[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]



 
    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/
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                    COMMITTEE ON ENERGY AND COMMERCE

               W.J. ``BILLY'' TAUZIN, Louisiana, Chairman

MICHAEL BILIRAKIS, Florida           JOHN D. DINGELL, Michigan
JOE BARTON, Texas                    HENRY A. WAXMAN, California
FRED UPTON, Michigan                 EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida               RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio                RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania     EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California          FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia                 SHERROD BROWN, Ohio
STEVE LARGENT, Oklahoma              BART GORDON, Tennessee
RICHARD BURR, North Carolina         PETER DEUTSCH, Florida
ED WHITFIELD, Kentucky               BOBBY L. RUSH, Illinois
GREG GANSKE, Iowa                    ANNA G. ESHOO, California
CHARLIE NORWOOD, Georgia             BART STUPAK, Michigan
BARBARA CUBIN, Wyoming               ELIOT L. ENGEL, New York
JOHN SHIMKUS, Illinois               TOM SAWYER, Ohio
HEATHER WILSON, New Mexico           ALBERT R. WYNN, Maryland
JOHN B. SHADEGG, Arizona             GENE GREEN, Texas
CHARLES ``CHIP'' PICKERING,          KAREN McCARTHY, Missouri
Mississippi                          TED STRICKLAND, Ohio
VITO FOSSELLA, New York              DIANA DeGETTE, Colorado
ROY BLUNT, Missouri                  THOMAS M. BARRETT, Wisconsin
TOM DAVIS, Virginia                  BILL LUTHER, Minnesota
ED BRYANT, Tennessee                 LOIS CAPPS, California
ROBERT L. EHRLICH, Jr., Maryland     MICHAEL F. DOYLE, Pennsylvania
STEVE BUYER, Indiana                 CHRISTOPHER JOHN, Louisiana
GEORGE RADANOVICH, California        JANE HARMAN, California
CHARLES F. BASS, New Hampshire
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska

                  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                 EDOLPHUS TOWNS, New York
  Vice Chairman                      DIANA DeGETTE, Colorado
ED WHITFIELD, Kentucky               LOIS CAPPS, California
BARBARA CUBIN, Wyoming               MICHAEL F. DOYLE, Pennsylvania
JOHN SHIMKUS, Illinois               CHRISTOPHER JOHN, Louisiana
JOHN B. SHADEGG, Arizona             JANE HARMAN, California
ED BRYANT, Tennessee                 HENRY A. WAXMAN, California
STEVE BUYER, Indiana                 EDWARD J. MARKEY, Massachusetts
GEORGE RADANOVICH, California        BART GORDON, Tennessee
CHARLES F. BASS, New Hampshire       PETER DEUTSCH, Florida
JOSEPH R. PITTS, Pennsylvania        BOBBY L. RUSH, Illinois
GREG WALDEN, Oregon                  ANNA G. ESHOO, California
LEE TERRY, Nebraska                  JOHN D. DINGELL, Michigan,
W.J. ``BILLY'' TAUZIN, Louisiana       (Ex Officio)
  (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)

  







    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. All market participants benefit from 
approved accounting standards and meaningful disclosure. 
Counterparts can better understand 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.
    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 misapplied, 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 long-lived assets; 
and the issuance of a report that encourages companies 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 statements. 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.
    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-to-market 
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 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:]
   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 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.

    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.
    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. Private-sector 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 
principle-based, 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 convergence 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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \2\ See, 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).
---------------------------------------------------------------------------
    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), subject 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.
                          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. Rule-based 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 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 
private-sector 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. 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 purpose 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 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
---------------------------------------------------------------------------
    \1\ Letter from Federal Reserve System Chairman Alan Greenspan to 
SEC Chairman Arthur Levitt (June 4, 1998).
---------------------------------------------------------------------------
    Some of the FASB's significant activities during 2001 included the 
following:

 Issuance of a standard that improved the transparency of 
        business combinations.2
---------------------------------------------------------------------------
    \2\ See FASB Statement No. 141, Business Combinations (June 2001).
---------------------------------------------------------------------------
 Issuance of a standard that improved the transparency of 
        purchased goodwill and intangible assets.3
---------------------------------------------------------------------------
    \3\ See FASB Statement No. 142, Goodwill and Intangible Assets 
(June 2001).
---------------------------------------------------------------------------
 Issuance of a standard that improved the transparency of asset 
        retirement obligations.4
---------------------------------------------------------------------------
    \4\ See FASB Statement No. 143, Accounting for Asset Retirement 
Obligations (June 2001).
---------------------------------------------------------------------------
 Issuance of a standard that improved the transparency of 
        impairment or disposal of long-lived assets.5
---------------------------------------------------------------------------
    \5\ See FASB Statement No. 144, Accounting for the Impairment or 
Disposal of Long-Lived Assets (August 2001).
---------------------------------------------------------------------------
 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
---------------------------------------------------------------------------
    \6\ See FASB Presents Financially Correct with Ben Stein (2001).
---------------------------------------------------------------------------
 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
---------------------------------------------------------------------------
    \7\ See Business Reporting Research Project, Steering Committee 
Report, Improving Business Reporting: Insights into Enhancing Voluntary 
Disclosures (2001).
---------------------------------------------------------------------------
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 Trustees-at-large who 
are not nominated by those organizations but are chosen by the sitting 
Trustees.
---------------------------------------------------------------------------
    \8\ See Attachment 1 for a list of the sponsoring organizations.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \9\ See Attachment 1 for a list of the current FAF Trustees.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \10\ See Attachment 2 for information about the Financial 
Accounting Standards Advisory Council.
---------------------------------------------------------------------------
    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 coordinate 
        their accounting-standard-setting roles with those of the FASB 
        with an eye toward streamlining certain activities.
---------------------------------------------------------------------------
    \11\ See Attachment 1 for information about the EITF.
---------------------------------------------------------------------------
 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.
---------------------------------------------------------------------------
    \12\ See Attachment 1 for information about the Board's agenda 
criteria.
---------------------------------------------------------------------------
 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.
---------------------------------------------------------------------------
    \13\ See 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.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \14\ See 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.''
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \15\ See FASB Statement No. 140, Accounting for Transfers and 
Servicing of Financial Assets and Extinguishments of Liabilities 
(September 2000).
---------------------------------------------------------------------------
 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
---------------------------------------------------------------------------
    \16\ See 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.''
---------------------------------------------------------------------------
 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
---------------------------------------------------------------------------
    \17\ See FASB Statement No. 107, Disclosures about Fair Value of 
Financial Instruments (December 1991).
---------------------------------------------------------------------------
 A reporting entity is required to disclose certain unrecorded 
        long-term obligations in its financial statements.18
---------------------------------------------------------------------------
    \18\ See FASB Statement No. 47, Disclosure of Long-Term Obligations 
(March 1981).
---------------------------------------------------------------------------
 A reporting entity is required to disclose indirect guarantees 
        of indebtedness of others in its financial 
        statements.19
---------------------------------------------------------------------------
    \19\ See FASB Interpretation No. 34, Disclosure of Indirect 
Guarantees of Indebtedness of Others (March 1981).
---------------------------------------------------------------------------
 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
---------------------------------------------------------------------------
    \20\ See FASB Statement No. 5, Accounting for Contingencies (March 
1975).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \21\ See 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).
    \22\ Transcript 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).
---------------------------------------------------------------------------
    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 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
---------------------------------------------------------------------------
    \23\ See 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.
    \24\ See Attachment 5 for a detailed listing of significant EITF 
issues related to special purpose entities and off-balance-sheet 
financial arrangements.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \25\ See FASB Statement No. 94, Consolidation of All Majority-Owned 
Subsidiaries (October 1987).
---------------------------------------------------------------------------
    The second major standard, issued in 1997, requires improved 
reporting of information about an entity's various operating 
segments.26
---------------------------------------------------------------------------
    \26\ See FASB Statement No. 131, Disclosures about Segments of an 
Enterprise and Related Information (June 1997).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \27\ See 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).
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \28\ See 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.

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 principal 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
---------------------------------------------------------------------------
    \29\ FASB Statement No. 57, Related Party Disclosures, paragraph 
24(f) (March 1982).
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \30\ One 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]).

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
---------------------------------------------------------------------------
    \31\ Statement 57, paragraph 2.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \32\ Statement 57, paragraphs 16 and 17.
---------------------------------------------------------------------------
     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 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
---------------------------------------------------------------------------
    \33\ See FASB Statement No. 115, Accounting for Certain Investments 
in Debt and Equity Securities (May 1993).
    \34\ See EITF Issue 98-10.
    \35\ See Statement 133.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    \36\ Statement 107, paragraph 5.
---------------------------------------------------------------------------
          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
---------------------------------------------------------------------------
    \37\ Statement 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.''
---------------------------------------------------------------------------
    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
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    \38\ Transcript of hearing, page 22.
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    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
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    \39\ Transcript of hearing, page 22.
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    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
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    \40\ Transcript of hearing, page 22.
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   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 receivable 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
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    \41\ See 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.''
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    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 quarters 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 financial 
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
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    \42\ Written statement by Lynn Turner in testimony before the 
Committee on Governmental Affairs, United States Senate, page 3 
(January 24, 2002).
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    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
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    \43\ William 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).
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    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
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    \44\ Powers Report, page 4.
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    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
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    \45\ Powers Report, page 4.
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    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
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    \46\ Powers Report, page 17.
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                               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
 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
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    \47\ The Royal Swedish Academy of Sciences, ``The Prize in Economic 
Sciences 2001,'' press release (October 10, 2001).
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    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, 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.
    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 business 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.
    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.
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    \1\ AICPA Special Committee on Financial Reporting, Improving 
Business Reporting--A Customer Focus, 1994.
---------------------------------------------------------------------------
    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
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    \2\A 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.
    \3\ GAO, The Accounting Profession: Major Issues: Progress and 
Concerns, GAO/AIMD-96-98, September 1996,p.16.
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    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 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
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    \4\ Statement 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).
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    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.
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    \5\ Available at the FASB's website: http://www.fasb.org.
    \6\ Wayne 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.
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                             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. 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.
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    \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.
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           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 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 non-financial 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 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.
    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 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 accountants 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, 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 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 
documentation 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.
    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 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 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 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.
    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.
    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?
    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 self-regulation 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?
    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 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 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 various 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.
    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 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.
    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 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.
    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?
    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.
    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.

   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 re-examination 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.
    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 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 sponsoring 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-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 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 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 investors?'', 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 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 short-
term 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.
   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.
    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 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, 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----
    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.]
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