GAO Forum on Governance and Accountability: Challenges to Restore Public Confidence in U.S. Corporate Governance and Accountability Systems
Published: 2003-01-24T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: On December 9, 2002, GAO convened a governance and accountability forum to discuss challenges facing regulators, the accounting profession, and boards of directors and management of public companies in effectively implementing the Sarbanes-Oxley Act of 2002 and related regulatory actions to improve public confidence in U.S. corporate governance and accountability systems. Major accountability breakdowns recent years, exacerbated in the last 2 years by the unprecedented massive breakdowns and bankruptcy of Enron and WorldCom, have contributed to the decline in investor confidence in U.S. capital markets. The forum focused on the four interrelated areas of corporate governance, the financial reporting model, the accounting profession, and regulation and enforcement that the accountability breakdowns have surfaced as critical areas to be strengthened. Addressing these challenges will involve the public, private, and not-for-profit sectors. In general, there must be the proper incentives, transparency, and accountability mechanisms in place to ensure the effectiveness of any system. As a result, these overarching principles were considered in connection with the issues discussed. Forum participants included individuals from federal and state government, the private sector, standards setting and oversight bodies, and a variety of other interested parties.
section_title: What GAO Found
paragraphs: There was general agreement among the participants that the root causes of the accountability breakdowns are systemic in nature, complex, and will require leadership and alterations to the current models in each of the four interrelated areas to transition to an overall system that is more focused on protecting the public interest and, in that regard, accountability. They also agreed that considerable actions have been taken and/or proposed towards achieving those objectives, but that having the "right people" and "stakeholders" involved was critical to successfully achieve and effectively maintain the necessary reforms. Several other key observations follow. Many boards of directors are reassessing their roles and responsibilities, and currently it is difficult to determine what is working and what is not working. Participants agreed there is no "silver bullet" to enhancing the effectiveness of boards of directors in their role of overseeing management and protecting the public interest. However, for a board to effectively perform its responsibilities, it must have the "right people" who possess an "independent spirit" and are "knowledgeable" of the company/industry and the company's constituencies. Little progress has been made moving toward a more comprehensive financial reporting model that would include such information as operating and performance measures and forward-looking information about opportunities, risks, and management's plans. The impetus for changing the financial reporting model needs more involvement of investors and other users of financial information as the current model is too driven by those who have historically focused more on the technical aspects of financial reporting, such as accountants, regulators, corporate management, and boards of directors. An "artful blend" of principle-based and rule-based accounting standards, as well as a financial reporting model with different tiers of reporting that provides full disclosure, are fundamental changes needed to improve the financial reporting model. An "expectation gap" of what an audit is and what users expect continues to exist, especially with the auditor's responsibility for fraud detection. Supplementing the traditional financial statement audit with a "forensic audit" as well as with a more informative auditor's report could help to narrow the "expectation gap." A strong, viable Securities and Exchange Commission is needed to maintain investor confidence. Concern was raised that the Commission is not fully at that status and that funding issues need to be resolved. The new Public Company Accounting Oversight Board needs to officially get up and running with immediate priorities focusing on establishing policies and procedures for performing its disciplinary, inspection, and standard-setting functions.

section_title: Letter
paragraphs: On December 9, 2002, GAO convened  a governance and accountability  forum to discuss challenges facing  regulators, the accounting profession,  and boards of directors and  management of public companies in  effectively implementing the  Sarbanes-Oxley Act of 2002 and  related regulatory actions to improve  public confidence in U.S. corporate  governance and accountability  systems.  Major accountability  breakdowns in recent years,  exacerbated in the last 2 years by the  unprecedented massive breakdowns  and bankruptcy of Enron and  WorldCom, have contributed to the  decline in investor confidence in U.S.  capital markets.  The forum focused  on the four interrelated areas of  corporate governance, the financial  reporting model, the accounting  profession, and regulation and  enforcement that the accountability  breakdowns have surfaced as critical  areas to be strengthened.
There was general agreement among the participants that the root causes of the  accountability breakdowns are systemic in nature, complex, and will require  leadership and alterations to the current models in each of the four interrelated  areas to transition to an overall system that is more focused on protecting the  public interest and, in that regard, accountability.  They also agreed that  considerable actions have been taken and/or proposed towards achieving those  objectives, but that having the “right people” and “stakeholders” involved was  critical to successfully achieve and effectively maintain the necessary reforms.   Several other key observations follow:
Many boards of directors are reassessing their roles and responsibilities and  currently it is difficult to determine what is working and what is not  working.
Participants agreed there is no “silver bullet” to enhancing the effectiveness  of boards of directors in their role of overseeing management and protecting  the public interest.  However, for a board to effectively perform its  responsibilities, it must have the “right people” who possess an  “independent spirit” and are “knowledgeable” of the company/industry and  the company’s constituencies.
Little progress has been made moving toward a more comprehensive  financial reporting model that would include such information as operating  and performance measures and forward-looking information about  opportunities, risks, and management’s plans.
The impetus for changing the financial reporting model needs more  involvement of investors and other users of financial information as the  current model is too driven by those who have historically focused more on  the technical aspects of financial reporting, such as accountants, regulators,  corporate management, and boards of directors.
Addressing these challenges will  involve the public, private, and not- for-profit sectors.  In general, there  must be the proper incentives,  transparency, and accountability  mechanisms in place to ensure the  effectiveness of any system.  As a  result, these overarching principles  were considered in connection with  the issues discussed.
Forum participants included  individuals from federal and state  government, the private sector,  standards setting and oversight  bodies, and a variety of other  interested parties. audit” as well as with a more informative auditor’s report could help to  narrow the “expectation gap.”
A strong, viable Securities and Exchange Commission is needed to maintain  investor confidence.  Concern was raised that the Commission is not fully at  that status and that funding issues need to be resolved. www.gao.gov/cgi-bin/getrpt?GAO-03-419SP.
To view the full report, click on the link above.  For more information, contact Jeffrey C.  Steinhoff, Managing Director, Financial  Management and Assurance, on (202) 512- 2600 or steinhoffj@gao.gov. up and running with immediate priorities focusing on establishing policies  and procedures for performing its disciplinary, inspection, and standard- setting functions.
The last 2 years witnessed major accountability breakdowns at Enron and  WorldCom leading to significant restatements of financial statements and  bankruptcy adversely affecting thousands of shareholders and employees.  Unfortunately, such failures were not isolated instances as other  accountability breakdowns in recent years included Qwest, Tyco, Adelphia,  Global Crossing, Waste Management, Micro Strategy, Superior Federal  Savings Banks, and Xerox. Although stakeholders of these companies were  directly affected by the accountability breakdowns, these failures have  cumulatively contributed to the general shaking of investor confidence in  U.S. capital markets.
Last year, on February 25, 2002, GAO held a forum to discuss systemic  issues related to these accountability failures, such as corporate  governance, accounting and reporting, and auditing. Since that time, major  reform legislation has been enacted—the Sarbanes-Oxley Act of 2002—and  regulators have proposed and/or finalized a number of new requirements to  address issues related to the failures. However, much of the regulatory  reform action is in process and experience will be needed to evaluate the  effectiveness of the changes. Moreover, the changes to date do not address  all the issues raised by the accountability breakdowns.
On December 9, 2002, GAO convened a governance and accountability  forum for the purpose of identifying past, pending, and proposed actions  designed to protect the public interest by  identifying challenges to improving public confidence in U.S. corporate  governance and accountability systems to assist regulators, the  accounting profession, and boards of directors and management of  public companies to effectively implement the Sarbanes-Oxley Act of  2002 and other related regulatory actions and  placing special interest on steps designed to enhance independence of  the corporate governance system and enhancing the  accounting/auditing and attest/assurance models for the 21st century.
Specifically, the forum focused on four interrelated areas—corporate  governance, the financial reporting model, the accounting profession, and  regulation and enforcement.
The invited participants were from public, private, and not-for-profit  entities having extensive experience and subject matter expertise in the  accounting profession, corporate governance issues, financial reporting  and disclosure models, auditing, accounting, and related regulatory issues.  GAO also extended invitations to chairs and ranking minority members of  relevant Congressional committees. Over 40 invites attended. As agreed  with the participants, the purpose of the discussion was not to reach a  consensus, but rather to engage in an open, no attribution-based dialogue.  Therefore, this report summarizes the collective discussion and does not  necessarily represent the views of any individual participant or GAO.
Corporate Governance The participants acknowledged that recent legislative and regulatory  reforms in response to issues raised by significant restatements of financial  statements and corporate failures were placing greater emphasis on the  roles and responsibilities of boards of directors. They noted that many  boards are reassessing their roles and responsibilities and, at this time, it is  difficult to determine what is working and what is not working.  Information on best practices of boards would be useful to help improve  board operations, for example in areas of improving communications with  management and using external advisors. However, participants generally  agreed that there is no “silver bullet” for enhancing the effectiveness of  boards of directors in their role of oversight of management and protecting  shareholders.
In discussing the role and responsibilities of boards of directors,  participants stated that it starts with having the right people on the board  who are independent, knowledgeable, and ethical and whose integrity is  unquestionable. The basic roles and responsibilities of the board were  defined as enhancing shareholder value, assessing and monitoring risk, and  ensuring management accountability. It was noted that boards need to do a  better job of identifying their constituencies and understanding and  addressing their concerns. In addition, board members have a  responsibility to educate themselves about the company’s operations and  plans and to seek advice of external experts, when and as appropriate.
Participants also focused on the roles of the nominating, compensation,  and audit committees noting that (1) nominating committees need to  independently identify candidates for board membership rather than  “rubber stamp” management’s candidates, (2) compensation committees  need to focus more on achievements related to the company’s long-term  strategic objectives and less on short-term accomplishments, such as  meeting earnings projections, and (3) audit committees need to work more  effectively with the independent auditor as defined by the Sarbanes-Oxley  Act of 2002, and not get “tied up” in procedural matters concerned with  their legal liabilities as committee members.
Participants stressed that having the “right people” on the board was just as  important if not more so than having the right rules. In that respect, it was  noted that board members should possess an “independent spirit” to ask  the tough and probing questions of management. Participants stated that  the existing system for identifying board members might not always be  attracting the “right people.” For example, it was stated that some board  members are serving on too many boards to be effective, and that some  board members are serving for personal incentives that could adversely  affect their independence. Some participants believed that in today’s  environment, potential legal liabilities were adversely affecting finding  qualified board members. Other participants believed that there is no  shortage of qualified board members willing to serve and that the board  needed to look beyond the “list of usual suspects.”
subsections: section_title: Financial Reporting
paragraphs: The traditional financial statements, in terms of form and content, have not  changed much over the years. The financial reporting model uses a mixture  of historical costs and fair value to present a company’s transactions. This  model has value but fails to meet the broader range of information needs of  investors who want more forward-looking information and data that reflect  a company’s overall performance, risk profile, and expectations for future  performance.
Little progress has been made in moving toward a more comprehensive  reporting model that would include both financial information (financial  statements and related disclosures) and nonfinancial information (such as  high-level operating and performance measures used by management and  forward-looking information about opportunities, risks, and management’s  plans). Participants stated that the current model is too driven by  accountants, regulators, corporate management, and boards of directors  who have historically focused on the technical aspects of financial  reporting and are more likely to move slowly and cautiously in making  changes. As a result, the current model has failed to get adequate “traction”  to move toward a more comprehensive reporting model.
Going forward, participants believed that the impetus for change to the  financial reporting model would have to come more from the investors and  other users of financial information who need timely, accurate, and useful  information to make value and risk judgments about publicly traded  companies. Also, a safe harbor for preparers and auditors of more forward- looking information may be necessary to progress. Other suggestions by  participants included moving toward more principle-based accounting  rules to provide more substance versus form in reporting. There was  general agreement that (1) a combination of principle-based and rule-based  standards would be needed and (2) principle-based accounting rules were  not a panacea to solve financial reporting problems. In that respect, some  participants suggested that standard setters first needed to get the basics  right with the current financial reporting model, for example in areas such  as accounting for pensions, post-employment benefits, and pro-forma  financial statements, to help restore investor confidence. It was also  suggested that the financial reporting model have different layers of  reporting, while still having full disclosure, coupled with different levels of  assurances depending on users’ needs. Such layering would allow a user to  “drill down” to the level of detail needed.
section_title: The Accounting Profession
paragraphs: An expectation gap between what an audit is and is not continues to exist,  especially with regard to the auditor’s responsibility for detecting fraud.  Some participants believed a periodic forensic audit may be needed to  supplement the traditional financial statement audit to assist in detecting  fraud. However, it was recognized that an audit cannot create precision or  certainty where such factors do not exist, as financial statements are not as  precise as users may believe. In addition, management and audit  committees have important roles and responsibilities for internal control to  prevent and detect fraud. The Sarbanes-Oxley Act of 2002 will help to close  the expectation gap concerning the effectiveness of internal control over  financial reporting by requiring management and auditor reporting on these  controls. Nonetheless, an expectation gap may still exist as users may be  expecting that an audit addresses internal control over the company’s  overall operations and performance. Educating users on the terminology of  internal control reporting, such as reportable conditions, was also urged so  that the users and capital markets do not over react in interpreting the  internal control reports.
Participants suggested the need for a new reporting model for auditing, a  renewed focus on the quality of auditing, and building more effective  working relationships with the audit committee. It was recognized that the  standard auditor’s report could be made more useful to users who are  seeking greater information about what the auditor did and found, as well  as expanded assurances. Tiered reporting that would provide expanded  optional assurances was suggested. Participants stated that the quality of  audits can be adversely affected by “time and fee pressures” that lead to  less substantive auditing. Caution was also urged that rotation of audit  partners required by the Sarbanes-Oxley Act of 2002 does not have the  unintended consequence of adversely affecting the quality of audits  through loss of experience with a particular company’s operations and  financial reporting. It was recognized that confidence in audits needs to be  restored not only for investors, but also to attract and retain the best  people for the accounting profession over time.
section_title: Regulation and Enforcement
paragraphs: A strong, viable Securities and Exchange Commission (SEC) is needed to  maintain investor confidence in the markets. Participants recognized that  the SEC’s resources had not kept up with its increased workload over the  years. This situation has adversely affected the SEC’s ability to adequately  enforce the securities laws and also its ability to invest in technology to  more efficiently manage its workload. Some participants suggested that the  SEC may wish to consider pursuing the status to operate independently in  setting its own funding levels, as the Federal Reserve does. It was also  suggested that the SEC needed to explore how it is using its enforcement  powers, as civil penalties may ultimately be hurting shareholders more  than those who have violated the securities laws. In that respect, the SEC  should reexamine the amount and targeting of its civil sanctions, its use of  criminal statutes, and working effectively with the Department of Justice to  put violators behind bars when appropriate.
The new Public Company Accounting Oversight Board (PCAOB) needs to  officially get up and running. Suggested priorities for the PCAOB included  establishing policies and procedures for disciplinary actions and  conducting inspections of registered public accounting firms. Also,  decisions need to be made on the setting of standards for auditing, quality  control, ethics, and independence. It was also suggested that the PCAOB  should evaluate the recent events that have affected the public’s confidence  in auditors to consider what further actions may be needed beyond those  mandated by the Sarbanes-Oxley Act of 2002 and recent regulatory changes  and proposals. In addition, the PCAOB needs to work cooperatively with  the SEC and state boards of accountancy. The fragmentation of the  regulatory system for the public accounting profession was not completely  dealt with by the Sarbanes-Oxley Act of 2002. At a minimum, the PCAOB  will need to effectively work with the other public regulators on  enforcement/disciplinary matters. Participants generally believed that the  provisions of the Sarbanes-Oxley Act of 2002 should be implemented and  assessed before the Congress should consider adding any new legislative  requirements; however, participants agreed that much can and should be  done by other responsible parties, such as by regulatory and self-regulatory  bodies, within their existing authority.
section_title: GAO Observations
paragraphs: Restoring public trust and confidence in a manner that can be sustained  over the long-term will require concerted actions by a variety of parties,  including accounting and auditing standard setters, regulators,  management and boards of directors of public companies. The Sarbanes- Oxley Act of 2002 provides a strong framework for more effective  corporate governance and regulation of the accounting profession. The  SEC and the stock exchanges, along with the Financial Accounting  Standards Board, have also been actively making progress to address a  range of issues raised by the accountability breakdowns. However, the  fundamental principles of providing the right incentives, providing  adequate transparency, and ensuring appropriate accountability are even  more important and relevant as the new structure and reforms are being  established.
It is important to recognize that rules alone will not effectively resolve the  problems that resulted in massive restatements of financial statements and  ultimately bankruptcy of certain public companies. The Congress cannot  legislate nor can regulators establish by rule human behavior or integrity to  always do the right thing in protecting the public’s interest. Public company  management needs to set the appropriate “tone at the top” and that culture  needs to be carried throughout the company and exhibited by the board of  directors in its oversight of management and in its protection of  shareholder interests.
The accounting profession needs to vigorously work to rebuild its greatest  asset—public trust—in order to restore faith in the integrity and objectivity  of the profession. Accounting and auditing standards need to be  reexamined to provide enhanced value to users of financial statements,  related disclosures, and more comprehensive business reporting. Users of  these products will need to step forward to help ensure the value of an  enhanced financial reporting model and related auditor assurances for the  effective functioning of U.S. capital markets. Accountants and regulators  who have historically driven changes to the financial reporting model do  not have the same set of needs as users of financial statements. In that  respect, a broader performance and accountability reporting model is  needed and should include not just financial statements but also  performance and other information necessary to better assess institutional  value and risk.
GAO will continue to play a professional, objective, nonpartisan and  constructive role in assisting the Congress, regulators, and the accounting  profession as initiatives are proposed, agreed upon, and become  operational. In that respect, the views of the participants in this forum  represent considerable experience in the matters discussed and represent  one way in which an independent party, such as GAO, can assist those who  define and/or implement policy.
The results of the forum are organized by the major areas of discussion and  reflect subsequent comments we received from the participants on a draft  of this report. Appendix I provides a list of the participants.
For additional information on our work concerning corporate governance,  the accounting profession, financial reporting, and related regulatory  matters, please contact Jeffrey C. Steinhoff, Managing Director, Financial  Management and Assurance, on (202) 512-2600 or at SteinhoffJ@gao.gov.
I wish to thank each of the participants for taking the time to share their  knowledge and to provide their insights and perspectives on the important  matters discussed during the forum. I look forward to working with them  on these important issues of mutual interest and concern in the future.
section_title: Corporate Governance
subsections: section_title: Defining the Roles and Responsibilities of the Board of Directors
paragraphs: Recent legislative and regulatory initiatives, such as the Sarbanes-Oxley  Act of 2002, Securities and Exchange Commission (SEC) proposals and  rules, and proposed revised stock exchange listing requirements, have  addressed weaknesses in corporate governance exposed by the major  financial reporting issues raised by restatements and corporate failures,  placing greater emphasis on the roles and responsibilities of boards of  directors. Although these reforms are not yet fully in place and not all  issues have been addressed, many corporate boards are reassessing their  roles. However, participants agreed that there is no “silver bullet” and that  it is difficult at this time to say what is working and what is not working.
Participants believed that it is important to continue working toward more  effective boards of directors and discussed the importance of clearly  defining and, in some cases, redefining, the roles and responsibilities of the  board of directors of public companies as a significant measure to help  restore investor confidence in the market. The board has a responsibility to  enhance shareholder value, assess and monitor risk, and ensure  management accountability. In that respect, the operations of the boards  should reflect a culture that embraces these responsibilities. In addition to  focusing on what accountants, regulators, and corporate management and  boards of directors (the “supply side”) should do, boards need to focus  more on what investors and other users of financial information (the  “demand side”) want from corporate governance.
In order to fulfill its responsibility of effectively overseeing management,  the board must have a thorough understanding of the company, its business  model and related risks, corporate culture, and the various interests the  board represents. Participants believed that the board has a responsibility  to educate itself through the use of external advisors or other means and  not rely solely on information provided by management. This will better  allow the board to raise difficult questions and probe issues to provide  input on strategy, assess and manage risk, and hold management  accountable for its actions. The time frame needs to be very clear, as  creating value is a long-term, not a short-term, process. Investors are not  looking for quick schemes that endanger the company.
In addition to its responsibility to oversee management, the board also has  a responsibility to shareholders and other stakeholders of the company,  such as employees, creditors, and the public. Participants believed that  boards need to do a better job of identifying their constituencies and  understanding and addressing their concerns. For example, from the  shareholders’ point of view, many believe that board structures have not  been working properly to both protect shareholders’ interests and grow  share value. We have become a nation of investors, and boards need to  focus attention on the fact that there has been a shift from shareholders not  only being individual investors but also institutional investors, such as  pension plans and mutual funds, which are acting as fiduciaries for others.  Institutional investors may have concerns different from those of individual  investors regarding expectations for corporate governance and the role of  the board of directors.
Participants also felt that boards needed to reexamine how they are  structured and how they operate. Many boards were not perceived to  function properly for investor protection, which is a negative reflection on  the entire corporate governance process. To some extent, deficiencies in  the functioning of boards may have been masked by the effect of a  flourishing market and may not have been readily apparent until market  downturns began to occur. It is incumbent upon boards to establish  processes that are appropriate and effective to restore investor confidence  rather than relying on a checklist approach to corporate governance.  Participants believed that information on best practices of boards would be  useful to help to improve board operations. Some best practices include  focusing on improving communications with management and using  external advisors. It was also suggested that boards should effectively use  the “gatekeepers” (auditors and audit committees) for help in the board’s  oversight of financial management and reporting activities of the company.
Independent committees of the board of directors, such as the auditing,  compensation, and nominating committees, play an important role in  effective corporate governance. Audit committees should not only oversee  both internal and external auditors, but also be proactively involved in  understanding issues related to the complexity of the business, and, when  appropriate, challenge management through discussion of choices  regarding complex accounting, financial reporting, and auditing issues. In  that respect, the role of the audit committee, which in some cases has not  been very active or effective in its oversight of management or auditors as  related to financial reporting, is evolving into not just financial  management oversight, but the overall aspects of the company’s financial  reporting, such as releases on earnings expectations and quarterly financial  reports. In addition, the Sarbanes-Oxley Act of 2002 defines a number of  audit committee responsibilities for the hiring, compensation, and  oversight of auditors. However, a serious concern exists over whether audit  committee members are focusing more on procedural matters to protect  themselves from liability than on improving their competence and  effectiveness as a committee. Also, compensation committees need to  understand the implications of compensation to provide incentives for  management to do the right thing for the company and its shareholders  versus themselves. Compensation committees need to focus on executive  performance more related to the company’s long-term objectives rather  than just short-term business results. In addition, nominating committees  need to ensure that they identify the right mix of talent to do the job and  make it clear to candidates what is expected of them as a board member  rather than merely approving candidates identified by management. In that  respect, some participants stated that boards are often made up of  consensus builders and, in that case, a dominant member of the board  could effectively control the board’s agenda.
Participants also discussed the importance of providing reasonable  transparency of key information, with regard to both financial information  of the company and board operations. Boards need to focus on enhancing  the quality and reliability of financial reporting, identifying key elements of  disclosure, and ensuring that such information is appropriately disclosed to  investors and the public. Participants also believed that there is a need for  better transparency of board activities to help restore investor confidence,  such as reporting on the board’s progress against best practices of leading  companies noted for the effectiveness of their boards. If the board is not  following best practices, it should report why it is not following these  practices. The point was also made that successful companies have  reinvented themselves through two fundamental focuses—ethics/integrity  and respect for people. These behaviors have been demonstrated by long- term successful companies.
section_title: Identifying the Right People to Serve on Boards
paragraphs: Participants stressed the importance of independence, both in fact and  appearance, as essential for the board to be able to fulfill its  responsibilities. Participants expressed the belief that having the right  people on the board is just as important if not more so as having the right  rules under which the board operates. Nominating committees need to  identify competent individuals who possess an “independent spirit” which  allows board members to raise difficult questions and probe issues related  to management’s decisions to ensure that the company operates honestly  and effectively in the shareholders’ interest. Even if board members are  independent, they can be ineffective as directors if they lack expertise or  knowledge relevant to the company and its business. Therefore, board  members must also be willing to educate themselves about the company  and the risks it faces rather than relying on a checklist mentality of  corporate governance requirements issued by the stock exchanges.
Participants also noted that unfortunately, as a result of the recent major  financial reporting issues leading to restatements and, in some cases,  bankruptcy, board members have focused on the rules and may be  concerned more about their personal reputation and financial liability  rather than focusing on protecting shareholders’ interests and adding  shareholder value. Participants expressed concern that disincentives such  as legal liabilities, including financial and reputation risks, may limit a  board’s ability to attract the right people to serve over time.
Participants raised the question whether the current system of selecting  directors needs to be reexamined because the existing system from a  shareholders’ point of view has not been working to get the right people on  boards. For example, it was viewed that individuals who serve on  numerous boards at the same time and/or who serve for personal  incentives, over time lose the “independent spirit” needed to be an effective  board member. Participants also stated there is some evidence that the  recruiting of directors is being adversely affected by the current  environment that is placing ever-increasing demands on board members.  Examples were cited of increased premiums for finding qualified board  members and such searches needing to identify 15 candidates for a board  position just to get one who is willing to serve. Other participants  commented that there is no shortage of qualified people to serve on boards  of directors. Many people are willing to serve higher goals and the selection  process needs to go beyond “its usual pool of suspects.” Some participants  suggested that perhaps serving as a director on a board should be a salaried  position if shareholders were willing to bear the cost. Other participants  noted, however, that having salaried board members could be problematic  because shareholders would have to be able to hire and fire the directors  that would cause great instability and salaried board members may also  lack an “independent spirit.”
Participants also discussed the appropriateness of the chief executive  officer (CEO) serving as chairman of the board of directors, which could  present potential conflicts resulting from a single individual functioning in  these dual roles. Some participants believed that separation of the CEO and  chairman of the board positions recognizes the differences in their roles  and eliminates conflicts in functions. For example, management is  responsible for the operations of the company and members of the board in  their oversight function should have the ability to challenge the CEO in  managing the company. Although the corporate governance community in  the United States may not currently be receptive to requiring the separation  of the CEO and the chairman of the board, such a practice does exist in the  United Kingdom, where apparently there is more receptivity. Therefore,  regulators may need to look beyond the United States to consider the merit  of whether these positions should be held by different individuals.
Other participants pointed out that not allowing the CEO to also serve as  the chairman of the board of directors does not guarantee that problems  will be avoided if the board lacks an independent spirit to question  management, citing such examples as Enron, Global Crossing, and  WorldCom, all of which had a separate CEO and chairman. Some  separations of the CEO and chairman functions are successful and others  are not. A CEO may lose authority when the position is too diluted. United  States firms have been successful because they have had strong leaders  running them, and an effective and strong board of directors can  counterbalance a strong executive.
section_title: Financial Reporting
subsections: section_title: Little Has Changed with the Financial Reporting Model
paragraphs: Participants commented that traditional financial statements, in terms of  their form and content, have not really changed over the years. The model  we have today can be traced all the way back to the early 1970s (back to  the Trueblood Committee). Participants attributed this lack of change to  the financial reporting model being largely driven by the supply side, that is  accountants, regulators, and corporate management and boards of  directors. Participants referred to a landmark study on financial reporting  by the Jenkins Committee as evidence that little has changed. Participants  acknowledged that accounting standards have changed to capture fair  value in addition to historical value, resulting in a model that is now a  mixture of the two, whereas the original financial statement model was  based solely on historical costs. However, the majority of the Jenkins  Committee’s recommendations never got any “traction” to move them  forward. The Financial Accounting Standards Board (FASB) has many of  these items on its agenda. At the same time, there are many other items on  FASB’s agenda. Participants felt that if stakeholders were serious about  improving the financial reporting model, a group would be established and  funded specifically for this purpose. Participants stated that such a group  was proposed by the Jenkins Committee, but it was never established.  There needs to be a sense of urgency in order to make the investment,  commitment, and ultimately change the model. However, one participant  questioned that since almost 10 years have gone by since the Jenkins  Committee made its recommendations, is there really a demand for  change?
section_title: Current Financial Reporting Model Has Limited Value in Today’s Business Environment
paragraphs: Some participants agreed that financial statements are an important aspect  of overall business reporting, but were concerned that the existing model  focuses too much on financial statements rather than on the broad range of  information that is needed by investors to make good financial decisions.  Other participants commented that financial statements that exist today,  while they may be useful to some, are not used very much by investors.  Financial statement disclosures are difficult to understand, as though  written in a “foreign language.” Participants stated that the disclosures  must be made more understandable.
However, there is a lot of dialogue taking place today concerning business  reporting. For example, regulators are asking what should be disclosed,  what is the purpose of financial statements, and how useful are they? What  are analysts doing with financial statements? What do analysts use to value  stock? Are they using financial statements? If so, what information in the  financial statements are they using to value stock? What additional  information would assist them in more accurately valuing stock?  Participants noted the need to report information about the business  model, as users of financial reports first must better understand the entity’s  business model in order to comprehend financial and nonfinancial  information about the entity.
Financial statements today focus on reliability much more than on  relevance. Historical information is reliable, but not necessarily relevant.  Fair value information is evolving but improvements in reliability are  needed. Participants agreed that reliability is fundamental to useful  business reporting; however, participants felt that financial reporting  would be much more useful if it were expanded to include key  performance indicators and measures (including disclosures on how the  key measures were chosen). Participants raised questions about the gaps in  reporting of intangibles. For example, in a knowledge-based economy, one  could argue that the most important assets are people (human capital);  however, current financial reporting records investments in people as an  expense and liability. Participants agreed that it would be useful if financial  reporting recognized people as assets, but raised the difficulty in valuing  human capital. Participants generally agreed that there is a demand for  both historical and fair value reporting. However, participants felt that  FASB needed to better differentiate between the two. In that respect, some  participants felt that FASB is marching toward a “fair value” path and  cautioned that the fair value reporting model is not always good and needs  to be used only where it really makes sense.
Participants acknowledged that financial reporting, in addition to being  largely driven by the accounting profession, also has been driven by the  legal system, resulting in an overload of information that is too complex  and not easily understood. Disclosures that run on for pages are not  understandable. Experts are needed to interpret the disclosures and  sometimes even they cannot decipher what is being reported. However,  participants understand that accountants are taking a risk when they issue  an opinion on the financial statements. The litigious environment has also  led to a “check box” mentality where it is more important to follow the  accounting rules when preparing financial statements than actually  reporting the economic substance of the transaction.
section_title: Considerations for Moving toward a Comprehensive Financial Reporting Model
paragraphs: Participants generally agreed that financial statements are not designed to  serve all business needs and that other types of business reporting are  needed to assist investors and other users in making decisions. Participants  also generally agreed that the demand side (investors and other users of  financial information), has not been as involved as it needs to be to make  financial reporting more meaningful and understandable. More needs to be  done to convince investors and other users to demand different reporting.  Voluntary disclosures are rare and only in industries that demand this type  of information. The voluntary process has resulted in some movement  toward better reporting, but it is very slow moving. Change is going to have  to come from the demand side and is going to require a lot of leadership  from very influential people. Input from advisory councils may also be  beneficial for developing a broader business reporting model. While it is  essential that a new model not be driven totally by the supply side  (accountants, regulators, corporate management, and boards of directors),  there cannot be a disconnect between the supply and demand sides.
Participants also cautioned that we need to move forward patiently toward  a new comprehensive reporting model. It was viewed that forward, real- time, qualitative information, all of which would be helpful in predicting  future cash flows, may require a safe harbor from liability. It is also  important to keep in mind the role of the regulator in this process since the  public needs to have confidence in the regulators to enforce rules.  Regulators may not be totally supportive of a more comprehensive  business model because they are concerned that the information would be  based on a lot of judgment and, therefore, lack of precision, which could  make enforcement of reporting standards difficult.
Participants discussed the lack of investor confidence in the current  financial reporting model and the need to first improve the reliability of  financial reporting before adding any new reporting. First, get the basics  right, that is, the “blocking and tackling” of financial reporting. Participants  cited accounting for pensions, postemployment benefits, and pro-forma  financial statements as examples of accounting treatments that need  attention before building on any new reporting requirements. Issuers of  financial statements who are inappropriately bending the current  accounting rules need to know they cannot get away with this anymore.
Participants discussed the merits of replacing accounting rules with  principle-based standards to promote more substance versus form in  reporting. However, some participants cautioned that principle-based  standards should not be viewed as a panacea to solve the problems with  financial reporting and could lead to an undesirable situation where you  would not have comparability or agreement as to the treatment of similar  transactions. Also, stakeholders may not interpret principles consistently,  and it is important for stakeholders to have the same conceptual  framework as preparers when interpreting a principle. In addition, you  would need the right kind of implementation guidance to carry out a  principle. Participants agreed that while accounting rules are also needed,  there should not be such blind adherence to accounting rules to result in  reporting form over substance. Participants offered that an “artful” blend of  both principles and rules would be useful. The Employee Retirement  Income Security Act (ERISA) was cited as an example of an approach that  blended both a principles-based (general fiduciary standards) and rules- based (prohibited transactions) approach to an important issue (retirement  security).
Participants also discussed the idea of exploring different levels or layers  of reporting while still having full disclosure. Such layering will allow users  to get only the information they need. For example, the basic level of  reporting would include performance and risk data, an industry layer could  include benchmarking information, and a company specific layer could  include information management feels it is appropriate to disclose that is  not contained in other layers of reporting. Along with this idea is the need  to explore different levels of verification or assurances by independent  parties based on the users’ need for such verification or assurances. For  example, what type of assurances are needed for nonfinanical information  and can auditors provide such assurances? Overall, it is critical to get the  demand side (investors and other users of financial information) to weigh  in on what information they need and want. It is not realistic to only expect  the supply side (accountants, regulators, and corporate management and  boards of directors) to come up with the best solutions for improving the  financial reporting model.
Although time did not permit its discussion, financial literacy was raised as  an important issue that needs addressing. Participants agreed that there  clearly is a need for more education and for investor assistance in this area.
section_title: The Accounting Profession
subsections: section_title: An Expectation Gap Exists Concerning the Role of Auditing
paragraphs: The participants discussed the auditor’s responsibility for detecting fraud  and the meaning of the assurances provided by the auditor’s report on the  financial statements. These issues have continued to plague the accounting  profession since the 1970s despite actions taken by the profession to  narrow the so-called “expectation gap” between what the public expects or  needs and what auditors can and should reasonably be expected to  accomplish. Users often equate a clean audit opinion with a seal of  approval that fraud does not exist and annual reports are both complete  and accurate. However, auditors do not provide absolute assurance and the  scope of the opinion is limited to certain financial-related information. One  participant explained that there are a lot of things an audit cannot do. For  example, an audit cannot create certainty in an environment where there is  no certainty. An audit cannot guarantee precision in an environment where  estimates are made. An audit cannot ensure that stock prices will be  achieved. We cannot lose sight of the fact that in a risk-taking environment  businesses do fail. Auditing is not the “be all” and “end all” to solve the  problems in the business place. However, participants generally agreed that  while the accounting profession needs to take additional steps to address  any misunderstanding as to the limits of an audit, there is room to improve  the audit process and auditor reporting.
Participants recognized that management has the responsibility for  preventing and detecting fraud. At the same time, they agreed that it is fair  to expect auditors to provide “reasonable assurance” of detecting any  material fraud. Participants discussed the need to mitigate the opportunity  and risk for fraud by educating boards of directors and ultimately changing  the tone at the top of the company. Some participants liked the idea of  auditors periodically performing more of a “forensic-type” audit in which  auditors would be more skeptical of management, but cautioned that this  approach could have a negative effect on audit quality because  management and the auditor might not work as actively together on an  ongoing basis. Participants agreed that an adversarial relationship between  the auditor and management would not be constructive in that the  cooperation of management is critical to both an effective and efficient  audit. However, participants agreed that auditors should be more skeptical  and should say no and walk away from clients more often than they  currently do. The participants applauded the deterrent put in place by the  Sarbanes-Oxley Act of 2002, which sends a signal that persons who prepare  or attest to fraudulent financial statements can go to jail. This deterrent has  raised awareness and conscientiousness within all levels of the financial  reporting and auditing process as to the significance of their job in  preparing financial statements.
Participants generally viewed the new internal control reporting  requirements of the Sarbanes-Oxley Act of 2002 as a good requirement. A  participant added that earlier mandatory internal control reporting  probably would have surfaced problems with ineffective boards of  directors and audit committees. However, participants cautioned that  reporting only on internal controls over financial reporting could lead to  more of a gap in what investors perceive as the scope of the auditor’s work.  For example, users of financial reports are interested in a company’s  overall performance and outlook and, accordingly, would be interested in  the effectiveness of internal control over the process that produces that  data. In that respect, participants also discussed the need for auditors to  expand their focus on internal control to include controls over  performance data in order to better meet the needs of investors for  assurances on financial statements and for understanding all business  risks. Also, new information not only needs to be useful, but also needs to  be understood by investors. For example, investors do not understand  terminology such as “reportable conditions,” which could result in  investors over- or under-reacting to problems. Participants also suggested  that the one-page audit opinion should be replaced with “tiered” reporting  of audit results, where firms can obtain the level of assurance they desired.  For example, in today’s environment, audit committees would most likely  ask for the deepest “tier” of audit reporting to better carry out their  responsibilities.
Participants generally agreed that the profession needs a new reporting  model for audits to eliminate the misunderstanding as to what an audit of  financial statements is and what its limits are. The participants  acknowledged that the financial audit process is largely driven by the  accounting profession and suggested that the profession needs to spend  more time understanding what the demand side (investors and other users  of financial information) needs and wants from auditors. However, the  participants recognized that one of the big obstacles for innovation in  reforming the audit process and auditor reporting is the auditor’s fear of  legal liability. One participant added that the current regulatory structure  has dampened the profession’s spirit for innovation.
section_title: More Attention Is Needed on the Quality of Audits
paragraphs: Participants commented that there are good solid audits being performed;  however, some participants expressed concern that overall, time and fee  pressures both from company management and from within the auditing  firms have resulted in less and less auditing, particularly less substantive  testing of transactions. In that respect, the financial audit is considered the  “loss leader” in many audit organizations with a focus on cutting hours and  costs and as a means to obtain consulting engagements. Some participants  also pointed out that most of the auditing is currently being performed by  inexperienced auditors. Further, several participants cautioned that the  auditor rotation rules currently being developed by the regulators could  further reduce audit quality by resulting in a loss of continuity, experience,  and technical knowledge on an audit.
Participants felt that the profession needs to elevate and restore the  importance and the quality of the financial statement audit. Participants  stated that the accounting profession needs to candidly discuss what it is  doing to improve the audit process to restore public trust. Further, a  growing concern for the profession is its ability to attract and retain the  best people over time. It was stated that auditors frequently leave the  profession early in their careers to join clients, and that over half of CPAs  are not practicing public accounting. One participant added that the  interest in the profession over the past 10 years has dropped by half,  although the recent publicity stemming from Enron and WorldCom, albeit  negative, has actually sparked increased interest in the profession.  Participants generally agreed that the profession needs to aggressively  address the issue of attracting the best people to the profession.
section_title: Auditors Need to Strengthen Their Relationship with Others in the Corporate Governance Process
paragraphs: Participants generally agreed that improvements in corporate governance  will bring about improvements in auditing. It was viewed that one of the  more positive outcomes of the Sarbanes-Oxley Act of 2002 is the  relationship the act establishes between the auditor and audit committee  by making the audit committee in essence the client, versus company  management. Historically, participants felt that auditor communication  with audit committees has been variable. Participants generally agreed that  auditors should be able to speak more freely, openly, and honestly with  audit committees on risks facing the company and on the appropriateness  of the company’s accounting policies. Audit committees should be  demanding more information from auditors and asking auditors if they  have sufficient resources, both in number and expertise, to adequately  perform the audit. Audit committees and auditors together can become  good safeguards for investors. A point was also made that the role of the  internal auditors, specifically their cooperation and coordination with the  external auditors and the board of directors, should be improved, which  ultimately could improve the quality of financial reporting and the external  audit. In addition, disclosures, such as those required to be reported to the  SEC on Form 8-K, should be improved to be more transparent and helpful  to regulators in determining the reasons and circumstances surrounding  auditor changes.
section_title: Regulation and Enforcement
subsections: section_title: Providing the SEC with Sufficient Resources to Restore Investor Confidence
paragraphs: Participants uniformly agreed that the nation needs a strong, viable SEC to  instill investor confidence in our markets. The SEC plays an important role  through its responsibilities to regulate activities of public companies and  their auditors and to conduct related enforcement actions, as well as to  establish and sustain the new Public Company Accounting Oversight Board  (PCAOB) established by the Sarbanes-Oxley Act of 2002 until the PCAOB is  certified by the SEC as ready to operate. However, participants noted the  SEC may not have been provided with sufficient resources to achieve such  results. For example, participants stated that the SEC has recently been  operating on a budget of about $450 million. It was noted that although  the Senate authorized about $750 million for the SEC for fiscal year 2003,  an amount that the Senate believed would be sufficient to implement  provisions of the Sarbanes-Oxley legislation to restore investor confidence,  the Office of Management and Budget only proposed a funding level of  about $500 million.
Participants believed that a lack of sufficient funding provides constraints  in two areas that are vital to the SEC—staffing and technology. To carry out  its important function of restoring investor confidence, the SEC may not  always be able to attract the right people and retain them under the existing  structure. In addition, to effectively conduct its reviews of public  companies, the SEC will require a large technology investment and related  training of SEC staff. Participants questioned whether, given the current  funding restraints, existing models for generating revenues for the SEC  were workable. Participants believe that models that provide temporary  resources to SEC, such as through fellowships from the accounting  profession, are not the answer to its funding and staffing problems and can  raise conflict of interest issues. Accordingly, some participants believed  that it is time to think about having the SEC operate independently in  setting its own funding levels, like the Federal Reserve, and to let the SEC  determine and set its own fees, with industry participation, for the  activities it conducts. If the SEC were able to establish its own annual  budget and collect fees, the SEC would be better able to conduct its  activities, attract the best people, and enhance its technology to more  efficiently and effectively operate. Participants noted that even if the SEC  were independent regarding its funding, the Congress could still oversee  the SEC.
section_title: Reconsidering the Existing Approach to Enforcement Actions to Restore Public Confidence
paragraphs: Participants discussed the importance of effective SEC enforcement  actions as a means of restoring investor confidence in the markets. The  SEC tries to create deterrence and be measured in imposing sanctions. If  there are no clear negative consequences to securities violations or  wrongdoing, investors may perceive that the system is not working  properly. Although the SEC has an array of sanctions available, all SEC  enforcement actions are civil based, which ultimately results in  shareholders bearing the burden of the costs of legal proceedings and  sanctions. Some participants believed that shareholders were benefiting  from litigation and questioned the appropriateness of civil-based  enforcement actions, citing the fact that shareholders have already been  financially hurt by the actions that lead to the sanctions. Participants also  discussed whether the right people were being held accountable and  whether the SEC’s civil-based enforcement actions were sufficient to  discourage the bad actors.
Participants raised questions about whether the SEC should reconsider the  amount and targeting of its civil sanctions and more frequently use other  types of remedies, such as criminal sanctions, to hold people accountable  for wrongdoing. In that respect, participants noted that the SEC should be  effectively using the option of referring cases when appropriate to the  Department of Justice for investigation for possible violation of criminal  statues. Participants questioned how well that process was working.
The Sarbanes-Oxley Act of 2002 provides for additional enforcement  authority for both the SEC and the newly created PCAOB. In response to  the question of whether the Sarbanes-Oxley Act of 2002 should be revisited,  participants believed that although ultimately some technical changes to  the act may be necessary, the SEC and the PCAOB needed to move forward  to implement the act. Also, the SEC and the PCAOB should explore  integrating their activities to get the new enforcement mechanisms in place  to determine how well they may address some of the issues discussed.
section_title: Establishing Priorities for the PCAOB
paragraphs: Participants believed that the PCAOB needs to be quickly set up and  establish its priorities so it can begin the difficult task of restoring public  confidence. Many participants believed that the PCAOB's most immediate  priority should be implementing a disciplinary process to let the public  know that failed auditing will be dealt with and trust can be restored. The  disciplinary process needs to have the necessary incentive measures to  serve as preventative measures before problems can become more serious.  Other immediate priorities should be setting up an inspection function of  auditors that audit SEC registrants and determining how standards that  govern the work of the accounting profession, such as auditor  independence rules and standards for conducting audits, should be set.  Some participants believed that the existing inspection process could be  improved by looking less at the accounting firms’ internal systems for  quality control and more at the quality of the judgments that were made by  the auditors in conducting the audit.
Participants also believed that the PCAOB also needs to evaluate the events  that have lead to the lack of public confidence in the markets and take a  fresh look going forward. For example, the PCAOB should consider the  reasons the accounting profession is organized the way it is, including  federal/state regulation such as the licensing structure, reasons accounting  firms practice as partnerships, the effects of private litigation, and the  structure and role of the state boards of accountancy. Participants also  noted that the PCAOB should take advantage of the fact that under the  current environment no one has more motivation for getting “bad auditors  off the street” than the accounting firms themselves. The accounting firms  do remove “bad auditors,” but this is accomplished without publicity so  that their efforts are not well known.
Participants also believed that a challenge facing the new PCAOB will be  dealing with the complex relationship between federal and state  governments involved in regulating the accounting profession.  Participants identified the need for better communication and sharing of  information between federal entities such as the SEC and the new PCAOB  and the state licensing and regulating entities. For example, states are often  hampered in their ability to take appropriate regulatory actions because  they do not get referrals from the SEC and the AICPA, or because those  organizations have made the information confidential. Also, ongoing  litigation impedes information flow. In addition, participants stated that  some states have been independently trying to address accountancy reform  and, in some cases, have proposed reforms that have gone further than the  Sarbanes-Oxley Act of 2002 because they feared that the federal  government would not act. This has led to additional inconsistency in  requirements between states.
Participants encouraged the SEC and the PCAOB to work closely with the  states in taking actions to restore public confidence and ensure an  appropriate degree of consistency needed for viable interstate commerce.  Some participants suggested that the PCAOB consider the banking industry  to provide examples of the integration of federal and state regulation and  lessons learned about that structure from the savings and loan and banking  crises. Participants noted that with increased globalization of businesses’  operations and the need for harmonization of accounting and auditing  standards, as well as the need for preemptive measures, there may be more  federal involvement such as the Sarbanes-Oxley Act of 2002.
section_title: GAO’s Governance and Accountability Forum
subsections: section_title: Participants
paragraphs: Gaston L. Gianni, Jr.
A.W. “Pete” Smith Jr.
section_title: GAO’s Mission
paragraphs: The General Accounting Office, the investigative arm of Congress, exists to  support Congress in meeting its constitutional responsibilities and to help improve  the performance and accountability of the federal government for the American  people. GAO examines the use of public funds; evaluates federal programs and  policies; and provides analyses, recommendations, and other assistance to help  Congress make informed oversight, policy, and funding decisions. GAO’s  commitment to good government is reflected in its core values of accountability,  integrity, and reliability.
section_title: Obtaining Copies of GAO Reports and Testimony
paragraphs: The fastest and easiest way to obtain copies of GAO documents at no cost is  through the Internet. GAO’s Web site (www.gao.gov) contains abstracts and full- text files of current reports and testimony and an expanding archive of older  products. The Web site features a search engine to help you locate documents  using key words and phrases. You can print these documents in their entirety,  including charts and other graphics.
Each day, GAO issues a list of newly released reports, testimony, and  correspondence. GAO posts this list, known as “Today’s Reports,” on its Web site  daily. The list contains links to the full-text document files. To have GAO e-mail this  list to you every afternoon, go to www.gao.gov and select “Subscribe to daily E-mail alert for newly released products” under the GAO Reports heading.
subsections: section_title: Order by Mail or Phone
section_title: To Report Fraud, Waste, and Abuse in Federal Programs
section_title: Public Affairs