the FASB has embarked on a project that would

address accounting simplification. The Board has its work cut out for it on this one,

and I am hopeful that it will ultimately yield some tangible results.

In closing, FEI supports the interest of this Committee in effective accounting

standards. However, we urge necessary steps to make sure we are responding appropriately to the problems that exist. In that regard FEI offers its support and the

assistance of its leaders to help the Committee identify a way forward. However,

as we embark on this journey, let’s be sure that we take the time to think carefully

about the issues, to be thorough in the identification of root causes, and based on

that analysis to distinguish problems that arise from fraud or misapplication of the

rules from those that arise from the rules themselves.

Perhaps most important, in an environment flush with cries for change, let’s not

confuse action and progress.

This completes my prepared remarks. I should like to thank the Chairman and

the members of the Subcommittee for allowing FEI the opportunity to testify.

Mr. STEARNS. Thank you.

Mr. Linsmeier, we welcome your opening statement.

STATEMENT OF THOMAS J. LINSMEIER

Mr. LINSMEIER. Chairman Stearns, Ranking Member Towns, and

members of the subcommittee, I appreciate the opportunity to testify here today.

I will address the specific question posed to the panel by sharing

with you ten lessons I have learned, or relearned, about accounting

standards as a result of Enron.

Lesson 1 is a no-brainer, accounting matters.

Lesson 2: Accounting standards were not the primary problem

with Enron. I think we have covered that well with Enron today.

Lesson 3 is that accounting standards do not reflect well the economics of some special purpose entities, or SPEs. SPEs commonly

are created to contractually isolate the risks and rewards relating

to a specific asset or project. The typical SPE charter explicitly

specifies the operating activities of the entity. Thus, from the beginning, the SPE is on autopilot, existing only to carry out its contractually specific sharing of risks and rewards. Its managers essentially have nothing to control.

Curiously, however, the current accounting is primarily based on

the concept of control. Assets are transferred from the books of the

sponsoring company once the SPE obtains control, however, the

key accounting question should be determining whether the sponVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00066 Fmt 6633 Sfmt 6602 W:\DISC\77990 pfrm11 PsN: 77990
63

soring company retains any risks or rewards from the transferred

assets, and how those risks and rewards should be reported. In

part, this is a consolidation issue. However, for the types of assets

transferred by Enron, current accounting rules provide only limited

guidance on when the SPE needs to be consolidated, and no guidance requiring recognition of risks and rewards retained by the

sponsoring company when the SPE is not consolidated.

To properly reflect the economics of SPEs and to prevent accounting abuses similar to Enron, comprehensive accounting and

disclosure standards must be developed to address both these

issues.

Lesson 4: Accounting standards that are too narrow can lead to

abuse. The limited accounting guidance that does exist for determining the consolidation status of SPEs similar to Enron’s was

meant to pertain only to leasing transactions. That guidance specifically states that it should not be applied to other transactions.

Yet, in the absence of any other guidance, a member of the SEC

staff announced that consolidation decisions for non-leasing SPEs

also could be based on the 3 percent outside ownership of assets

standard used for leasing transactions. This is not unusual. In absence of accounting standards that are directly applicable, accountants often find guidance by analogy to a similar standard. While

there is some economic intuition provided for the 3 percent standard in the leasing industry, there is no economic basis for using a

similar standard in other settings. Thus, in absence of alternative

guidance, making decisions by analogy to a related but narrow

standard can lead to accounting that fails to protect investors.

Lesson 5: Accounting standards with bright line tests fail to protect investors. A bright line test, like the 3 percent standard for

non-consolidation of SPEs, allows companies to structure transactions to avoid an undesired accounting result. These transactions

are engineered to lie on one side of the line. The undesirable accounting representation that results from being on the wrong side

of the lie tends to force transactions to be accounted for one way,

causing the accounting benchmark to define the economic depiction

of the transaction. As a result, investor protection suffers.

Lesson 6: accounting standards that are too general also can lead

to abuse. In addition to SPE transactions, Enron also traded in a

considerable number of long-term contracts to sell energy at specified prices for periods up to 20 years. The accounting standard in

this area is general, requiring that these contracts be marked-tomarket, but not specifying how the market price should be determined. While, in general, mark-to-market accounting leads to better investor protection by providing an early warning when prices

move south, its implementation in these contracts is subject to manipulation because it requires significant judgment to estimate how

observable short-term energy price movements will extrapolate to

the long-term, potentially allowing huge swings in reported gains

and losses. While there is no evidence that Enron manipulated its

accounting numbers through these estimates, the fact remains that

general guidance such as this can provide an opportunity for abuse.

Lesson 7: Accounting standard setting is complicated and takes

time. Lessons 4 through 6 suggest that for an accounting standard

to facilitate investor protection, it should be broad and neither too

64

specific nor too general. Given the complexity of modern business

transactions, developing broad standards that both satisfy these

constraints and accurately depict the economics of the transaction

is a complex task that naturally takes time. That said, there is no

good explanation for why the FASB has not been able to set a consolidation standard for SPE for over a decade. Efforts need to be

undertaken to make the standard setting process more efficient.

Lesson 8: The accounting standard setting process has become

too political, which slows progress to improved standards. Standard

setting profits from the political nature of its activity. However, of

late, the standard setting has become too political. Emboldened by

their success in opposing the FASB’s proposal to expense stock option compensation, opponents of FASB’s proposals have found that

complaints to Congress have been quite successful in impeding

FASB’s progress, with congressional hearings becoming commonplace before a final standard can be passed. These hearings often

produce arguments suggesting that the proposed standard will materially alter business, as we know it, significantly affecting the

competitiveness of U.S. companies. However, I have seen no evidence of the significant deleterious effects claimed by businesses

after the proposal has passed. Yet the delay for lobbying activities

significantly slows FASB’s progress, hindering its ability to develop

timely standards that may serve to reduce accounting abuses, such

as those found at Enron.

Lesson 9: For the reasons discussed in my written testimony, accounting standard setting should remain in the private sector.

However, I have one suggestion I believe should be given consideration. Currently, FASB funding is provided, in part, by companies

and audit firms that at times are strong opponents to its proposals.

Consideration should be given as to whether a different funding

structure for the FASB could improve the efficiency and effectiveness of the standard setting process.

Lesson 10, and the most important: Accounting standards cannot

protect investors, proper implementation of standards by accounting professionals leads to investor protection. Enron’s collapse has

called into question the functioning of auditors, audit committees

and accounting standards. In the end, however, I must conclude

that the accounting problems surfaced by Enron had little to do

with the quality of accounting standards but arose primarily due

to failures in their application. This fundamental problem arises

because auditors and audit committees are hired not by the investors they are obligated to serve, but by the companies they must

scrutinize. For me, the ultimate public policy issue is to find a way

to mitigate this conflict of interest, thereby serving better the ultimate objectives of investor protection and continuing efficiency of

U.S. markets.

Thank you for your attention. I will be pleased to answer any of

your questions.

[The prepared statement of Thomas J. Linsmeier follows:]

PREPARED STATEMENT OF THOMAS J. LINSMEIER

Chairman Stearns, Ranking Member Towns, and members of the Subcommittee,

I appreciate the opportunity to testify here today. I will address the specific question

posed to the panel, ‘‘Are current financial accounting standards protecting invesVerDate 11-MAY-2000 14:54 Jun 26, 2002 Jkt 010199 PO 00000 Frm 00068 Fmt 6633 Sfmt 6621 W:\DISC\77990 pfrm11 PsN: 77990
65

tors?’’, by sharing with you ten lessons I have learned or relearned about accounting

standards as a result of Enron.

LESSON 1: ACCOUNTING MATTERS

Rarely has a corporate bankruptcy had such wide repercussions on the accounting

profession. Capital markets, and indeed capitalism itself, can function efficiently

only if the highest standards of accounting, disclosure, and transparency are observed. The collapse of Enron is raising significant questions about the institutions

governing public capital markets, and especially the role of the accounting profession. Issues are being raised about the regulation of auditors, the functioning of

audit committees, conflicts of interest in accounting firms, and the quality of U.S.

accounting standards. Clearly accounting matters. The purpose of the hearings

today is to address one of these issues: the quality of accounting standards. I commend the Committee for addressing this important issue.

LESSON 2: ACCOUNTING STANDARDS WERE NOT THE PRIMARY PROBLEM WITH ENRON

Enron has admitted in its November 2001 filings with the SEC and through its

February 2002 report by a committee of its board of directors that it failed to comply

with U.S. accounting standards for most of the transactions at issue. Proper application of existing accounting and disclosure standards for Enron’s off-balance-sheet

partnerships (sometimes called special purpose entities) would have increased the

reported amounts of debt and decreased the reported amounts of net income in

Enron’s 1997-2001 financial statements, making transparent to capital markets its

declining financial fortunes.

LESSON 3: ACCOUNTING STANDARDS DO NOT REFLECT WELL THE ECONOMICS OF SOME

SPECIAL PURPOSE ENTITIES (OR SPE’S)

SPEs commonly are created to contractually isolate the risks and rewards relating

to a specific asset or project. The typical SPE charter explicitly specifies the operating activities of the entity. Thus, from its beginning, the SPE is on autopilot, existing only to carry out its contractually specified sharing of risks and rewards; its

managers have essentially nothing to control.

Curiously, however, the current accounting by sponsoring companies is primarily

based on the concept of control. Assets are transferred from the books of the sponsoring company once the SPE obtains control. However, the key accounting question

should be determining whether the sponsoring company retains any risks or rewards in the transferred asset and how those risks and rewards should be reported.

In part, this is a consolidation issue. However, for the types of assets transferred

by Enron, current accounting rules provide only limited guidance on when the SPE

needs to be consolidated and no guidance requiring recognition of risks and rewards

retained by the sponsoring company when the SPE is not consolidated.

To properly reflect the economics of SPEs and to prevent accounting abuses similar to Enron, comprehensive accounting and disclosure standards must be developed

to address both these issues. I understand the SEC has charged the FASB with

achieving this outcome by June of this year. Given that the FASB has struggled

with this issue for over a decade, I am not optimistic about its ability to succeed

in such a short time frame. However, to protect investors, it must succeed.

LESSON 4: ACCOUNTING STANDARDS THAT ARE TOO NARROW CAN LEAD TO ABUSE

The limited accounting guidance that does exist for determining the consolidation

status of SPEs similar to Enron’s was meant to pertain only to leasing transactions.

That guidance specifically states that it should not be applied to other transactions.

Yet, in the absence of any other guidance, a member of the SEC staff announced

that consolidation decisions for non-leasing SPEs also could be based on the 3% outside ownership of assets standard for SPE leasing transactions. This is not unusual;

in absence of accounting standards that are directly applicable, accountants often

find guidance by analogy to a similar standard. While there is some economic intuition provided for the 3% standard in the leasing industry, there is no economic basis

for using a similar standard in other settings. Thus, in absence of alternative guidance, making decisions by analogy to a related but narrow standard can lead to accounting that fails to protect investors.

LESSON 5: ACCOUNTING STANDARDS WITH BRIGHT LINE TESTS FAIL TO PROTECT

INVESTORS

A bright line test, like the 3% standard for non-consolidation of SPEs, allows companies to structure transactions to avoid an undesired accounting result. These

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transactions are engineered to lie on one side of the line. The undesirable accounting representation that results from being on the wrong side of the line tends to

force all transactions in this fuzzy area to be accounted for one way, causing the

accounting benchmark to define the economic depiction of the transaction and constraining auditors’ ability to require an alternative accounting representation when

it better reflects economic reality. As a result, investor protection suffers.

LESSON 6: ACCOUNTING STANDARDS THAT ARE TOO GENERAL ALSO CAN LEAD TO ABUSE

In addition to SPE transactions, Enron also traded in a considerable number of

long-term contracts to sell electricity or buy natural gas at specified prices for periods up to 20 years. The accounting standard in this area is general, requiring that

these contracts be ‘‘marked-to-market’’ but not specifying how the market price

should be determined. While in general ‘‘mark-to-market’’ accounting leads to better

investor protection by providing an early warning when energy prices move south,

its implementation in these contracts is subject to manipulation because it requires

significant judgment on the part of management to estimate how observable shortterm energy price movements will extrapolate to the long-term, potentially allowing

huge swings in reported gains and losses. The FASB currently is working on a

project to make ‘‘mark-to market’’ accounting guidance more specific. While there is

no evidence that Enron manipulated its accounting numbers through these estimates, the fact remains that general guidance such as this can provide an opportunity for abuse.

LESSON 7: ACCOUNTING STANDARD SETTING IS COMPLICATED AND TAKES TIME

Lessons four through six suggest that for an accounting standard to facilitate investor protection it must (1) be broad enough to contemplate all related transactions

to which it may be analogized and (2) be specific enough to mitigate opportunities

for manipulation without providing bright line cutoffs. In other words, effective

standards should be neither too specific nor too general. Given the complexity of

modern business transactions, developing broad standards that both satisfy these

constraints and accurately depict the economics of the transaction is a complex task

that naturally takes time. That said, there is no good explanation for why the FASB

would need more than a decade to set a consolidation standard for SPEs. Efforts

need to be undertaken to make the standard setting process more efficient.

LESSON 8: THE ACCOUNTING STANDARD SETTING PROCESS HAS BECOME TOO POLITICAL,

WHICH SLOWS PROGRESS TO IMPROVED STANDARDS

Standard setting profits from the political nature of its activity by surfacing valuable questions and potential implementation issues that when addressed can materially improve the final standard. In addition, by following an open due process, the

resulting accounting standards gain better acceptance from various accounting constituencies. However, of late, standard setting has become too political. Emboldened

by their success in opposing the FASB’s proposal to expense stock option compensation, opponents of FASB’ proposals have found that complaints to Congress have

been quite successful in impeding FASB’s progress, with Congressional hearings becoming commonplace before a final standard can be passed. These hearings often

produce arguments suggesting that the proposed standard will materially alter business, as we know it, significantly affecting the competitiveness of U.S. companies.

However, I have seen no evidence of the significant deleterious effects claimed by

businesses after the proposal has passed. Yet the delay for lobbying activities significantly slows FASB’s progress, hindering its ability to develop timely standards

that may serve to reduce accounting abuses, such as those found at Enron.

LESSON 9: ACCOUNTING STANDARD SETTING SHOULD REMAIN IN THE PRIVATE SECTOR

To make standard setting most efficient and to ensure that the constructive political attributes of the process are focused exclusively on pertinent economic issues,

standard setting should reside in an organization that is not influenced by other important but unrelated issues of the day. Private sector standard setting has performed this function well and with improvements in its efficiency and reductions in

the amount of political intervention, I fail to see a better alternative. In this regard,

I have one suggestion that I believe should be given consideration. Currently FASB

funding is provided, in part, by companies and audit firms that at times are strong

opponents to its proposals. Consideration should be given as to whether a different

funding structure for the FASB could improve the efficiency and effectiveness of the

standard setting process.

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LESSON 10: ACCOUNTING STANDARDS CANNOT PROTECT INVESTORS; PROPER IMPLEMENTATION OF STANDARDS BY ACCOUNTING PROFESSIONALS LEADS TO INVESTOR PROTECTION

In the United States, well-policed stock markets, fearsome regulators at the Securities and Exchange Commission, rigorous accounting standards, and confidence in

audit skills of CPA’s and audit committees, have long been seen as crucial to the

biggest, most liquid and admired capital markets in the world. Enron’s collapse has

called into question the functioning of auditors, audit committees and accounting

standards. In the end, however, I must conclude that the accounting problems surfaced by Enron had little to do with the quality of accounting standards but arose

primarily due to failures in their application. The fundamental problem arises because auditors and audit committees are hired not by the investors they are obligated to serve but by the companies that they must scrutinize. For me the ultimate

public policy issue is to find a way to mitigate this conflict of interest, thereby serving better the ultimate objectives of investor protection and continuing efficiency of

U.S. capital markets.

Thank you for your attention. I will be pleased to answer the Committee’s questions.

Mr. STEARNS. I thank both of you. I will start out the questions.

Mr. Linsmeier, do you think that are more Enrons out there?

Mr. LINSMEIER. Well, let us consider what Enron—what happened with Enron. To the best of my knowledge——

Mr. STEARNS. Because you are saying here FASB has taken 10

years to come up with consolidated standards. You are pointing out

some of the slowness of the process, and you are pointing out some

of the conflicts of interest, and you are pointing out these things

which would lead me to believe that Enron is not alone, that there

are other Enrons. And so is that——

Mr. LINSMEIER. Perhaps there are companies out there that are

not following GAAP and that is not being detected by their auditors, to the extent that we will not find out about those problems

for a period of time. Perhaps that is true.

Mr. STEARNS. You know, some of the technical aspects in these

SPEs, these special purpose entities, when I first saw that they

used a 3 percent outside ownership test for nonleasing of SPEs, I

thought that seemed pretty doggone small.

Mr. LINSMEIER. So did I.

Mr. STEARNS. Do you think Congress, or FASB, or the American

Institute of Accounting, or SEC should stipulate it should be 20

percent, or 10 percent, and is that problematic, or would that actually—if that practice is instituted, would we actually see a better

understanding of these sheltering of debt?

Mr. LINSMEIER. Well, first of all, the reaction to the 3 percent,

let me give you a little background. The reason why 3 percent

might make some economic sense for leasing transactions is the

margin is that industry is so slow and so small and the competition

is so high that giving away 3 percent of the return——

Mr. STEARNS. Is their profit.

Mr. LINSMEIER. [continuing] is their profit. And it materially

changes the economics of that SPE. But, now—and then let us

think about the 3 percent standard. You asked about a 3 percent

standard versus a 10 percent standard. Part of my testimony is any

bright line test will create incentives for someone to be just on the

other side. What Enron tried to do is be just on the other side, but

failed. They didn’t do it right. And that is why we can say that existing accounting standards were not the problem with Enron.

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If they had structured their transactions sufficiently to be on the

other side and not transferred some of the risk in that process,

they could have potentially been following GAAP.

Mr. STEARNS. Ms. Hinchman, Mr. Bass wanted to introduce you.

I guess he worked with you.

Ms. HINCHMAN. Yes, he did, in another lifetime.

Mr. STEARNS. And so I’m sorry Mr. Bass—— Mr. BASS. Congratulations, Grace, you have come a long way in

the last 25 years.

Ms. HINCHMAN. Thank you, Mr. Congressman, so have you.

Mr. BASS. Where are those tough questions you had, I want to

ask a couple of those.

Ms. HINCHMAN. Don’t you have to go to a vote or something on

the floor?

Mr. STEARNS. Ms. Hinchman, you stated that valuation of nontraded instruments is imprecise and that ‘‘some of your members

ensure that this fact is communicated clearly by disclosing ranges

of values in their disclosures.’’ Do you think the disclosure of a

range of values should be mandated?

Ms. HINCHMAN. Well, you are talking about the valuation aspect

in the mark-to-market.

Mr. STEARNS. Nontraded instruments.

Ms. HINCHMAN. Correct. And that is something that we are currently working with FASB in one of our technical committees right

now, and we are not yet at a position to make a statement on that,

but I will certainly get back to you and the subcommittee with our

findings.

Mr. STEARNS. Is it possible that Beerstown Ladies who did the

investment out there in the Midwest in mutual funds, and they did

so well they beat all the people on Wall Street, and they used to

study all these financial accounting reports.

Ms. HINCHMAN. It was an investment club, or something like

that.

Mr. STEARNS. Yes, investment club, the Beerstown Ladies, I remember. Can we have effective financial accounting standards

without this labyrinth of complexity? I mean, is it possible—are we

as Members of Congress being Don Quixote, thinking that we can

make it so that the average person out there can understand something he is investing in, or does he have to go to a stockbroker,

stock analyst, or somebody that he has got to rely on? Is there any

way that we would somehow have a financial accounting standard

that people, the common man or woman, could understand?

Ms. HINCHMAN. Well, that is certainly what we, our membership

of FEI, would like to see have happen, and that is why we did go

to the FASB pleading with them to try and make more simple the

current panoply of standards that they have to abide by because

it has become virtually impossible.

One example that has often held out, which is in my more complete comments, is the FAS 133 on derivatives. It is, I am told, unusable. It is 800 pages of uninterpretable, unusable standards for

guidance. And it has been a huge problem for our members in

order to apply that to their businesses. And that is why we have

begun to work with FASB in terms of making more simple a board

range of principles for these standards instead of having the actual

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rules in terms of abiding by the standards. And we hope to work

with them, but it is a tough challenge, but it is something that we

have to do because today the investors cannot use the standards

for the purposes that they are intended.

Mr. LINSMEIER. Could I comment on that just briefly?

Mr. STEARNS. Yes.

Mr. LINSMEIER. I think there is something that is useful to understand. There is a difference between complexity of standards

and complexities of financial statements that investors read. And

there is the possibility that standards should be complex to control

the activities or to monitor or help focus the activities of people

within corporations, and auditors and their aspects, and yet not

have the financial statements be complex. I think there is a distinction. We want those financial statements, those reports, to communicate fairly the economics of a company and hopefully have some

people understand that. The business is complex.

Mr. STEARNS. But you heard the expression I said earlier, which

is ‘‘cash is fact and everything else is opinion.’’ Let me have the distinguished ranking member ask, and then we will finish up.

Mr. TOWNS. Thank you very much, Mr. Chairman. Let me ask,

why didn’t the analysts in companies such as J.P. Morgan and, of

course, CitiBank, loan officers see this coming? Did they, in fact,

use the same accounting standards to make their loans? I mean,

why wouldn’t the analysts be able to figure this out? I mean, there

is talk, I think, J.P. Morgan and Chase appears to have lost approximately $1.3 billion, and CitiBank maybe $800,000, almost a

million. Wouldn’t analysts sort of—I am trying to see why wouldn’t

they see this.

Mr. LINSMEIER. Well, remember, for Enron, the accounting was

incorrect. They have admitted that in their filings. So, we trust

those reports to indicate that what is being said is correct, that

then their analysts have a difficult time to be able to ferret that

out, if, as what has been publicly stated, they didn’t follow GAAP.

In addition, though, I think we had a circumstance for a company that is doing extremely well, and a lot of people want to believe that it was doing that well and didn’t scrutinize it as carefully

because reading the financial statements of Enron is a very difficult task, and they did work very hard at not saying things in

their reports.

Ms. HINCHMAN. Congressman, I think from FEI’s perspective,

this has been a huge wake-up call for our members. And I think

because of the investigations that are going on, which will yield the

answer to your question, we don’t know specifically, but it certainly

has caused our membership to wake up and be more scrutinizing

and be more demanding on the part of its auditors, on the part of

its investment analysts all up and down the line, so we can avoid

anything like this happening again.

Mr. TOWNS. Well, let me ask this question. What should the Congress do to try to prevent this kind of stuff from happening ever

again?

Ms. HINCHMAN. Well, not to take the other side of my co-witness

here, but FEI just recently submitted a letter to the Wall Street

Journal, New York Times and Washington Post in support of the

oversight of Congress in the role of accounting policy, legislation,

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standards, et cetera. And we certainly endorse that and think it is

appropriate. A proactive oversight role on the part of Congress on

these issues I think is timely, warranted, and potentially very productive, but we would like to see the actual standards developed

in an organization like a FASB, a private sector organization, because that is where the independence of the private sector from the

business community and the accounting community can come into

play and develop the best standards.

I think you would probably agree with me that you all do not

want to be legislating accounting standards, and FEI would not

want you to do that either, quite honestly, but I think a consistent

oversight role, I think, is a healthy, warranted and helpful role

that you all can be playing.

Mr. TOWNS. Because I look at the J.P. Morgan situation, of

course. and according to testimony in another committee, it said

that some people saw it and a red flag went up, and of course others didn’t, and that bothered me. I mean, a person is an analyst,

and one person is able to see it and another one doesn’t see it. You

are talking about a lot of money here, $1.3 billion.

Ms. HINCHMAN. And a lot of lives, too, have been ruined.

Mr. TOWNS. Yes, a lot of people are hurt by this, so I was just

wondering, from that standpoint—because some were able to see it,

others were not able to see it, and of course now we have this mess.

So, I was just wondering in terms of what could we do to try to

further prevent this kind of situation, and you answered that part,

and I thank you for it.

Did you want to add anything, Mr. Linsmeier?

Mr. LINSMEIER. I don’t think we are in disagreement. I mean, my

comments about congressional involvement was not ones looking at

the overall oversight or structure of the profession. I mean, what

I mention in the testimony is that, in part, we have problems in

the standard setting area in that it is not very timely. And if there

is a structural issue to try to induce more timely standard setting

by, in part, not being involved with the individual standards but

the overall structure of the process, that is important.

But I think, more importantly, there are some conflicts that arise

where money flows here, and the two issues that I brought up were

the FASB is funded by public accounting firms and by companies

that tend to lobby them. That is one, but that is not as significant.

To me, the big significant issue, if there was an application of

standards problem here, is why didn’t the auditors and the audit

committee perform their oversight here? And what I raised to you

is—and I don’t know that there is a natural automatic response—

but what I raised to you is the auditors are paid by the company.

The audit committee, even though they represent the shareholders,

receive much of their resources from the company. We have a natural conflict of interest that has gone on from the time of the

Treadway Commission to this time period, that money comes from

the people that the auditors and the audit committees are trying

to scrutinize, think that is a natural conflict of interest.

Mr. TOWNS. I yield back.

Mr. STEARNS. Are you saying the auditor of the board of directors

has failed?

Mr. LINSMEIER. I am saying the audit committee——

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Mr. STEARNS. Audit committee of the board of directors.

Mr. LINSMEIER. It seems yes.

Mr. STEARNS. We have a vote, we have about 3 minutes left, so

I am going to thank you and adjourn the subcommittee. And

thanks again for your patience in waiting through the first panel.

[Whereupon, at 12:10 p.m., the subcommittee was adjourned.]

[Additional material submitted for the record follows:]

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