Susan S Bies: Lessons to be re-learned from recent breakdowns in corporate
accounting
Remarks by Ms Susan S Bies, Member of the Board of Governors of the US Federal Reserve System,
before the Institute of International Bankers, New York, 10 June 2002.
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Good afternoon. Thank you for the invitation to speak today with members of the Institute of
International Bankers. My remarks will not be in the traditional "what have we learned from..." format,
but rather the more realistic what we should re-learn from Enron and other recent, well-publicized
breakdowns in accounting, auditing, and corporate governance. As a regulator dealing with these
types of issues, I find I draw on my experience in bank financial management and accounting. I also
want to continue to meet groups like yours so that I can stay aware of current issues facing bank
managers.
I am going to touch on three broad areas in addressing issues arising from recent breakdowns in
corporate accounting: the current state of accounting and auditing in the United States, the role that
bankers should play as users of financial information, and good corporate governance practices that
bankers should apply within their own organizations.
Let me be clear about my premise. The root causes of the breakdowns in corporate financial reporting
that have been widely disclosed in the past few months are ineffective corporate governance, financial
reporting, and risk management practices. The lessons we can re-learn from recent events should not
be news to anyone. Rather, recent events should serve as a wake up call to corporate boards,
management, and auditors to follow through on their fundamental and traditional professional and
ethical standards of conduct and control processes. The issues are not new, but the scope and
frequency of breakdowns are of concern. As news reports and congressional testimony on various
aspects of these breakdowns occur, corporations and auditors should address the issues raised so
that they do not compromise the reputation of their organizations.
Accounting practices in complex organizations
First, let me address the state of accounting and audit practices.
Mergers and business innovations have increased the scale and scope of large organizations. Further,
significant developments in financial theory and technology have led to the development of financial
instruments that facilitate the separation and reallocation of risks to parties more willing and able to
bear them. A byproduct of these developments is that it has become ever more difficult for outsiders to
understand the financial positions of complex organizations.
The current framework of financial reporting in the United States effectively represents the
performance of most corporations most of the time. Indeed the high quality of accounting standards in
this country is one critical reason why capital markets are so efficient. But the lessons of the past few
months remind us that accounting rules can be bent. For six years I was a member of the Emerging
Issues Task Force of the Financial Accounting Standards Board. This is the rulemaking body that
deals with divergence in practice. The EITF's role is to provide timely financial reporting guidance
where divergence in practice is developing.
In the time I served on the EITF I came to understand that professionals could and did disagree on the
best accounting standard to apply to a new type of transaction. That is at the very heart of the struggle
to keep accounting standards current. The rapid pace of innovations that I just mentioned makes it
impractical to have a rule in place to anticipate every business transaction. Rather, the more complex
and dynamic the world of business becomes, the more important it is that accounting be based on
strong principles that are sufficiently robust to provide the framework for proper accounting of new
types of transactions.
In the course of their work, financial officers and auditors face conflicts between the needs of the
client, which is the management and board of the corporation that engages them, and the professional
ethical standards that outside parties--investors, customers, and creditors--expect from them. While
auditors are engaged by boards of directors, the users of the auditors' opinions are these third parties.
If outsiders did not need independent assessments of standardized financial information, companies
could design their accounting systems in any way they desired to support their business objectives.
But the effective functioning of U.S. capital markets requires that basic information on the financial
condition and performance of the organization be prepared and presented in a consistent way so that
outsiders using the information can compare different companies. Thus, we need to insist on higher
professional standards and not permit financial officers and auditors to benefit from "gaming" the
rulesbased accounting standards that are increasing in complexity, particularly in the United States.
The core of these basic accounting principles should be professional standards followed by every
corporate accountant and every outside auditor that would insist that they can answer "yes" to these
questions: "Does the accounting method selected faithfully represent the economics of the
transaction? Does the recognition, measurement and disclosure provide the user of financial reports
with sufficient information to discern the nature of the significant transactions and risks of the
organization?"
But rules alone do not guarantee good financial reporting. For Enron and other recent examples, weak
corporate governance practices apparently permitted sham transactions and misleading financial
reporting to occur. Outside auditors erred in trying too much to please a paying client. They forgot that
their professional role is to provide assurance to users of financial reports that the quality of financial
reporting meets the expectations of the marketplace.
Some observers have asserted that new accounting standards are needed. I do not know the specifics
of many of the irregularities that have recently come to light. But judging from the publicly available
information, I believe that what we need most is to restore the integrity of corporate accountants and
the quality of the audit process rather than extensive new accounting standards.
One reason that accounting in the United States has become so rule-based is that we tend to add new
accounting standards when abuses occur even when the abuses resulted from accounting and audit
failures. An example of this that bankers can relate to is FAS 115--accounting for investment
securities.
When this standard was developed, the perceived abuse was a handful of banks selling securities
from their investment portfolios to take gains into income, while leaving underwater securities in the
portfolio. Such "cherry picking" was an abuse even under the old standards, which said investment
portfolios were not to used as trading accounts. Discipline against the few offending banks and their
outside auditors would have provided a warning to other organizations.
Problems cannot be solved without addressing their root causes. At times new rules just create more
work. It may appear the problem is solved because "something" was done. But unless the root cause
is addressed, the problem will recur at a cost to the private sector of additional regulatory burden. And
let me remind you again that one of the root causes of recent events is the outside auditor failing to
serve both the board of directors and interested third parties.
Discipline against auditors should occur when accounting standards have been manipulated. The
present industry-driven process clearly has not worked and a new oversight process is needed to
ensure audit quality.
Achieving sound accounting and disclosure practices in complex banking organizations
Corporate boards and accounting officers need to shoulder their responsibilities too. Bankers have a
unique perspective on this. Bankers are heavy users of financial reporting information, whether they
are making a business loan, underwriting a debt issue, or managing assets in a trust account. Thus,
bankers should consider the perspectives of both preparer and user when supporting alternatives for
accounting and disclosure.
Banks are becoming complex organizations themselves. Investors are finding it harder to understand
the quality of financial performance and risk exposures at banks. Thus, bankers should be leading the
development of more transparent financial reporting and disclosures. Generally Accepted Accounting
Standards tend to be focus on point-in-time information. The movement to more fair-value accounting
can mislead users of information when gains and losses are not realized. These point-in-time
snapshots fail to convey information to readers of financial statements that helps them understand the
quality of earnings.
The surprises that typically occur at banks are due to the nature of risk exposures and the quality of
risk management practices, including use of off-balance sheet vehicles. To keep both boards of
directors and investors aware of these unseen risks, bankers should turn to their internal control and
reporting systems. Banks are taking a leading role in the evolution of risk management, and this
discipline can provide a framework for better disclosure.
In addition to applying sound accounting treatments, managers must ensure that public disclosures
clearly identify all significant risk exposures--whether on or off the balance sheet--and their effect on
the firm's financial condition and performance, cash flow and earnings potential, and capital adequacy.
Equally important are disclosures about how risks are being managed and the underlying basis for
values and other estimates included in financial reports. A sound risk management system should
continually monitor risks in a changing business climate--including credit, market, liquidity, and
operational risks.
Disclosures consistent with the information used internally by risk managers could be very useful to
market participants, as would information on the sensitivity to changes in underlying assumptions.
Companies should do more than meet the letter of the standards that exist; they should be sure that
their financial reports and other disclosures focus on what is really essential to help investors and
other market participants understand their businesses and risk profiles.
I particularly want to emphasize that disclosure need not be in a standard accounting framework or
exactly the same for all--otherwise we would be certain to create statistical artifacts and implications of
safe harbors. Rather, we should all insist that each entity disclose what it believes its stakeholders
need to evaluate its risk profile. The uniqueness of risks and business lines in complex organizations
means that disclosures--to be effective--should be different for each bank. That is the approach being
taken in developing the Basel II Capital Accord. Disclosure rules that are built too rigidly while risk
management processes continue to evolve may make them less effective in describing the risk profile
of a specific organization. But if bankers do not voluntarily improve disclosures, rules will be written.
Financial institutions should continue improving their risk management and reporting. When they are
comfortable with the reliability and consistency of the information in these reports, they should begin
disclosing this information to the market, perhaps in summary form. Not only would this disclosure
provide more qualitative and quantitative information to the market, but also the resulting discussion
about risk management practices would help the market assess the quality of the risk oversight and
risk appetite of the organization.
Banks also should consider the way they communicate information about their financial health to their
customers. Bankers know that if their reputations are placed at risk it can lead to significant loss of
business and even liquidity runs. While customers continue to shop at K-Mart despite its bankruptcy,
some bank customers leave when the hint of impropriety or losses occurs. At the same time, few bank
customers can interpret financial reports of corporations, especially banks with complex operations.
This is the dichotomy faced in always looking for more disclosures. Information overload can
overwhelm some readers of financial reports. As with any form of corporate communication, bankers
may want to tailor various disclosures to different audiences.
Banking supervision and accounting and disclosure
The Federal Reserve has long supported sound accounting policies and meaningful public disclosure
by banking and financial organizations with the objective of improving market discipline and fostering
stable financial markets. The concept of market discipline is assuming greater importance among
international banking supervisors as well. The January 2001 proposal to amend and augment the
Basel Capital Accord, called Basel II, seeks to strengthen the market's ability to aid bank supervisors
in evaluating capital adequacy. The proposal consists of three pillars, or tools: risk-based capital (pillar
I), risk-based supervision (pillar II), and disclosure of risks and capital adequacy to enhance market
discipline (pillar III). This approach to capital regulation, with its market-discipline component, signals
that sound accounting and disclosure will continue to be important aspects of our supervisory
approach for many years to come.
The goal in the Basel process is to develop a risk-sensitive framework that provides appropriate
incentives to banking organizations to maintain strong capital positions and sound risk management
systems. The history of the 1990s, which includes episodes of global financial instability spreading
from small countries through international capital markets and banks, underscores the need to
maintain adequate capital in internationally active banks.
Basel II would also improve risk disclosure by many banks worldwide. The proposal recommends
specific disclosures to better convey an institution's capital adequacy and risk profile. The incentives in
Basel II should greatly diminish the opacity that cloaks many international financial institutions and
help bring about a convergence of international norms on banking disclosure. I believe that
counterparties will expect, indeed force, greater disclosure. But Basel II will not be effective until the
end of 2006. Recent history certainly teaches us that understanding what drives a counterparty's
financial performance and its risk appetite is necessary now for accurately pricing any transaction or
even for deciding whether to engage in a transaction. Improve your organization's disclosure with
every financial report--and begin now.
Corporate governance
As bankers, you and your directors have specific responsibilities to manage your risks and effectively
oversee the system of internal controls.
Not only are the activities of banks central to credit intermediation, in this country banks fund those
activities in part with federally insured deposits. These deposits are the lowest cost source of funds for
bankers because of the government's guarantee.
Bank directors are not expected to understand every nuance of banking or to oversee each
transaction. They can look to management for that. They do, however, have the responsibility to set
the tone regarding their institutions' risk-taking and to implement sufficient controls so that they can
reasonably expect that their directives will be followed. They also have the responsibility to hire
individuals who they believe have integrity and can exercise a high level of judgment and competence.
All the banking agencies have issued guidance describing the proper roles of bank officers and
directors regarding policies, procedures, information systems, and controls. For example, the banking
agencies hold boards of directors responsible for ensuring that their organizations have an effective
audit process and internal controls adequate for the nature and scope of their business. The reporting
lines of the internal audit function should be such that the information provided to directors is impartial
and not unduly influenced by management.
Internal controls are the responsibility of line management. Line management must determine the level
of risks they need to accept to run their business, and assure themselves that the combination of
earnings, capital and internal controls is sufficient to compensate for the risk exposures. Staff areas
such as accounting, internal audit, risk management, credit review, compliance, and legal,
independently review, test, and monitor the control processes to ensure that they are effective and that
risks are measured appropriately. The results of these independent reviews should be routinely
reported to executive management and the board of directors. Both executive management and the
board should be engaged enough in the process to determine if these reviews are in fact independent
of the operating areas they are designed to review, and that the senior officers in those roles can
speak freely on issues that need to be addressed.
Audit committee members should have regular time in meetings to talk with the outside auditors
without managers present. Best practices for audit committee processes have been laid out many
times, including in the 1980s by the Treadway Commission and in 2000 by the Blue Ribbon
Committee. Beyond that, boards of directors and managers should periodically test where they stand
on ethical business practices. For example, they should ask, "Are we squeaking by on technicalities,
adhering to the letter but not the spirit of the law? Are we compensating others and ourselves based
on our contributions to the organization, or are we taking advantage of opportunities and abusing our
positions?"
The Arthur Andersen matters and other corporate events currently being addressed also provide
lessons for bankers as they try to increase earnings by cross selling more products. When line officers
are compensated on sales and cross selling, a strong, independent quality-assurance or risk review
function becomes even more essential. For public accounting firms, strong quality assurance functions
are needed to protect the core business integrity of attestation services when the firm is trying to win
consulting contracts. In banks, where credit is still the dominant risk exposure, the chief credit officer
should make sure unacceptable credit risks are not taken to win fee income business whose net
revenue may not cover credit exposures.
If the financial and reputation integrity of the corporation are to be protected, decentralized processes
demand a system of strong, independent internal controls. When revenue and risk come into conflict,
the board of directors and executive management must decide where to draw the line. They should be
able to rely on the independent control processes to alert them when exceptions to accepted
standards occur.
My intent today is to remind everyone of the importance of maintaining sound ethical practices to help
protect the reputation of your bank. As recent events have demonstrated, if we fail to do so, the market
will eventually enforce the discipline. And that discipline can be harsh and sometimes indiscriminate.
Investors and customers act decisively, once confidence is lost.
Conclusion
Sound accounting, auditing, and disclosure, consistently applied, have long been at the heart of
efficient markets. The issues currently being identified as breakdowns in these basic functions should
serve as wakeup calls to managers, boards of directors and auditors. We need to be sure that the
responses to these issues focus on the root cause of the event and do not create more regulatory
burden and leave the root cause unaddressed.
We also need to have realistic expectations. Financial reporting and corporate governance are still
effective at most corporations. Given human nature, we must expect that rules will sometime be
broken. But we can expect oversight boards to enforce penalties appropriate to the situation that will
discourage others from breaking the rules in the future.
The complex nature of organizations--and constantly changing services, customers, and business
conditions--suggests that market participants need additional types of information. Leading firms have
been developing comprehensive risk management processes for internal decisionmaking that can
provide the framework for more meaningful disclosures. Regulators should encourage financial firms
to develop these new approaches and, in these early stages, give them the flexibility to choose the
most appropriate format for disclosure. In doing so, they will enhance the quality of information
available for effective market discipline and banking supervision in ways that strengthen the financial
system.
Though the quality of bank accounting and control systems is strong, bankers should heed lessons to
be re-learned from Enron and other recent events. They should strengthen corporate governance to
prevent such abusive practices from occurring at their institutions.